Central banking in the credit turmoil
Marvin Goodfriend
Discussion
Frank Smets
European Central BankInternational ConferenceBank of Japan
27/28 May 2009
These comments are my own and should not be attributed to the ECB. I would like t
Francesco Papadia (ECB) for giving permission to use many of the graphs in this prand Kristina Morkunaite for updating them.

Comment 1: Goodfriend’s taxonomy• Goodfriend’s taxonomy (in particular thedifference between monetary policy andinterest rate policy) is very much inspired by
the Fed’s monetary policy implementation
framework.
• I am not convinced this is the best way ofdescribing monetary policy implementation in
many other countries, where a distinction
between monetary policy and liquidity
management policies is more appropriate.

Comment 1: Goodfriend’s taxonomy• Monetary policy is setting and signalling theappropriate level of short-term interest rates,
mostly through a tunnel system:– Determined by a marginal lending facility (againstcollateral), a deposit facility and a main policy rate.
– Even in the absence of a remuneration of excess
reserves, the deposit facility will put a lower boundon the short-term money market interest rate.

Comment 1: Goodfriend’s taxonomy• Liquidity management policy consists of:– Type, frequency, maturity, scope of market
operations (typically repurchase agreements);– Reserve requirements, type and horizon ofmaintenance period, remuneration;• Main objectives:– Keep money market rates close to the main policyrate.
– Ensure a well-functioning, liquid, interbank moneymarket, which is the core of the transmission
mechanism.

• Separation principle.

Comment 1: Goodfriend’s taxonomy• The financial crisis has not fundamentallychanged this approach (see, for example,Borio and Nelson, 2008).
• However, it has changed the focus in at least
three different ways.

Central bank as market maker of last resort– When liquidity in the interbank market breaks downbecause of adverse selection problems, the liquidity
management by the central bank becomes crucial in
avoiding that funding problems propagate into asystemic crisis.
– In effect, the central bank becomes the market
maker of last resort.
– In doing so, a fine balance has to be kept in mind
between replacing the interbank market andencouraging a reactivation of the interbank market.

Lower bound and signalling• When short-term interest rates are hitting thelower bound:– Signalling about future short-term interest rates
becomes even more important:– Liquidity management policy may help thissignalling process by, for example, lengthening therefinancing operations.

Collateral policy and liquidity• Through its collateral policy, the central bank
may also affect activity in other markets thanthe interbank market.

Comment 2: Fiscal aspects of credit policy• Goodfriend lays out the fiscal policy aspects of
the Fed policies (in particular the credit policy);• “It is important to appreciate the difficulties towhich the Fed exposes itself in the pursuit ofcredit policy initiatives that go beyond
traditional last resort lending to depository
institutions”:– Reach, pricing, allocation, …

• He argues the Fed must be accountable forthese fiscal policy aspects and this may
undermine the central bank’s independence.

Fiscal policy aspects of central bankpolicies• Proposes an Accord :– Fed should adhere to “Treasuries only” assetacquisition policy; Cooperation on exit.
– The use of monetary policy for the fiscal purpose offunding credit policy should not undermine pricestability;– Agree on long-term inflation objective;– Allow Fed to build up surplus capital to guarantee
financial independence;– Agree on those principles so that the Fed can act
preemptively, flexibly and aggressively against
either rising inflation or a deepening contraction
and deflation, if either demands Fed actionCredit versus liquidity risk
• It is important to make a distinction between
credit risk and liquidity risk; between
insolvency and illiquidity.
• While central banks are in the business ofcreating liquidity and can thus solve liquidity
problems, they can and should not address
solvency problems. That is in the realm offiscal policy.
• Of course, it is not easy to distinguish credit
from liquidity risk and in the process central
banks will take on more credit risk.

Monetary financing of government
debt• There are risks from large purchases ofgovernment debt.
– May turn into pressure for monetary financing of thedebt, with possibly negative effects on inflation
expectations.
– Related to this, there may be an exit problem,
leading to financial losses when interest rates start
to rise, undermining the financial independence ofthe central bank.

The ECB’s response to the credit crisis

Inflation and growth outlook (SPF)
Inflation and growth outlook in the euro area
Survey of Professional Forecasters - One-year ahead
32
10-1-2-3
2007Q1

2007Q3

2008Q1

Growth forecast

2008Q3

2009Q1

Inflation forecast

ECB rates and EONIA

Minimum bid rate%

Deposit rate

Marginal lending rate

EO NIA

6.00

65.50

5.5

5.00

54.50

4.5

4.00

43.50

3.5

3.00

32.50

2.5

2.00

21.50

1.5

1.00

10.50

0.5

Jan-07Mar-07 May-07

Jul-07

Sep-07 Nov-07

Jan-08Mar-08 May-08

Jul-08

Sep-08 Nov-08

Jan-09 Mar-09 May-09%

Euribor – Eonia swap rate spread (1)1-week

1-month3-month

400
350
300
250
200
150
100
50
0-50
Jan-07

M ar-07 M ay -07

Jul-07

Sep -07

Nov-07

Jan-08M ar-08 M ay -08

Jul-08

Sep -08

Nov-08Jan-09M ar-09 M ay -09

Consolidated balance sheet of the Eurosystem

Asset s EUR 914 bln

Liabilities EUR 914 bln

27 Jul 2007
Dom e s tic andfore ign as s e t
portfolio
Bank note s

M ROCA

GD and AF

LTRO and LF
Claim s of US FED
USD re financing
ope rations

FTO and DF

Euro liquidity operations: outstanding amounts

FTO Providing
1m STROFTO Absorbing€ bln

Marginal Lending Facility
3M LTRO
Deposit Facility

6M LTRO
MRO

900

900

800

800

700

700

600

600

500

500

400

400

300

300

200

200

100

100

00-100-100-200-200-300-300-400
Jan 07

Mar 07

May 07

Jul 07

Sep 07

Nov 07Jan 08

Mar 08

May 08Jul 08

Sep 08

Nov 08

Jan 09Mar 09-400
May 09Maintenance period 11 July to 7 August 2007

Daily reserve surplus/deficit (left-hand scale)

Average daily reserve surplus (left-hand scale)

EONIA (right-hand scale)
5.00

170.0
150.0
130.0

4.75

MRO withbenchmark
MRO withbenchmark +1.0 bn +1.0 bn

110.0
90.0
70.0

MRO withbenchmark+1.0 bn

MRO withbenchmark+1.0 bn

regular LTRO
of 50 bn

4.25

30.0
10.0

4.00 %-10.0
-30.0

3.75

-50.0
-70.0

3.50-90.0-110.0

3.25-130.0-150.0l 07

l 07

l 07

l 07

l 07

27 Ju

28 Ju

29 Ju

30 Ju

31 Juug 07

l 07
26 Juug 07

l 07
25 Ju07 A

l 07
24 Ju

ug 07

l 07
23 Ju

06 A

l 07
22 Ju

05 A

l 07
21 Ju

ug 07

l 07
20 Ju

ug 07

l 07
19 Ju

04 A

l 07
18 Ju

7l 07
17 Ju

03 A

l 07
16 Ju

ug 0l 07
15 Ju

7l 07
14 Ju

02 Al 07
13 Ju

ug 0

l 07

01 A

l 07

3.00
12 Ju

-170.011 Ju

EUR billions

50.04.50

Other features of operational framework• Large number of counterparties;• Wide set of collateral;• Different maturities;• When MFIs stop trusting each other, thisturned out to be important for the ability of thecentral bank to step in as a liquidity provider
and market maker of last resort:– No need for TAF, TSLF, PDCF in the euro area.

Important features of financial system• Significant differences in financial structure in
the US versus the euro area:– Much larger share of MFI loans in household andbusiness financing in the euro area (more likeJapan);– Much less important securitisation activity. At itspeak 3% of GDP in the euro area versus 17% in theUnited States.

• Less need for direct intervention in credit
markets (CPFF, TALF); more focus on fundingof the MFI sector.

Financial turmoil phase (Aug07-Sep08)• Separation principle maintained:• Liquidity management policy much more
active to avoid that MFI funding problems turninto solvency problems:• Front-loading of liquidity in the maintenance period;• Fine-tuning operations to keep EONIA close to theminimum bid rate;• Lengthening of maturity of operations to increase certainty
in liquidity management;

Euribor – Eonia swap rate spread

1-week

1-month3-month

400
350
300
250
200
150
100
500-50
Jan-07

M ar-07 M ay -07

Jul-07

Sep -07

Nov-07

Jan-08M ar-08

M ay -08

Jul-08

Sep -08

Nov-08Jan-09M ar-09

M ay -09

Spread between 3-month Deposit andOvernight Index Swap rates

EURGBP

USD

400

350

300

250

200

150

100

500-50
Jan-07Mar-07

May-07

Jul-07

Sep-07

Nov-07

Jan-08Mar-08May-08

Jul-08

Sep-08Nov-08Jan-09Mar-09

May-09

Intra-euro area government bondspreads
EUR
Spain Gov Spread

Germany 10-2y
Italy Gov Spread

France Gov Spread
Greece Gov Spread

400350300
250200150
100
500-50
Jan-07 Mar-07 May-07

Jul-07

Sep-07

Nov-07 Jan-08

Mar-08 May-08

Jul-08

Sep-08Nov-08 Jan-09 Mar-09 May-09

Maintenance period 8 August – 11 September 2007

Daily reserve surplus/deficit (left-hand scale)

supplem entary
LTROof 40.0 bn

FTO of61.1 bn

FTO of 94.8 bn

Average daily reserve surplus (left-hand scale)

MRO w ithbenchm ark+14.5 bn

MRO w ithbenchm ark +5.0 bn

170.0

MRO w ithbenchm ark +73.5 bn

150.0
130.0

MRO withbenchmark+1.0 bn

90.0

EUR billions

110.0

30.0

EONIA (right-hand scale)

FTO of 42.2 bn
5.00

FTO of-60.0 bn

4.75

regular LTRO
of 50.0 bn

4.50

70.0
50.0

4.25

10.0

4.00 %

-10.0
-30.0
-50.0

FTO of47.7 bn-70.0

FTO of 7.7 bn

3.75

MRO w ithbenchm ark+46.0 bn

3.50

-90.0
-110.0-130.03.25-150.0

ug 07

ug 0

ug 07

ug 07

ug 0ug 07

ug 0

ug 0ug 07

ug 0ug 07

ep 07

ep 0ep 07

ep 0

ep 07

ep 07

ep 0

ep 07

ep 07

ep 0

ep 07

21 A

22 A

23 A

24 A

25 A

26 A

27 A

28 A

29 A

30 A

31 A

01 S

02 S

03 S

04 S

05 S

06 S

07 S

08 S

09 S

10 S

11 S

7

ug 0
20 A

7

ug 07
19 A

7ug 07
18 A

7

ug 0
17 A

7ug 07
16 A

7

ug 07
15 A

7ug 0714 A

7ug 07
13 A

7

ug 0
12 A

7ug 07
11 A

7

ug 07

7

ug 0

10 A

7ug 07
08 A

3.00

09 A

-170.0Euro liquidity operations: outstanding amounts

FTO Providing
1m STROFTO Absorbing€ bln

Marginal Lending Facility
3M LTRO
Deposit Facility

6M LTRO
MRO

900900800

800

70070060060050050040040030030020020010010000-100-100-200-200-300-300-400
Jan 07-400
Mar 07

May 07

Jul 07

Sep 07

Nov 07

Jan 08Mar 08

May 08Jul 08

Sep 08

Nov 08

Jan 09Mar 09

May 09

Consolidated balance sheet of the Eurosystem

Asset s EUR 914 bln

Liabilit ies EUR 914 bln

Asset s EUR 1059 bln

Liabilit ies EUR 1059 bln
26 Sep 2008

27 Jul 2007

Dom e s tic andfore ign as s e t
portfolio

Bank note sDom e s tic andfore ign as s e t
portfolio

Bank note sM ROM RO
LTRO and LF
CACAGD and AF

LTRO and LF

FTO and DF
Claim of US FED

USD re financing
ope rations

GD and AF

FTO and DF

USD re financing
ope rations

Claim of US FED

Inflation and growth outlook (SPF)
Inflation and growth outlook in the euro area
Survey of Professional Forecasters - One-year ahead
32
10-1-2-3
2007Q1

2007Q3

2008Q1

Growth forecast

2008Q3

2009Q1

Inflation forecast

ECB rates and EONIA

Minimum bid rate%

Deposit rate

Marginal lending rate

EO NIA

6.00

65.50

5.5

5.00

54.50

4.5

4.00

43.50

3.5

3.00

32.50

2.5

2.00

21.50

1.5

1.00

10.50

0.5

Jan-07Mar-07 May-07

Jul-07

Sep-07 Nov-07 Jan-08

Mar-08 May-08

Jul-08

Sep-08 Nov-08 Jan-09

Mar-09 May-09%

Financial and economic crisis (Sep08-?)• High uncertainty following the collapse andnear-collapse of a number of financial
institutions:– Complete breakdown of the interbank market;– Clear feedback loops to real economy andgeographically.
– General rise in risk aversion.

Financial and economic crisis (Sep08-?)• Coordinated interest rate cuts; and extended
use of dollar swaps.
• Full allotment at fixed rate, no fine-tuning
operations, but expansion of balance sheet.
– As a result the MRO rate becomes the upper boundof the corridor and EONIA rate drops to close todeposit rate.

• Further lengthening of operations;• Wider collateral set.

Euribor – Eonia swap rate spread

1-week

1-month3-month

400
350
300
250
200
150
100
50
0-50
Jan-07

M ar-07 M ay -07

Jul-07

Sep -07Nov-07

Jan-08M ar-08 M ay -08

Jul-08

Sep -08

Nov-08Jan-09M ar-09 M ay -09

Spread between 3-month Deposit andOvernight Index Swap rates

EURGBP

USD

400350300
250200150100500-50
Jan-07

M ar-07 M ay -07

Jul-07

Sep -07

Nov-07

Jan-08M ar-08 M ay -08

Jul-08

Sep -08

Nov-08Jan-09M ar-09 M ay -09

Intra-euro area government bondspreads
EUR
Spain Gov Spread

Germany 10-2y
Italy Gov Spread

France Gov Spread
Greece Gov Spread

400350300
250200150100500-50
Jan-07 Mar-07 May-07

Jul-07

Sep-07 Nov-07 Jan-08 Mar-08 May-08

Jul-08

Sep-08 Nov-08 Jan-09 Mar-09 May-09

Inflation and growth outlook (SPF)
Inflation and growth outlook in the euro area
Survey of Professional Forecasters - One-year ahead
32
10-1-2-3
2007Q1

2007Q3

2008Q1

Growth forecast

2008Q3

2009Q1

Inflation forecast

ECB rates and EONIA

Minimum bid rate

Deposit rate

Marginal lending rate

EO NIA

6.00

65.50

5.5

5.00

54.50

4.5

4.00

43.50

3.5% 3.00

3 %

2.50

2.5

2.00

21.50

1.5

1.00

10.50

0.5

0.000Jan-07 Mar-07 May-07

Jul-07

Sep-07 Nov-07 Jan-08

Mar-08 May-08

Jul-08

Sep-08 Nov-08 Jan-09 Mar-09 May-09

Euro liquidity operations: outstanding amounts€ bln

FTO Providing
1m STROFTO Absorbing

Marginal Lending Facility
3M LTRO
Deposit Facility

6M LTRO
MRO

900

900

800

800

700

700

600

600

500

500

400

400

300

300

200

200

100

100

00-100-100-200-200

-300

-300

-400
Jan 07 Mar 07-400
May 07

Jul 07

Sep 07

Nov 07

Jan 08Mar 08 May 08

Jul 08

Sep 08

Nov 08

Jan 09 Mar 09 May 09

Consolidated balance sheet of the Eurosystem
Asset s EUR 914 blnLiabilit ies EUR 914 bln

Asset s EUR 1059 bln

Liabilit ies EUR 1059 bln

26 Sep 2008

27 Jul 2007
Dom e s tic andfore ign as s e t
portfolio

Dom e s tic andfore ign as s e t
portfolio

Bank note s

Bank note s
M RO
M RO
LTRO and LF
CACA

GD and AF

LTRO and LF

FTO and DF
Claim s of US FED

USD re financing
ope rations

GD and AF

USD re financing
ope rations

FTO and DF

Asset s EUR 1514 bln

Liabilit ies EUR 1514 bln

1 May 2009

Dom e s tic andfore ign as s e t
portfolioM ROBank note s

GD and AF

LTRO and LF
CAFTO and DF
USD re financing
ope rations

Claim s of US FED
Claim s of SNB

Claim s of US FED

Phase IV?
• Short-term interest rates close to the lower
bound.
• What’s next: Three measures have beenannounced:– EIB becomes a counterparty of the ECB;
– Further lengthening of maturity of LTROs to one
year; financing will be there till 2010;– Outright purchases of covered bonds