The Atlanta Fed's macroblog provides commentary on economic topics including monetary policy, macroeconomic developments, financial issues and Southeast regional trends.

Authors for macroblog are Dave Altig and other Atlanta Fed economists.

January 31, 2014

A Brief Interview with Sergio Rebelo on the Euro-Area Economy

Last month, we at the Atlanta Fed had the great pleasure of hosting Sergio Rebelo for a couple of days. While he was here, we asked Sergio to share his thoughts on a wide range of current economic topics. Here is a snippet of a Q&A we had with him about the state of the euro-area economy:

Sergio, what would you say was the genesis of the problems the euro area has faced in recent years?

The contours of the euro area’s problems are fairly well known. The advent of the euro gave peripheral countries—Ireland, Spain, Portugal, and Greece—the ability to borrow at rates that were similar to Germany's. This convergence of borrowing costs was encouraged through regulation that allowed banks to treat all euro-area sovereign bonds as risk free.

The capital inflows into the peripheral countries were not, for the most part, directed to the tradable sector. Instead, they financed increases in private consumption, large housing booms in Ireland and Spain, and increases in government spending in Greece and Portugal. The credit-driven economic boom led to a rise in labor costs and a loss of competitiveness in the tradable sector.

Was there a connection between the financial crisis in the United States and the sovereign debt crisis in the euro area?

Simply put, after Lehman Brothers went bankrupt, we had a sudden stop of capital flows into the periphery, similar to that experienced in the past by many Latin American countries. The periphery boom quickly turned into a bust.

What do you see as the role for euro area monetary policy in that context?

It seems clear that more expansionary monetary policy would have been helpful. First, it would have reduced real labor costs in the peripheral countries. In those countries, the presence of high unemployment rates moderates nominal wage increases, so higher inflation would have reduced real wages. Second, inflation would have reduced the real value of the debts of governments, banks, households, and firms. There might have been some loss of credibility on the part of the ECB [European Central Bank], resulting in a small inflation premium on euro bonds for some time. But this potential cost would have been worth paying in return for the benefits.

And did this happen?

In my view, the ECB did not follow a sufficiently expansionary monetary policy. In fact, the euro-area inflation rate has been consistently below 2 percent and the euro is relatively strong when compared to a purchasing-power-parity benchmark. The euro area turned to contractionary fiscal policy as a panacea. There are good theoretical reasons to believe that—when the interest rate remains constant that so the central bank does not cushion the fall in government spending—the multiplier effect of government spending cuts can be very large. See, for example, Gauti Eggertsson and Michael Woodford, “The Zero Interest-rate Bound and Optimal Monetary Policy,” and Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo, "When Is the Government Spending Multiplier Large?

Theory aside, the results of the austerity policies implemented in the euro area are clear. All of the countries that underwent this treatment are now much less solvent than in the beginning of the adjustment programs managed by the European Commission, the International Monetary Fund, and the ECB.

Bank stress testing has become a cornerstone of macroprudential financial oversight. Do you think they helped stabilize the situation in the euro area during the height of the crisis in 2010 and 2011?

No. Quite the opposite. I think the euro-area problems were compounded by the weak stress tests conducted by the European Banking Association in 2011. Almost no banks failed, and almost no capital was raised. Banks largely increased their capital-to-asset ratios by reducing assets, which resulted in a credit crunch that added to the woes of the peripheral countries.

But we’re past the worst now, right? Is the outlook for the euro-area economy improving?

After hitting the bottom, a very modest recovery is under way in Europe. But the risk that a Japanese-style malaise will afflict Europe is very real. One useful step on the horizon is the creation of a banking union. This measure could potentially alleviate the severe credit crunch afflicting the periphery countries.

Thanks, Sergio, for this pretty sobering assessment.

John RobertsonBy John Robertson, a vice president and senior economist in the Atlanta Fed’s research department

Editor’s note: Sergio Rebelo is the Tokai Bank Distinguished Professor of International Finance at Northwestern University’s Kellogg School of Management. He is a fellow of the Econometric Society, the National Bureau of Economic Research, and the Center for Economic Policy Research.

January 31, 2014 in Banking, Capital and Investment, Economics, Europe, Interest Rates, Monetary Policy | Permalink


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November 20, 2013

The Shadow Knows (the Fed Funds Rate)

The fed funds rate has been at the zero lower bound (ZLB) since the end of 2008. To provide a further boost to the economy, the Federal Open Market Committee (FOMC) has embarked on unconventional forms of monetary policy (a mix of forward guidance and large-scale asset purchases). This situation has created a bit of an issue for economic forecasters, who use models that attempt to summarize historical patterns and relationships.

The fed funds rate, which usually varies with economic conditions, has now been stuck at near zero for 20 quarters, damping its historical correlation with economic variables like real gross domestic product (GDP), the unemployment rate, and inflation. As a result, forecasts that stem from these models may not be useful or meaningful even after policy has normalized.

A related issue for forecasters of the ZLB period is how to characterize unconventional monetary policy in a meaningful way inside their models. Attempts to summarize current policy have led some forecasters to create a "virtual" fed funds rate, as originally proposed by Chung et al. and incorporated by us in this macroblog post. This approach uses a conversion factor to translate changes in the Fed's balance sheet into fed funds rate equivalents. However, it admits no role for forward guidance, which is one of the primary tools the FOMC is currently using.

So what's a forecaster to do? Thankfully, Jim Hamilton over at Econbrowser has pointed to a potential patch. However, this solution carries with it a nefarious-sounding moniker—the shadow ratewhich calls to mind a treacherous journey deep within the hinterlands of financial economics, fraught with pitfalls and danger.

The shadow rate can be negative at the ZLB; it is estimated using Treasury forward rates out to a 10-year horizon. Fortunately we don't need to take a jaunt into the hinterlands, because the paper's authors, Cynthia Wu and Dora Xia, have made their shadow rate publicly available. In fact, they write that all researchers have to do is "...update their favorite [statistical model] using the shadow rate for the ZLB period."

That's just what we did. We took five of our favorite models (Bayesian vector autoregressions, or BVARs) and spliced in the shadow rate starting in 1Q 2009. The shadow rate is currently hovering around minus 2 percent, suggesting a more accommodative environment than what the effective fed funds rate (stuck around 15 basis points) can deliver. Given the extra policy accommodation, we'd expect to see a bit more growth and a lower unemployment rate when using the shadow rate.

Before showing the average forecasts that come out of our models, we want to point out a few things. First, these are merely statistical forecasts and not the forecast that our boss brings with him to FOMC meetings. Second, there are alternative shadow rates out there. In fact, St. Louis Fed President James Bullard mentioned another one about a year ago based on work by Leo Krippner. At the time, that shadow rate was around minus 5 percent, much further below Wu and Xia's shadow rate (which was around minus 1.2 percent at the end of last year). Considering the disagreement between the two rates, we might want to take these forecasts with a grain of salt.

Caveats aside, we get a somewhat stronger path for real GDP growth and a lower unemployment rate path, consistent with what we'd expect additional stimulus to do. However, our core personal consumption expenditures inflation forecast seems to still be suffering from the dreaded price-puzzle. (We Googled it for you.)

Perhaps more important, the fed funds projections that emerge from this model appear to be much more believable. Rather than calling for an immediate liftoff, as the standard approach does, the average forecast of the shadow rate doesn't turn positive until the second half of 2015. This is similar to the most recent Wall Street Journal poll of economic forecasters, and the September New York Fed survey of primary dealers. The median respondent to that survey expects the first fed funds increase to occur in the third quarter of 2015. The shadow rate forecast has the added benefit of not being at odds with the current threshold-based guidance discussed in today's release of the minutes from the FOMC's October meeting.

Moreover, today's FOMC minutes stated, "modifications to the forward guidance for the federal funds rate could be implemented in the future, either to improve clarity or to add to policy accommodation, perhaps in conjunction with a reduction in the pace of asset purchases as part of a rebalancing of the Committee's tools." In this event, the shadow rate might be a useful scorecard for measuring the total effect of these policy actions.

It seems that if you want to summarize the stance of policy right now, just maybe...the shadow knows.

Photo of Pat HigginsBy Pat Higgins, senior economist, and


Photo of Brent MeyerBrent Meyer, research economist, both of the Atlanta Fed's research department

November 20, 2013 in Fed Funds Futures, Federal Reserve and Monetary Policy, Forecasts, Interest Rates, Monetary Policy | Permalink


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'The shadow rate ... is estimated using Treasury forward rates out to a 10-year horizon.'

The Wu-Xia paper mentions forward rates, but it also describes a three-factor model incorporating 97 different macro series.

Since June 2013, the shadow policy rate has declined from -0.80% to a series-low -1.98%, while forward rates have been rising.

Is this sharp decline in the shadow policy rate due to changes in the macro series (e.g. accelerating GDP growth, to name one example), changes in forward rates, or both?

Posted by: Jim Haygood | January 13, 2014 at 04:45 PM

This has to be wrong, or a bad construct. Any full forward rate measure shows positive rates until you get to the far end of the yield curve.

Posted by: David Merkel | March 16, 2015 at 05:56 AM

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May 23, 2012

The three faces of postcrisis monetary policy

The latest edition of the San Francisco Fed's Economic Letter (written by Michael Bauer)has a nice review of the different channels through which the Fed's Large Scale Asset Purchase (LSAP) programs—QE, or quantitative easing more popularly—are thought to work:

"Central bank LSAPs potentially may affect interest rates through at least three channels. Notably, all three channels can broadly affect longer-term interest rates, extending beyond those securities that the central bank announces it will purchase:

  • A portfolio balance channel, because the supply of long-maturity bonds available to private investors is reduced. The reduced supply of longer-term securities targeted by the Fed lowers the amount of interest rate risk in investor portfolios. That in turn decreases the risk premium that they require to hold both the targeted securities and other assets of similar duration. Longer-term interest rates are lowered across the board as a result. Gagnon et al (2011) emphasize this channel for QE1.
  • A signaling channel, which arises when the Fed's announcements are interpreted as signals of its intent to hold down short-term interest rates further into the future. Bauer and Rudebusch (2011) argue that this channel played an important role for QE1.
  • A market functioning channel, because QE1 provided relief when conditions in financial markets were dire, liquidity very low, and panic widespread. The Fed's intervention calmed investor fears. Thus, the intervention substantially supported a range of asset prices, including MBS and corporate bonds, lowering their yields."

The article references include links to the Gagnon et al. paper and the Bauer and Rudebusch paper, but none to any studies addressing the "market functioning channel." So I'll provide one: "Did the Federal Reserve's MBS Purchase Program Lower Mortgage Rates?" by Diana Hancock and Wayne Passmore, both senior staff members for the Federal Reserve of Board of Governors. According to Hancock and Passmore, the market functioning channel is key to appreciating the impact of QE1:

"We use empirical pricing models for MBS yields in the secondary mortgage market and for mortgage rates paid by homeowners in the primary mortgage market to measure how distorted mortgage markets were prior to the Federal Reserve's intervention, and the course of market risk premiums during the restoration to normal market functioning...

"We argue that this return to normal pricing occurred because the Federal Reserve's announcement signaled a strong and credible government backing for mortgage markets in particular and for the financial system more generally...

"More specifically, we estimate that the Federal Reserve's MBS purchase program over the course of 16 months reestablished normal market pricing in the MBS market and resulted in lower mortgage rates of roughly 100 to 150 basis points for purchasing houses. Most of the decline in mortgage rates occurred between the announcement of the program, on November 25, 2008, and the implementation of the program in the first quarter of 2009. After this point, both mortgage rates and risk premiums remained relatively stable until the end of the Federal Reserve MBS purchase program."

Hancock and Passmore note that the portfolio balance channel may have played a role after the completion of the QE1 purchases once market functioning had normalized, but the biggest bang was that renormalization itself.

Bauer's observations align with Hancock and Passmore's conclusions:

"QE1 had very pronounced effects on interest rates. The key announcements led to decreases of close to one percentage point. The announcements not only lowered yields on targeted Treasury securities and MBS, but also on corporate bonds...

"The two other programs, QE2 and MEP [maturity extension program], also affected yields of securities that were not targeted for Fed purchases... Generally though, QE2 and MEP affected interest rates much less than QE1 did. One reason is that bond market functioning had largely returned to normal. In addition, expectations of future short-term interest rates were already very low when these programs were announced, leaving little room for further signaling effects. Finally, QE2 and MEP were smaller than QE1."

Earlier this week, in a speech delivered in Tokyo at the Institute of Regulation and Risk, Federal Reserve Bank of Atlanta President Dennis Lockhart provided his view on this evidence:

"In my view, these [the QE1] purchase programs played an important role in the transition away from the emergency lending facilities created earlier in the crisis. The emergency credit facilities worked well to stem the downward spiral of the immediate post-Lehman period. Financial markets began the process of repair during the first half of 2009 but were still suffering from relatively serious liquidity pressures. The QE1 operation sustained the liquidity support that had been previously provided by lending through the emergency facilities.

"Because asset purchases largely replaced emergency loans made during the crisis, the net increase in the Fed's balance sheet was relatively modest. In this sense, the quantitative easing label is misleading. The intent and effect of the policy was not to inject a new and sizable quantity of reserves into the economy. Rather, the effect was to sustain liquidity in still struggling and fragile financial markets, particularly those related to residential real estate. For that reason, I prefer the term ‘credit easing' to describe this policy action."

However, the smaller impact of QE2 leads Lockhart to a different conclusion regarding the largest contribution of that program:

"I view QE2 differently. The FOMC [Federal Open Market Committee] formally announced QE2 in November 2010, with its decision to purchase $600 billion in longer-term Treasury securities. However, the policy was signaled in an important speech from Federal Reserve Chairman Ben Bernanke in August of that year. The circumstances at the time were dominated by a falling trend in measured inflation, weakening inflation expectations, and rising probabilities of outright deflation. Each of these developments was effectively reversed as the expectations for QE2 took root, expectations that were ultimately validated by FOMC action.

"Unlike QE1, QE2 did materially expand the size of the Federal Reserve's balance sheet. In my view, this distinction is important. The intent and effect of the two rounds of asset purchases were different. QE1 served to maintain liquidity at a time when financial markets were exceptionally unsettled. In contrast, QE2 was a more traditional monetary action to preserve price stability."

In a sense, this places the effects of QE2 in the signaling channel category, albeit with an emphasis on inflation expectations rather than interest rates directly.

Bauer's article also covers post-QE2 policy—the maturity extension program (MEP, or "Operation Twist") and the insertion of specific calendar dates (currently at least late 2014) to provide forward guidance on the period of time that the FOMC anticipates that the federal funds rate will remain at exceptionally low levels. Lockhart also describes these policies in terms of the "signaling channel," though in these cases with interest rate effects front and center:

"In terms of intent and effect, I think of the explicit forward guidance and the MEP in similar terms. We have entered a phase of the recovery in which sustained monetary accommodation is warranted in order to preserve and advance what is still modest progress on employment and economic growth. Importantly, this modest progress is occurring in the context of what, for me, is acceptable performance with respect to our price stability mandate. Actions that reinforce the maintenance of policy accommodation are appropriate. It is through that lens that I view the MEP and explicit forward guidance on policy rates."

Lockhart's remarks provide his perspective on three somewhat distinct policy challenges—market dysfunction, disinflationary pressures, and a need to sustain monetary policy accommodation—that motivate his support for the three major policy initiatives of the postcrisis period:

"Let me summarize this brief tour of postcrisis monetary policy. I view the sequence of nontraditional monetary policy actions as tailored responses to the particular needs of the economy and financial system at the time they were implemented. My conclusion is that by and large policy actions have been appropriate to the diagnosis of circumstances at the time. And in my assessment they have worked pretty well."

In this light, President Lockhart delivers his policy punch line:

"I have reframed to some extent the original question of what more can be done around the point that policy actions must be matched to circumstances. The challenge policymakers face is judging appropriateness of a tool for circumstances. As popular as it might be in some quarters to rule out further LSAPs (QE3, as it is known), I do not think this option can be taken off the table. QE3 will work under the right circumstances. But I don't believe such circumstances prevail at this time."

David AltigBy Dave Altig, executive vice president and research director at the Atlanta Fed


May 23, 2012 in Federal Reserve and Monetary Policy, Interest Rates, Monetary Policy | Permalink


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"...places the effects of QE2 in the signaling channel category, albeit with an emphasis on inflation expectations rather than interest rates directly."

yep, also keep in mind:
1. if the Fed is credibly setting inflation expectations (inflation targeting) you cannot draw any conclusions about the output gap from inflation. Wages contracts are set based on expectations in the NK framework. The correct interpretation of the SF Fed letter (see below figure 2) is that for those with bargaining power, wage increases are based on expected inflation (about the mode of the non-zero wage increases).

Thus, a credible central bank targeting inflation will get it, regardless of the size of the output gap. (That's just the implication of the expectation-augmented Phillips curve)

2. now, lets talk about what are the right expectations to set (Figure 8):

nominal expectations!

3. "well, there is a lot of uncertainty about the output gap. " Yep: Orphanides 1999 paper actually tells you that under such uncertainty, ngdp targeting is superior and would have avoided the errors of the 1970s when we overestimated the output gap.

Posted by: dwb | May 23, 2012 at 06:33 PM

Will this really help the people?

Posted by: Tom Henry | June 12, 2012 at 05:28 AM

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January 06, 2012

In the interest of precision

As you may have heard, the minutes of the December 13 meeting of the Federal Open Market Committee (FOMC) contained the news that, starting with this month's meeting, committee members will be jointly publishing not only their personal projections for gross domestic product growth, unemployment, and inflation, but also the monetary policy assumptions that underlie those forecasts. In an article published earlier this week, the enhancement to these projections, known as the Summary of Economic Projections (SEP), was described in the Wall Street Journal this way (with my emphasis added):

"Federal Reserve officials this month will begin detailing their plans for short-term interest rates, a move that could show that the central bank's easy-money policies will remain in place for years and give the economy a boost."

A similar description appeared in the Journal yesterday (again, emphasis added):

"The Fed has just taken a historic step towards increasing its transparency and accountability by saying it will begin to release interest-rate projections several years out at the conclusion of its next policy meeting on Jan. 25. This means Fed officials will soon let the world know exactly what path they believe interest rates will follow—and they, after all, set the path of interest rates."

I added the emphasis in both of those passages because I think the highlighted language isn't quite right. Here is the actual language that appears in the FOMC minutes:

"In the SEP, participants' projections for economic growth, unemployment, and inflation are conditioned on their individual assessments of the path of monetary policy that is most likely to be consistent with the Federal Reserve's statutory mandate to promote maximum employment and price stability, but information about those assessments has not been included in the SEP.…

"… participants decided to incorporate information about their projections of appropriate monetary policy into the SEP beginning in January. Specifically, the SEP will include information about participants' projections of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP also will report participants' current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions."

The minutes are pretty clear about what this information is intended to convey…

"Most participants agreed that adding their projections of the target federal funds rate to the economic projections already provided in the SEP would help the public better understand the Committee's monetary policy decisions and the ways in which those decisions depend on members' assessments of economic and financial conditions."

…and what it is not intended to convey (here too, emphasis added):

"Some participants expressed concern that publishing information about participants' individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants' projections of the target federal funds rate as signaling the Committee's intention to follow a specific policy path rather than as indicating members' conditional projections for the federal funds rate given their expectations regarding future economic developments. Most participants viewed these concerns as manageable…"

In fact, the first Journal piece mentioned above does document some of the expressed concerns near the end of the article. For example:

"… some might mistakenly see the forecasts as an ironclad commitment, rather than a projection that could change as economy evolves."

That caveat does speak to concerns of some FOMC participants that the projections would establish a specific policy path. But the issue is about more than maintaining flexibility in the face of changing economic conditions. The broader point is that the new information in the SEPs, according to the minutes, is not intended to be a device for signaling the policy path that the FOMC, by official vote, intends to pursue.

This may seem like a small detail. But when it comes to the central bank's communications tools, even the small details matter.

David AltigBy Dave Altig, senior vice president and research director at the Atlanta Fed


January 6, 2012 in Fed Funds Futures, Federal Reserve and Monetary Policy, Interest Rates, Monetary Policy | Permalink


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It's a forecast of policy, notwithstanding a current conditional commitment to hold policy steady.

Tricky time for implementation.

Posted by: JKH | January 07, 2012 at 06:32 PM

A key unintended consequence of this will be that everyone will be able to see, by comparing the evolving history of forecasts-vs-subsequent data, which members of the FOMC are actually decent economic forecasters and which are charlatans.

This may not bode well for public faith in the Federal Reserve.

Posted by: Wisdom Seeker | January 10, 2012 at 07:52 PM

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September 30, 2011

Fed Treasury purchases: How big is big?

In his July 13 testimony to Congress, Federal Reserve Chairman Ben Bernanke discussed the large-scale asset purchase program to buy $600 billion of longer-term Treasury securities that started in November 2010 and was completed in June 2011. The chairman noted:

"The Federal Reserve's acquisition of longer-term Treasury securities boosted the prices of such securities and caused longer-term Treasury yields to be lower than they would have been otherwise. In addition, by removing substantial quantities of longer-term Treasury securities from the market, the Fed's purchases induced private investors to acquire other assets that serve as substitutes for Treasury securities in the financial marketplace, such as corporate bonds and mortgage-backed securities. By this means, the Fed's asset purchase program—like more conventional monetary policy—has served to reduce the yields and increase the prices of those other assets as well. The net result of these actions is lower borrowing costs and easier financial conditions throughout the economy."

Chairman Bernanke went on to observe in a footnote in his prepared remarks from that testimony:

"The Federal Reserve's recently completed securities purchase program has changed the average maturity of Treasury securities held by the public only modestly, suggesting that such an effect likely did not contribute substantially to the reduction in Treasury yields. Rather, the more important channel of effect was the removal of Treasury securities from the market, which reduced Treasury yields generally while inducing private investors to hold alternative assets (the portfolio reallocation effect). The substitution into alternative assets raised their prices and lowered their yields, easing overall financial conditions."

In a similar way, the maturity extension program—dubbed "Operation Twist" by some—announced by the Federal Open Market Committee last week is designed to further remove longer-term Treasury securities from the market, a move that, other things being equal, should put downward pressure on longer-term rates. Jim Hamilton at Econbrowser has taken a stab at estimating the effects and concludes that it is likely to be modest. Atlanta Fed President Dennis Lockhart shared a similar sentiment, described in more detail later in this posting, in a speech earlier this week.

So what share of outstanding marketable long-term Treasury securities (excluding those held to maturity on government accounts) does the Federal Reserve hold? The following chart shows that the Fed's share of marketable long-term securities with more than five years to maturity increased substantially as a result of the $600 billion asset purchase program between November 2010 and June 2011 (see the chart). This large run-up confirms the point made by Chairman Bernanke that this program removed a considerable supply of longer-term securities from the market (relative to what it would have been otherwise).

The new maturity extension program will replace $400 billion of shorter-dated Treasury securities that the Fed holds with an equal face-value amount of longer-term securities, and this move will further increase the Fed's relative holdings of marketable longer-term Treasury securities. As President Lockhart noted in his speech, the impact of this program cannot be known precisely, but he expects it to have a modest, positive influence:

"The Fed's maturity extension program and additional mortgage-backed securities purchases are meant to further ease financial conditions ceteris paribus, other things being equal. Of course, other things almost certainly will not stay equal, and other factors will influence what really happens to rates and spreads as policy intent encounters the real world….

"In my view, the maturity extension program along with the MBS purchases represents a measured, incremental attempt to add more support to the recovery. It's not a fix for everything that ails the economy, but it should help."

John Robertson By John Robertson, vice president and senior economist in the Atlanta Fed's research department


September 30, 2011 in Federal Reserve and Monetary Policy, Interest Rates, Monetary Policy | Permalink


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December 17, 2010

What's behind the recent rise in Treasury yields?

David Beckworth, who blogs at Macro and Other Market Musings, posted a comment regarding macroblog's post "What might monetary policy success look like?" from December 2. Beckworth's comment specifically mentioned this chart…

… as part of this question:

"How did you create the latter figure [shown above]? Using the Fed's own constant maturities series (for both the nominal and real yield), the figure I come up with is less impressive. It shows a turnaround in inflation expectations about the time QE2 is promoted by Fed officials, but then inflation expectations stall and remain far from the 'mandate-consistent inflation rate.'
"Here is a post where I placed one such graph."

And here's the graph of expected inflation from Beckworth's post:

The series shown in the Beckworth chart has a different economic meaning than the chart shown in the original macroblog post (as was suggested by another commentator to our earlier post).

The chart Beckworth shows in his referenced blog post is the five-year Treasury Inflation-Protected Securities (TIPS) spread (the difference in nominal and real Treasury yields at five-year maturities). And so when he states, "This figure shows average annual expected inflation over the next five years has been flatlining around 1.55% over most of November" it means just that: it's examining the next five-year period (2010–15). I've reposted below an updated version of this chart, along with the 10-year TIPS spread. Since Beckworth's comment on macroblog, the five-year TIPS spread has widened about 13 basis points, depending on the measure you're using.

The chart used in the December 2 macroblog post is a different measure altogether. It's the five-year/five-year forward break-even inflation rate—not the TIPS spread. This chart shows a measure of expected inflation in the five-year period beginning five years from now. So this chart shows what investors expect to be the cumulative change in the consumer price index beginning in November 2015 through November 2020. Put another way, it's the realized inflation that would provide an equivalent return to both the nominal Treasury securities and the real TIPS securities. An updated picture is provided below.

Thus we're talking about apples and oranges in two respects: (1) these two charts cover different periods (2010–15 versus 2015–20); and (2) the two calculations themselves are different (taking a simple nominal-real spread versus the 5-year/5-year forward calculation).

Now what's the point of all of this, besides highlighting the minutiae of measuring inflation expectations? Resurrecting Beckworth's question and answering it help illuminate the recent concern about increases in Treasury yields. Indeed, since the November Federal Open Market Committee (FOMC) meeting, longer-dated yields have risen considerably, with the 10-year bond's yield up 86 basis points, for example. But the recent movements in nominal and real yields can be placed in two categories: (A) from when the Federal Reserve began signaling consideration of further asset purchases (late August) to the November FOMC meeting, and (B) the post-November FOMC meeting period. In period A, nominal yields were relatively flat while real yields declined somewhat, indicating a healthy rise in inflation expectations from the lows seen this summer (this change is shown by the increase in the TIPS spreads and breakeven inflation rates during the period).  In period B, the rise in nominal yields has been primarily driven by a rise in real yields (not unanchored inflation expectations).

As Martin Wolf wrote in Tuesday's Financial Times on this issue, "To understand what is going on, we need to distinguish the role of shifts in real interest rates from that of shifts in inflation expectations." As is evident in the charts, and in one of Beckworth's most recent posts, real rates have risen alongside nominal rates—a sign that inflation expectations are now relatively stable.

By Andrew Flowers, senior economic research analyst in the Atlanta Fed's research department


December 17, 2010 in Deflation, Inflation, Interest Rates, Monetary Policy | Permalink


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Remember to check changes in CDS to see if any part of the change in real yields is due to a change in credit risk.

Posted by: tew | December 17, 2010 at 05:55 PM

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February 16, 2010

Do we need to rethink macroeconomic policy?

The aftermath of a crisis is always fertile ground for big thoughts. Big thinking is exactly what we get from Olivier Blanchard (the International Monetary Fund's director of research) and his colleagues Giovanni Dell'Aricca and Paolo Mauro, in their new overview of the financial crisis and what it means for how we think about and, more importantly, practice macroeconomic policy. Titled, appropriately enough, "Rethinking Macroeconomic Policy," one of the more provocative parts of their analysis was highlighted in the Wall Street Journal:

"Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.

"At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further."

Paul Krugman approves, as does Ken Houghton at Angry Bear, who concludes with this comment:

"None of the major Macro work ever done, from Barro forward, has ever found damage to economic growth from 4% inflation."

I suppose that the modifier "major" provides something of an escape clause, but as a general proposition there is at least some evidence that 2% is preferable to 4%. From the IMF itself, for example, there is this

"The threshold level of inflation above which inflation significantly slows growth is estimated at 1–3 percent for industrial countries and 11–12 percent for developing countries. The negative and significant relationship between inflation and growth, for inflation rates above the threshold level, is quite robust..."

… which confirms the results of an earlier IMF study:

"Our more detailed results may be summarized briefly. First, there are two important nonlinearities in the inflation-growth relationship. At very low inflation rates (around 2–3 percent a year, or lower), inflation and growth are positively correlated. Otherwise, inflation and growth are negatively correlated…"

To be sure, there are plenty of studies suggesting modest increases in the rate of inflation from the levels currently targeted by many central banks would not be problematic—here, for example. But the point is that the evidence is not clear cut that an increase from an average rate of inflation in the neighborhood of 2 percent to the neighborhood of 4 percent would be innocuous. And there is always this element, noted by John Taylor in the aforementioned Wall Street Journal article:

"John Taylor, a Stanford University monetary-policy specialist who served in the Bush administration Treasury department, says that inflation could become hard to constrain if the target is raised. 'If you say it's 4%, why not 5% or 6%?' Mr. Taylor said. 'There's something that people understand about zero inflation.' "

So, the issue comes down to whether the uncertain costs of raising the average inflation rate is justified by the goal of avoiding the zero bound. At Free Exchange, the blog of The Economist, there is some skepticism:

"… the value of avoiding the zero bound depends on the seriousness of the macroeconomic situation. From the vantage point of 2010, a higher target rate seems like a great idea, but economic crises this severe are rare events. Even if there are only small costs to a 3% target relative to a 2% target, they may not be worth the trouble if the goal is to avoid serious trouble once every 80 years.

"There is a concern that with a higher level of inflation, inflation will become more volatile and expectations less anchored. At the same time, the higher target might not be enough to handle a recession as deep as the most recent downturn; to achieve the equivalent of a Taylor rule indicated -5% federal funds target without being constrained by the zero lower bound, the Fed would need to target inflation at at least 7%. Separately, these criticisms seem compelling, but taken together they cancel each other out."

Those are good arguments in my view, but my doubts about running policy to avoid the zero bound run even deeper. Among the lessons taken from the financial crisis, I include this: The "zero bound problem" was not all that big of a problem at all.

The Federal Open Market Committee moved the federal funds rate target to its effective lower bound (0 to ¼ percent) on Dec. 16, 2008. After a very rough start to 2009, gross domestic product (GDP) growth improved substantially in the second quarter. By the third quarter, growth was positive and, as far as we currently know, clocked in near 6 percent in the fourth. Is this the stuff of zero bound disaster?

In fact, Blanchard and company acknowledge that…

"It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap."

… but follow up with this:

"But it is clear that the zero nominal interest rate bound has proven costly."

Clear? Proven? I don't see it, and the IMF authors, in my view, explain why the zero bound problem was of limited relevance in the recent crisis:

"Markets are segmented, with specialized investors operating in specific markets. Most of the time, they are well linked through arbitrage. However, when, for some reason, some of the investors withdraw from that market (be it because of losses in some of their other activities, loss of access to some of their funds, or internal agency issues), the effect on prices can be very large. In this sense, wholesale funding is not fundamentally different from demand deposits, and the demand for liquidity extends far beyond banks. When this happens, rates are no longer linked through arbitrage, and the policy rate is no longer a sufficient instrument for policy." (I added the emphasis.)

The highlighted passage, of course, does not say "the policy rate is no longer a necessary instrument," and I certainly cannot prove that the trajectory of the economy in 2009 wouldn't have been better if only we had another 100 to 200 basis points in the tool kit. But color me a skeptic, and put me down on the petition to not experiment with higher inflation to avoid a problem that was not so clearly a problem.

Update: Related thoughts, from Mark Thoma and from Caroline Baum.

By Dave Altig, senior vice president and research director at the Atlanta Fed

February 16, 2010 in Inflation, Interest Rates, Monetary Policy | Permalink


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The severity of the zero bound problem depends not only on the depth of a downturn, but also on the level of equilibrium (full-employment) real interest rates.

Keynes in his General Theory discusses how growing prosperity leads to a higher saving rate (a saving glut?) and lower equilibrium interest rates, which limits the effectiveness of monetary policy. This is one of the reasons why he advocates a strong fiscal policy. So if we indeed experience a global saving glut then we can either follow Keynes’s original advice and rely on fiscal policy (maybe for a very long time) or we can increase the target inflation rate. This is something Keynes did not think about because his model did not include inflation expectations, but it would be a natural extension of his ideas.

From this perspective, the key questions are whether the saving glut is real, whether it is likely to persist and how much it affects equilibrium interest rates. If we indeed experience a permanent decline in equilibrium real interest rates that would in my view constitute an important argument in favor of a higher inflation target.

Is there enough evidence to support the ‘saving glut’ argument for a higher inflation target?

1) First of all, the Flow of Funds Accounts show that in the 00s full employment became possible only when net borrowing (adjusted for net issuance of equity) reached 15% of GDP, compared to 8% of GDP in the 1990s.
2) This increase in the full-employment level of net borrowing strongly correlates with the US current account deficit, suggesting that it reflects various trends in the real sector, rather than simply an increase in the level of leveraged financial investment.
3) It seems likely that the high level of borrowing observed in the 00s could be sustained not only because the interest rates remained low, but also because the real estate prices were going up (the collateral effect). Without the collateral effect, full employment would most likely demand much lower interest rates than what we saw in the 00s. It is possible that the real fed funds rate may remain negative even at full employment. If this is indeed the case then a 2% inflation target would put a very serious constraint on monetary policy.

So, at first sight there is at least some evidence in favor of a higher inflation target. This evidence is far from being conclusive, since the relationships between various macroeconomic variables are very complicated, but I think this particular argument in favor of a higher inflation target deserves much more attention than it now receives.

Posted by: Doctor Who | February 16, 2010 at 06:30 PM

Blanchard's reason for suggesting a higher rate of inflation is to give central banks more room to cut rates in an emergency -- to get farther from the zero bound. Why not consider negative rates instead? There is no reason depositors cannot be charged for leaving funds on deposit, which is effectively a negative rate. The Fed has the authority to charge depositors for holding excess reserves. This avoids many of the distortions introduced by higher inflation.

Posted by: Douglas Lee | February 17, 2010 at 09:13 AM

If I may say so, I think that you (not that you are the only one) are missing the point here, and treating Blanchard et al with too much respect. Whatever it actually says, I do not think that this proposal is about targeting 4% as opposed to 2% inflation in the abstract. It is probably true that the efficiency cost of 4% underlying inflation would not be much greater than 2%. But the real point of this proposal is to excuse a SHIFT from 2% to 4%, and the transfer of wealth from creditors to debtors that this would involve. It is not big thinking, it is dishonest thinking. Moreover, it is also unwise thinking, because it is the bias in favour of debtors that got us into our present mess in the first place. Blanchard should be sent packing from the IMF back to some academic position where he can express provocative ideas without any responsibility.

Posted by: RebelEconomist | February 17, 2010 at 01:31 PM

Hello all, first time posting. This is a great website with intelligent topics and discussions. If someone could please help me understand the above article and comments. Are we discussing how much further, and to what extent the Fed should artificially manipulate interest rates? Are we trying to find a model for the "correct" artificial rate? In all seriousness, why don't we let the market determine what the interest rate should be?

The original post says this:

"The Federal Open Market Committee moved the federal funds rate target to its effective lower bound (0 to ¼ percent) on Dec. 16, 2008. After a very rough start to 2009, gross domestic product (GDP) growth improved substantially in the second quarter. By the third quarter, growth was positive and, as far as we currently know, clocked in near 6 percent in the fourth. Is this the stuff of zero bound disaster?"

Based on your paragraph quoted above, I think we would both agree that the Fed Funds rate is a powerful tool. Simply, if the economy slows down, lower the rate, more money, more elasticity; if the economy heats, raise the rate, less money, more expensive.
Looking at a Fed Funds chart, rates were lowered from January 2001 until August 2004, remaining under 2% for roughly 3 years, one of those averaging around 1%. Around September of 2004 rates started to climb, finally resting above 5% in March 07. We know the history since then.

Is it possible that the low rates from 01-04, and then the higher rates from 04-07 helped greatly to cause the situation we are in now? After all these years of working papers, models, assumptions, policy tools, and targets, we have yet to find anything smarter than the market itself. In my opinion, this paper on a new targeted inflation rate is laughable, it’s similar to the IMF's Guillermo Calvo paper "Is Inflation Effective for Liquidating Short-Term Nominal Debt?” If inflation is so fantastic for the economy, why don’t they give every person in America a counterfeit machine? Our GDP would be off the charts.

The inflation target paper raises a good question, if person is not happy with a 4% inflation target rate, shouldn’t the same person be unhappy with a 2% inflation rate?

To drive my point home, why are we trying to create answers for an interest rate that the market provides already?

Posted by: WilliamATL | February 17, 2010 at 04:06 PM

This has already been tried implicitly in the United States by watering down the inflation measures over the last thirty years to allow the Fed more room to keep an easy monetary policy. If the CPI had incorporated real estate inflation, market rates would've been higher and the Bush administration would've been less inclined to propose so much unwise and wasteful spending and tax cut programs.

Posted by: Les | February 17, 2010 at 07:50 PM

Better not to target any fixed rate but to adapt it to changing circumstance. When long term rates fall below their long term average indicating an increase in leverage, allow inflation to rise. When long term rates rise above their long term average indicating too much inflation, allow it to fall.

Posted by: Lord | February 18, 2010 at 03:15 PM

Great post. Anyone think the Federal Reserve needs to be audited?

Posted by: uspiggybank | February 18, 2010 at 06:25 PM

The inverse correlation between growth and inflation at rates above 2 is hardly surprising, even to a Blanchardian inflationist like me. Imagine a world where all nations follow passive monetary policies, perhaps increasing reserves at a certain fixed rate over time. The functions that relate reserves to nominal demand are mostly a lot of noise, but, taking the path of nominal demand as given, the function that relates inflation to growth is quite precise, and of course the relation is inverse. In this thought experiment, there is no reason to suppose an independent role for the inflation rate in determining growth. Rather, growth is determined primarily by growth in productive potential, and the inflation rate is a residual.

The real world may be different. Monetary policy is seldom entirely passive, and sometimes central bankers do achieve their intentions. But if you look at inflation and growth and ask which one should be treated as exogenous, it seems to me that growth is the obvious candidate. The supposedly active intentions of central bankers are often conditioned by growth expectations. (Surely, for example, a large part of the reason that the Greenspan Fed was able to maintain such low inflation rates in the period after 1995 was that high growth rates removed political pressure for inflationary policies, while a large part of the reason that the Miller Fed tolerated high inflation rates was political pressure resulting from the growth slowdown.)

Posted by: Andy Harless | February 18, 2010 at 07:23 PM

I am afraid the folks at Angry Bear, and Krugman have another agenda that a higher inflation rate plays into.

I think that first you start with the idea of stable monetary policy. Deflation is terrible, but inflation is also bad. Taylor does the best job of putting a rule to it.

As you say, there is a strong correlation between inflation rates higher than 3% in developed economies and negative effects in the economy. Rational people "get" that.

Clearly, the fiscal policy of this administration, and the administration before that was inflationary. The Fed policy has been inflationary as well, because it had to be.

Going forward, we need far better fiscal policy. It will allow the Fed to concentrate on the inflation picture and not concentrating on being the banker of last resort.

Posted by: Jeff | February 18, 2010 at 10:47 PM

Anybody catch the mistake in Friday's CPI report? The Shelter component of the CPI, which has a 32 percent weighting, was calculated incorrectly from the sum of its own components. This seems to indicate that someone at the BLS edited this field to override the calculation. Shelter inflation should have been 0.1 instead of -0.5. The CPI should have been 0.5, not the 0.2 that was reported.

Posted by: Les | February 22, 2010 at 11:55 AM

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November 24, 2009

Interest rates at center stage

In case you were just yesterday wondering if interest rates could get any lower, the answer was "yes":

"The Treasury sold $44 billion of two-year notes at a yield of 0.802 percent, the lowest on record, as demand for the safety of U.S. government securities surges going into year-end."

"Demand for safety" is not the most bullish sounding phrase, and it is not intended to be. It does, in fact, reflect an important but oft-neglected interest rate fundamental: Adjusting for inflation and risk, interest rates are low when times are tough. A bit more precisely, the levels of real interest rates are tied to the growth rate of the economy. When growth is slow, rates are low.

The intuition behind this point really is pretty simple. When the economy is struggling along—when consumer spending is muted and businesses' taste for acquiring investment goods is restrained—the demand for loans sags. All else equal, interest rates fall. In the current environment, of course, that "all else equal" bit is tricky, but the latest from the Federal Reserve's Senior Loan Officer Opinion Survey is informative:

"In the October survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households. However, the net percentages of banks that tightened standards and terms for most loan categories continued to decline from the peaks reached late last year."

Demand also appears to be quite weak:

"Demand for most major categories of loans at domestic banks reportedly continued to weaken, on balance, over the past three months."

This economic fundamental is, in my opinion, a good way to make sense of the FOMC's most recent statement:

"The Committee… continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

Not everyone is buying my story, of course, and there is a growing global chorus of folk who see a policy mistake at hand:

"Germany's new finance minister has echoed Chinese warnings about the growing threat of fresh global asset price bubbles, fuelled by low US interest rates and a weak dollar.

"Wolfgang Schäuble's comments highlight official concern in Europe that the risk of further financial market turbulence has been exacerbated by the exceptional steps taken by central banks and governments to combat the crisis.

"Last weekend, Liu Mingkang, China's banking regulator, criticised the US Federal Reserve for fuelling the 'dollar carry-trade', in which investors borrow dollars at ultra-low interest rates and invest in higher-yielding assets abroad."

The fact that there is a lot of available liquidity is undeniable—the quantity of bank reserves remain on the rise:


But the quantity of bank lending is decidedly not on the rise:


There are policy options at the central bank's disposal, including raising short-term interest rates, which in current circumstances implies raising the interest paid on bank reserves. That approach would solve the problem of… what? Banks taking excess reserves and converting them into loans? That process provides the channel through which monetary policy works, and it hardly seems to be the problem. In raising interest rates paid on reserves the Fed, in my view, would risk a further slowdown in loan credit expansion and a further weakening of the economy. I suppose this slowdown would ultimately manifest itself in further downward pressure on yields across the financial asset landscape, but is this really what people want to do at this point in time?

If you ask me, it's time to get "real," pun intended—that is to ask questions about the fundamental sources of persistent low inflation and risk-adjusted interest rates (a phrase for which you may as well substitute U.S. Treasury yields). To be sure, the causes behind low Treasury rates are complex, and no responsible monetary policymaker would avoid examining the role of central bank rate decisions. But the road is going to eventually wind around to the point where we are confronted with the very basic issue that remains unresolved: Why is the global demand for real physical investment apparently out of line with patterns of global saving?

By David Altig, senior vice president and research director at the Atlanta Fed

November 24, 2009 in Federal Reserve and Monetary Policy, Interest Rates, Monetary Policy, Saving, Capital, and Investment | Permalink


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Can you say what you mean? (when you work as a public servant)

Bankers make more money investing in totally risk free, highly liquid earning assets, mis-named excess reserves @.25% rather than zero percent t-bills. Not too complex.

Banks are unencumbered in their lending operations(except the venerated, & capricious, 10% bank capital ratios).

Again, whether it's dis-intermedition (contraction or outflow of funds), from the non-banks, or financial intermediaries (e.g., hedge funds, investment banks, finance companies, insurance companies, mortgage companies, pension funds, etc.),

c. 80% of the lending market,

or IMPOUNDING savings within the commercial banking system, both are contractionary (the source of savings deposits within the monetary system is other bank deposits, directly or indirectly via currency, or the bank's undivided profits accounts).

Lower the remuneration rate on excess reserves. Then get the member banks out of the savings business. I.e., money flowing “to” the intermediaries never leaves the monetary system as anyone who has applied double-entry bookkeeping on a national scale should know. And why should the member banks pay for something they already own (interest). The member banks would be smaller, and more profitable, if they did not (1966 proved that, Dr. Alton Gilbert wasn't an expert: "Requiem for Regulation Q: What It Did and Why It Passed Away").

Monetary savings are LOST TO INVESTMENT (bottled up), within the banking and monetary system. I.e., savings held within the monetary system have a transactions velocity of zero, and are a leakage in the Keynesian national income concept of savings.

IOR's are not offsetting when the system's expansion coefficient varies widely

On IORs: Banks create new loans-deposits. The bankers are getting paid twice, for new, free, and additional earning assets (regardless of the expansion coefficient). Interest on reserves is a fraud and deceit upon the American people.

Posted by: Spencer Bradley Hall | November 26, 2009 at 07:59 PM

Thanks for doing this blog. I'll try to keep my comments to a technical nature.

On one hand, I agree that there has been some flight to safety in recent weeks, which I think reflects concerns about the economy's dependence on monetary stimulus, and the sustainability of the stimulus.

On the other hand, I also see indications that the recent retreat in Treasury rates is due also to an increase in the scale of monetary stimulus. The federal funds rate has fallen in recent weeks to around 12 bips, after hovering around 20 bips for most of the year.

This decline roughly coincided with the recent redemption of $185 billion from Treasury's supplementary financing account, which boosted the pace of the increase in excess reserves.

Also, for most of this year the Fed had been able to restrain the stimulus effect of its asset purchase programs by reducing borrowing from the Fed - in essence, replacing the large borrowed reserves built up in 2008 with non-borrowed reserves. But there seems to be little borrowed reserves left that the Fed can reduce, and so its asset purchases seem recently to be translated practically 1:1 into additional excess reserves.

Or this could perhaps be a case of steady monetary stimulus having partly delayed, and thus accelerating effects.

In a different time in a different country, a central banker once explained to me how he would know when monetary stimulus had surpassed its usefulness. He said it's like trying to pour coffee while blindfolded: the only way you know the cup is full is when you can feel the coffee spilling across the table. By that he meant when CPI accelerates.

But this is a novel situation, in which the scale of monetary stimulus is very large and yet the deflationary forces from deleveraging are very powerful. So perhaps the coffee is spilling out, but the table is tilted enough that the Fed isn't feeling any where it has its hand.

Posted by: Tom | November 27, 2009 at 01:23 AM

The Fed is in a box. Raising short term rates now would be bad policy. Perhaps being more stringent on the type of collateral that they take would be a step toward signaling to the market that they are ever vigilant, and are not encouraging bubbles.

Saving is up because people are scared (in the US). Bankers have told me they cannot find good credit risks to lend to. Plus, their existing loans are being paid off as quickly as possible. They are forced to buy treasuries to put their money to work.

The propensity to save in Asia is high. There seems to be a cultural bias toward saving versus spending. The Chinese populace has become richer, but they have not spent those riches and are saving them.

It would be interesting to look at the savings rate of the US from the late 1880's to 1920 to see how it compares. Maybe there is a correlation with saving and development?

Secondly, the economic environment is so uncertain. Business is terrified of the coming actions of the Obama administration. Cap and trade, higher taxes, health care regulations and taxes, pro union actions, and more regulation in general are troubling to any business. The costs of all these actions are not easily quantified into any model-so it's hard to make a decision. The result, is no action. Cash piles up.

Posted by: Jeff | November 27, 2009 at 08:58 AM

In regard to the final question, why is the demand to borrow seemingly lower than the supply of capital, I wonder if it is some combination of:

A. Demographic changes - if young people generally borrow and take risks, and older people generally save (lend), perhaps the baby boom retirement is causing too much savings to chase too few risk takers?

B. Business changes - in the past, the hottest areas of the economy (say railroads) required large amounts of capital investment. Increasingly, the hottest areas (the internet/google) use relatively little capital, and are largely self-financing. Perhaps this shift implies that the same amount of savings is now chasing fewer opportunities for capital investment.

C. Changes in retirement expectations - in the early 1900s, I think many people never expected to retire, and consequently never saved. Now, most expect to retire and most save to attempt to fund that retirement. That increases the number of people looking to save/lend.

I wonder if A, B and C are large enough to cause macroeconomic impacts. I think they could amplify each other, in the sense that there are both fewer risk-taking borrowers per retiree/lender, and each risk-taker needs less capital investment than before.

Posted by: Chris | November 30, 2009 at 06:50 PM

I'd like to play devils' advocate with regard to the fear of rampant inflation that is expected.

True, the money supply has expanded enormously in the credit crisis. It is mind boggling to think about. How could it not lead to rampant inflation?

First, the money isn't in the economy. It is on bank balance sheets.
They are reinvesting it in government treasuries. They are not lending it. As a matter of fact, their credit standards are so high they won't lend it. Furthermore, their outstanding loans are being repaid-so this cash is being reinvested in treasuries as well.

Once the Fed sees that money is being lent out-and the velocity of money picks up-they undertake open market operations aggressively to sop up cash. They raise discount rates by a little-and change the collateral that they take to make it tougher for prime brokers to get cash from the Fed.

If they are fast enough, we will have limited inflation in the overall economy.

Posted by: jeff | December 04, 2009 at 01:14 PM

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September 01, 2009

Us and them: Reviewing central bank actions in the financial crisis

With all the focus on the financial crisis in the United States, folks in this country might sometimes lose sight of the fact that this crisis has been global in nature. To provide some perspective on the global dimensions of the crisis, we are providing a few summary indicators of financial sector performance and central bank policy responses in the United States, the United Kingdom, the Euro Area, and Canada. Based on this general review, we surmise that some of the experiences have been remarkably similar, while others appear to be quite different. To pre-empt the question: Why these four regions? The reason is simply that the data were readily available. We encourage readers to use data from other areas, and let us know what you find.

The first chart compares relative changes in monthly stock market price indices for 2005 through the end of August. During the crisis, market participants significantly reduced their exposure to risky assets, which helped push equities lower. All indices peaked in 2007, except Canada, which technically peaked in May 2008. Canada outperformed relative to the others in early 2008 but suffered proportionally similar losses thereafter. The United Kingdom, Euro Area, and Canada bottomed in February 2009 while the United States bottomed in March 2009. The Euro Area to date has experienced the strongest rebound in equities, increasing by almost 40 percent since the trough in February. However, Europe also had the largest peak-to-trough decline, almost 60 percent. Canada and the United States have jumped by about 33 percent since their respective lows in February and March, while U.K. stock prices have risen by about 30 percent since February.


The second chart compares long-term government yields. As the crisis unfolded in late 2007, yields on 10-year U.S. Treasuries sank as global flight to quality helped push yields lower. Yields on U.S., U.K., and Canadian bonds have all moved lower than they were prior to the onset of the crisis. Interestingly, in the Euro Area, prior to the crisis, sovereign yields were at or below bond yields in the other countries but are now slightly above those. In fact, Euro Area yields haven't moved much since the beginning of the crisis in late 2007.


The third chart contrasts monetary policy rates in the four regions. The chart shows that all the central banks lowered rates aggressively, but there are some subtle differences in the timing. For the United Kingdom, Euro Area, and Canada, the bulk of policy rate cuts came after the financial market turmoil accelerated in the fall of 2008, whereas in the United States the majority of the cuts came earlier.

The Fed was the first to lower rates, cutting the fed funds rate by 50 basis points in September 2007 at the onset of the crisis. The Fed continued to lower rates pretty aggressively through April 2008, with a cumulative reduction of 325 basis points. Once the financial turmoil accelerated again in the fall of 2008 the Fed cut rates again by another 200 basis points.

The Bank of Canada's cuts followed a generally similar timing pattern to the Fed but with differences in the relative magnitude of the cuts. In particular, the Bank of Canada rate lowered rates by 150 basis points through April 2008 and then by another 275 basis points since September 2008.

Similarly, the Bank of England cut rates three times in late 2007/early 2008, totaling 75 basis points. But like the Bank of Canada, the bulk of their policy rate cuts didn't come until the increased financial turmoil in the fall of 2008. Between September 2008 and March 2009, the Bank of England cut the policy rate by 450 basis points.

Unlike the other central banks, the European Central Bank (ECB) did not initially adjust policy rates down as the crisis emerged in late 2007. In fact, after holding rates steady for several months it increased its rate from 4 percent to 4.25 percent in July 2008. It started cutting rates in October 2008, and from October 2008 to May 2009 the ECB reduced its refinancing rate by 325 basis points. Of the four regions, the ECB currently has the highest policy rate at 1 percent. For some speculation about the future of monetary policy rates for a broader set of countries, see this recent article from The Economist.


The final chart compares relative changes in the size of balance sheets across the four central banks. The balance sheet changes might be viewed as an indication of the relative aggressiveness of nonstandard policy actions by the central banks, noting that some of the increases can be attributed to quantitative easing monetary policy actions, some to central bank lender-of-last-resort functions, and some to targeted asset purchases.

The sharpest increases in the central bank balance sheets came in the wake of the most intense part of the financial crisis, in the fall of 2008. There had been relatively little balance sheet expansion until the fall 2008. Prior to that, the action was focused mostly on changing the composition of the asset side of the balance sheet rather than increasing its size. The size of both U.S. and U.K. balance sheets has more than doubled since before September 2008, although both are now below their peaks from late 2008. Note that in the case of the Bank of England, quantitative easing didn't begin until March 2009, and the subsequent run-up in the size of the balance sheet is much more significant than in the United States. Prior to that, the increase in the Bank of England balance sheet was associated with (sterilized) expansion of its lending facilities.

In contrast, the Bank of Canada and ECB increased their balance sheets by about 50 percent—much less than in the United Kingdom or United States. By this metric, nonstandard policy actions have been less aggressive in Canada and the Euro Area. Why these differences? This recent Reuters article provides a hypothesis that focuses on institutional differences between the Bank of England and the ECB. In a related piece, this IMF article compares the ECB and the Bank of England nonstandard policy actions.


Note: The Bank of England introduced reforms to its money market operations in May 2006, which changed the way it reports the bank's balance sheet data (see BOE note).

By John Robertson, vice president and senior economist, and Mike Hammill and Courtney Nosal, both economic policy analysts, at the Atlanta Fed

September 1, 2009 in Europe, Financial System, Interest Rates, Monetary Policy | Permalink


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Re : "Of the four regions, the ECB currently has the highest policy rate at 1 percent."

Please, this is the kind of "analysis" we all could do without. You are comparing apples and pears. If you want to compare the US policy rate, i.e. an interbank overnight rate target, to something relevant in the Eurozone, then pick a euro overnight rate. Eonia has been at around 0.35% since June, not 1%, which is currently used as the very long term tender rate. As to 1 month Euribor, it is currently 0.48% while 1 month USD Libor is 0.28%.

Posted by: Henri Tournyol du Clos | September 01, 2009 at 07:12 PM

Yeah, but this analysis is accurate with the situation and the subject "Bank Actions".

Posted by: Andrew | September 08, 2009 at 04:46 AM

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July 14, 2009

A funny thing happened update

More than a week has passed since the Regulation D changes went into effect, and it appears that the changes are having a noticeable, if not dramatic, impact on pricing in the funds market—see the updated effective funds rate chart below.


The funds rate did fall last week, and it is possible that the softening was related to an increased supply of fed funds by Federal Home Loan Banks as they sought to reduce their excess reserve balances because they no longer earned interest on those balances. But if that is in fact the explanation, the effect was not large: Fed funds are still trading in a relatively narrow range between about 5 and 40 basis points each day. Though, as the chart shows, the effective fed funds rate has drifted lower so far in July—it was at 15 basis points on Friday, July 10, down from 20 basis points on July 1. The current rate is well above the January low of 8 basis points.

Despite the large increase in supply of funds in the market that might have resulted from the Reg D change, it seems to me that the opportunity for arbitrage profits is helping keep the effective funds rate hovering in the neighborhood of the interest rate paid by the Fed to eligible institutions on their reserve balances.

By John Robertson, vice president in research at the Atlanta Fed

July 14, 2009 in Interest Rates, Monetary Policy | Permalink


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Trivia. If the FOMC wanted rates to fall, and insured member banks to lend, the policy makers would lower the renumeration rate on excess reserves. It's too high relative to the target FFR.

Posted by: flow5 | July 14, 2009 at 06:43 PM

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