Monetary Policy Challenges Prescriptions
OutlineMonetary Policy in the 21st Century: Challengesand Prescriptions.
R. Anton Braun*
Federal Reserve Bank of Atlanta
CIGS Joint Seminar on Macroeconomics
Tokyo, Japan
December 22, 2014
*These are my own personal views and not necessarily those of theFederal Reserve System.

Monetary Policy Challenges Prescriptions
Introduction

Motivation

The 21st Century has marked a turning point for the conductof monetary policy.
To understand how signification the changes have been it isperhaps useful to review some orthodox views from the end ofthe last century about monetary policy and financial
regulation.

Monetary Policy Challenges Prescriptions
Introduction

Orthodox views about Monetary Policy in 1999
1

Monetary Policy is a highly effective tool for macroeconomic
stabilization.

2

The way to stabilize the macroeconomy is to manipulate anarrow short-term overnight interest rate to produce a stableinflation rate of about 2 percent.

3

The Great Moderation demonstrates that this policy is soeffective that business cycles are largely a relic of the past.

4

Inflation risks are asymmetric. The biggest risk facing centralbankers is the risk that expectations become unanchored andhigh inflation results.

5Currency pegs always fail. The Asia crisis could have been
avoided if e.g. Thailand had never tried to control theexchange rate.

Monetary Policy Challenges Prescriptions
Introduction

Orthodox Views About Lender of Last Resort in 1999
The risk of a financial crises in the U.S. and UK is very
remote.
Commercial banks are well regulated and deposit insurance
means that the risk of a bank run is remote.
Markets for the provision of other financial services are highly
competitive and light regulation of investment banks, lifeinsurance companies and other financial intermediaries isappropriate.
Competition encourages innovation and growth.
Private arrangements for dealing with failure (changes inmanagement, M&A, bankruptcy) are adequate forincentivizing shadow banks to do the right thing.

Fear of contagion. Decision of the NY to orchestrate a bailoutof LTCM in 1998 rather than to let it fail established aprecedent that proved unsustainable.

Monetary Policy Challenges Prescriptions
Introduction

Japan’s Experience Was Special and Not Viewed as
Relevant for the U.S. or Europe.

The excesses of Japan’s bubble economy and the banking
problems that followed reflected weak regulatory oversight.
Japan’s experience with deflation and slow growth reflected:
A reluctance on the part of the monetary authority to growmonetary base enough. (The Quantity Theory of Money is welland alive.)
A breakdown in the monetary transmission mechanism due todelays in recapitalizing and restructuring banks.

Monetary Policy Challenges Prescriptions
Introduction

Enter the 21st Century

Great Moderation has been replaced by a Great Recession or
perhaps a Great Stagnation?
Biggest concern of central bankers is preventing deflation.
Massive increases in monetary base have little or no effect on
the price level.
Central bankers are discovering that it is considerably moredifficult to stabilize the economy when the policy rate is zero.
Exchange rate management is back in fashion (Switzerland).
Fear of contagion and bank runs is even more pronounced now
than in 1998.

Monetary Policy Challenges Prescriptions
Introduction

Plan For my Talk

Start with a discussion of the U.S.
Monetary Policy
1 When to exit.
2 How to exit.
3 How to conduct monetary policy post exit.

Regulation of financial Intermediaries
1 Mitigating the risk of bank runs in formal and shadow banking

sector.
2 Too big to fail.

I will then make some general comments about recent
developments in other countries.

Monetary Policy Challenges Prescriptions
Introduction

US Current Developments
Liftoff decision guided by Dual Mandate
Employment
Ample and broad-based evidence of steady improvement in
employment conditions in 2014.
Conventional measure of unemployment has fallen from 6.7
percent in Dec. 2013 to 5.8 percent in Nov. 2014.
Reasons for caution.
Broader-based U-6 unemployment rate which, includes thoseworking part-time for economic reasons and marginallyattached, is still high (11.4 percent).
Employment relative to working population is also depressed.
70.6 percent in October 2006
68.8 precent in October 2014
Gap is 3.7 million working-aged people.

Monetary Policy Challenges Prescriptions
Introduction

US Current Developments: Inflation
CORE#PCE#Inﬂa?on#

Percent#Change#from#Quarter#One#Year#Ago,#Quarterly,#Seasonally#
Adjusted!!
2.5#

2.0#

1.5#

1.0#

0.5#

0.0#
1'Jul'09#

1'Jun'10#

1'May'11#

1'Apr'12#

1'Mar'13#

1'Feb'14#

Inflation: In January 2012 FOMC set a long run target of 2%
inflation.
For past two years inflation has been well below this target.

Monetary Policy Challenges Prescriptions
Introduction

A Conundrum

Developments in labor market suggest real economic growth isabove long run trend.
Yet prices are not showing much evidence of firming.
This combination of low unemployment and low inflation ispuzzling.
The FOMC has been specific that its decision on the timing oflift-off will be data dependent.
Any case for liftoff in 2015 will require either a coherent
narrative for the puzzling data on unemployment and inflation
or a resolution of the conundrum as new data arrives.

Monetary Policy Challenges Prescriptions
Introduction

How Will U.S. Liftoff Occur?

Interest Rate on Excess Reserves (IOER) is the policy newinstrument.
Exit will be effected by raising the IOER.
This allows the Fed to normalize policy in a way that sterilizes
the size of its balance sheet.
A higher IOER increases the return from depositing excess
reserves at the FED.
This in turn raises the reservation interest rate that a bankrequires to lend reserves in Federal Funds (FF) market.
A higher IOER will be associated with a higher FF rate.

Monetary Policy Challenges Prescriptions
Introduction

FF Rate Puzzle
Previous logic implies that the IOER provides a floor for theFF rate. But, right now IOER is 0.25% and FF rate is at
about 0.12%.
Question: How much will IOER have to go up before FF rate
rises?
No arbitrage arguments suggest that FF (and other marketrates) will rise with IOER.
Transactions costs with arbitrage. At very low rates thesetransactions costs can be significant.
If FF rate does not move up with IOER, reverse repo
operations can be used to provide a more effect floor on theFF rate.

Monetary Policy Challenges Prescriptions
Introduction

Fed Reverse Repo Operations
NY Fed has been experimenting with reverse repos since
September 2013.
Fed sells U.S. Treasuries and promises to repurchase them at
a future date at a pre-specified price.
Can think of the Fed as offering a deposit rate for cash toqualified counterparties.
Broader set of counterparties than FF market:
Banks and Savings and Loan Associations
Government Sponsored Enterprises
Money Market Funds

In principal, demand can be very high.
Size of Reverse Repo operations is currently capped at $300
billion per day.

Monetary Policy Challenges Prescriptions
Introduction

Post Lift-Off Issues
In an ideal world the FF rate would rise above the IOER afterliftoff and live in a corrider that is determined by the IOER
and Discount Window Lending rate.
This won’t happen until reserves are drained to the point
where excess reserves disappear.
It could take many years for this to happen.
In the meantime the Fed will be implementing its interest rate
policy by offering interest earning deposits to banks and otherfinancial intermediaries if the reverse repo facility is heavily
used.
This is costly and will result in lower remissions to Treasury.
Marvin Goodfriend of CMU has a provocative discussion ofthis issue.

Monetary Policy Challenges Prescriptions
Introduction

U.S. Financial Regulation: Guided by Concerns about
Bank Runs and Contagion
Regulators are very focused on shadow bank bank runs.
In 2007 breakdown in the tri party repo market and Reserve
Primary Fund breaking the buck are perceived to have played acentral role in creating and propagating the financial crisis.
Prime institutional MMFs will have mandatory net asset values
and redemption gates from 2016.
Concerns that if reverse repo operations by FED are notcapped, this could increase the risk of bank runs by MMFs.
Fed is a safe haven for cash in times of financial market duress.
Large counterparties including: companies, hedge funds andetc. are being told by banks we don’t want your deposits!
From Jan. 1 banks will have to hold reserves ranging from 40 100 percent for large deposits that are considered to be “hot.”Monetary Policy Challenges Prescriptions
Introduction

Too Big to FailThe costs of being labeled a Systemically Important Financial
Intermediaty SIFI (too-big-to fail) are large and increasing.
International accord to impose capital surcharges of SIFI of2.5%. Peak surcharges in U.S. could be as high as 4.5 percent
for those heavily reliant on short-term wholesale funding.
2 Stress testing is a very time consuming and costly process.
1

SIFI’s submit capital plans and illustrate that that capitalratios remain above regulatory thresholds under severe stressed
scenarios produced by the Fed and developed in house.
Stress tests have bite. If the capital plan is rejected dividends
can not be paid.

Monetary Policy Challenges Prescriptions
Introduction

Pushback Against New Regulations

Regulatory reforms of MMFs were narrow. Lots of MMFs willcontinue to promise a NAV of 1 dollar.
Dodd-Frank “Prohibition Against Federal Government
Bailouts of Swaps Entities” is about to be removed.
Swaps and derivative trading desks will be allowed to trade in
OTC products in entities that have FDIC protection.

Monetary Policy Challenges Prescriptions
Introduction

Prescriptions for Monetary Policy in the 21st Century

Situation in Europe and Japan is distinct from U.S.
Real economic growth is anemic or negative.
Inflation is much further below target and falling.
Three policy responses.
1
2
3
4

Negative policy rates
Managed exchange rates.
Loans to banks.
QEMonetary Policy Challenges Prescriptions
Introduction

Negative Interest Rates
Denmark, ECB and SNB have all set policy rates negative.
Two rationales:
12

Ease Monetary policy.
Lower excess reserves.
Market rates are close too or on the floor of the corridor.
Lowering the floor is the more effective then lowering theceiling.

Limits on how negative you can go. People and banks cankeep cash underneath their mattress instead.
Rogoff has a solution. Ban large denomination notes.
Replace of e-payment systems that are run preferably by thecentral bank.
This allows the central bank to make interest rates morenegative.

Monetary Policy Challenges Prescriptions
Introduction

QE

Japan large scale asset purchases of government debt, RIETsand ETFs.
Surprise factor wears off.
Open ended purchases are constrained by available supply ofthe asset.
Transmission to price level is indirect.

Monetary Policy Challenges Prescriptions
Introduction

Q.E. not as potent as FOMC Anticipated: Inflation
Forecast Errors
Core PCE Price Index: Track Record of BVARs versus SEPs

2.6

Four quarter percent change

2.3

2Midpoint of SEP central tendency for
FOMC meetings in fourth quarter

2012

2013

2011

1.7

1.4

Actual through 2014Q2
1.1

0.8
12/1/2010
2010Q412/1/2011
2011Q412/1/2012
2012Q412/1/2013
2013Q412/1/2014
2014Q412/1/2015
2015Q412/1/2016
2016Q4

2017Q49

Monetary Policy Challenges Prescriptions
Introduction

Q.E. not as potent as FOMC Anticipated: GDP ForecastErrors
Forecast errors of 1-year ahead GDP growth projections from midpoint ofcentral tendency of FOMC economic projections made in the fourth
quarter of each calendar year
1

Percentage points

0-1

Forecast error
computed asDecember 2013
SEP forecast for2014 growth(3.0%) minus
December 2014
SEP forecast for2014 growth(2.35%)-2
Third release estimates(also known as “First Final”)-3-4
Current vintage
estimates

-5
2007

2008

2009

2010

2011

2012

2013

Year that forecast is made1

Monetary Policy Challenges Prescriptions
Introduction

Irrelevance of Open Market Operations at Zero Bound
Why hasn’t Q.E. been more effective?
Important difference between QE and Friedman’s helicopter
drops of money.
Neil Wallace provided a theoretical argument in 1981 for why
this might be the case.
Woodford has recently revisited this issue and shown that theWallace argument is reasonably robust.
Financial frictions mean the Wallace result will not holdexactly.
Other extenuating factors.
Neither QE nor negative policy rates can force banks to lend.
New regulatory restrictions on banks make it more costly forbanks to lend!

Monetary Policy Challenges Prescriptions
Introduction

Forward Guidance: Theory
Woodford argues that the best way for a central bank tostimulate the economy when interest rates are zero is topre-commit to a future course of action.
Example: Suppose a central bank closed its doors for businessand posted a sign on the door that stated we will open again
for business once the inflation rate hits three percent. If thepublic believed what was written on the sign this would
stimulate the economy.
Why? the central bank is promising not to tighten monetary
policy at the first sign of inflation. People anticipate easy
monetary policy in the future and this affects their decisions
today.

Monetary Policy Challenges Prescriptions
Introduction

Forward Guidance in Practice

Recent actions by the Fed, ECB, Bank of Japan and otherbanks can be interpreted as efforts to pursue this suggestion.
Some specific examples that we have seen:
Promises by central banks to keep the interest rate at zero
until the inflation rate and/or unemployment rate hit particularthreshold values.
Promises to pursue open ended purchases of government debt
and other purchases until the inflation rate hits 2 percent.

The credibility and thus effectiveness of these measures can beassessed by comparing them with the example I gave above.

Monetary Policy Challenges Prescriptions
Introduction

Real Estate Booms and Macroprudential Policy

Confronting booms in real estate prices.
Sudden collapse of real estate prices has strong negative
effects on the economy.

Monetary Policy Challenges Prescriptions
Introduction

Sweden:GDP GrowthFigure 2. GDP with uncertainty
bands
Annual percentage change, seasonally-adjusted dataNote. The uncertainty bands are based on the Riksbank’s historical forecasting errors. There is alsouncertainty for the outcomes for GDP, as the figures in the National Accounts are revised several years after
the preliminary publication.

Sources: Statistics Sweden and the Riksbank

Monetary Policy Challenges Prescriptions
Introduction

Sweden: Inflation
Figure 3. CPI with uncertainty
bands
Annual percentage change

Note. The uncertainty bands are based on the Riksbank’s historical forecasting errors.

Sources: Statistics Sweden and the Riksbank

Monetary Policy Challenges Prescriptions
Introduction

Sweden: Housing Prices
Housing prices in Sweden
Annual percentage change
302520151050-5-10-1506

0708

09

10

Tenant-owned apartments
Chart 3:1

11121314

Single-family houses
Source: ValueguardMonetary Policy Challenges Prescriptions
Introduction

Sweden: Household Debt
Swedish household total debt anddisposable incomes
SEK billion
3,500
3,000

2,500
2,000
1,500
1,000
500

070

7376

798285
Debt

Chart 3:4

8891

94

9700

03

06

09

12

Disposable income
Sources: Statistics Sweden and the Riksbank

Monetary Policy Challenges Prescriptions
Introduction

Sweden: Policy Rate
Figure 1. Repo rate withuncertainty bands
Per cent

Note. The uncertainty bands for the repo rate are based on the Riksbank’s historical forecasting errors and the ability of risk-premium adjusted forward rates toforecast the future repo rate for the period 1999 up to the point when the Riksbank started to publish forecasts for the repo rate during 2007. The uncertainty
bands do not take into account the fact that there may be a lower bound for the repo rate. Outcome data are daily rates and forecasts are quarterly averages.

Source: The Riksbank

Monetary Policy Challenges Prescriptions
Introduction

Booms
Does it make sense to raise the policy rate when inflation andGDP growth are low?
Sweden (and Norway) have decided that the answer is no.
They are now experimenting with macro-prudential tools
Instead.
Sweden Macro Prudential Measures
Increased the LTV cap to 85% in 2010.
Risk weight floor on mortgages increased from 15 to 25
percent effective Jan. 2015
3 Countercyclical bufffer set at 1 percent effective Jan. 2015.
12

These measures require coordination between central bankand other government agencies FSA, MOF.
Reduces the independence of the central bank.
How strong are these measures?
What is the correct policy mix?

Monetary Policy Challenges Prescriptions
Conclusion

Concluding Remarks

Thank you!