Simon M Potter: Implementing monetary policy post-crisis - what have
we learned? What do we need to know?
Remarks by Mr Simon M Potter, Executive Vice President of the Markets Group of the
Federal Reserve Bank of New York, at a workshop organized by Columbia University SIPA
and the Federal Reserve Bank of New York, New York City, 4 May 2016.
* * *
I would like to thank Antoine Martin for his assistance in preparing these remarks.
I would like to welcome you to this workshop, organized jointly by the School of International
and Public Affairs at Columbia University and the Federal Reserve Bank of New York. We
have assembled an excellent set of presenters and discussants focused on the topic of
implementing monetary policy post-crisis, who are here to ask important questions such as
what have we learned from our experience and what do we need to know going forward? I
am expecting an active and stimulating dialogue on a range of topics. As always, these
remarks are my own and do not necessarily reflect the views of the Federal Reserve Bank of
New York or the Federal Reserve System.
As most of you know, the Federal Reserve System is engaged in an extended effort to
evaluate potential long-run monetary policy implementation frameworks.1 There are many
reasons to take a close look at the issues now. For example, the Federal Reserve has new
tools, like the authority to pay interest on reserves and reverse repurchase agreements with
an expanded set of counterparties, which were not available pre-crisis.2 The money markets
in which the Trading Desk of the Federal Reserve Bank of New York (the Desk) operates
have different dynamics than before, in part because of our large-scale asset purchases. We
want to take stock of these changes and ask ourselves what the best way of implementing
monetary policy is today and in future environments in a manner that is consistent with the
Federal Reserve's normalization principles.3
To make good choices about the monetary policy implementation framework going forward, it
is, of course, useful to learn from the past. Our task is to assess the strength and
weaknesses of existing and previous frameworks, particularly through the lens of what
happened during the recent global financial crisis, when central banks were called on to
innovate in a number of ways. In addition, the varied experience of other central banks prior
to the crisis can also provide valuable insights. What have they learned about what worked
well, or did not work so well, with their frameworks?
The current framework in the United States looks very different than the pre-crisis framework.
One way in which it is different is that excess reserves are much higher than they used to be.
This shift is due, in large part, to the large-scale asset purchases that the System undertook,
starting in December 2008. But, if you look closely, you'd see that excess reserves actually
started expanding earlier and control of the federal funds rate deteriorated.4 So what
happened?
In reviewing the events of the second half of 2007 and most of 2008, it is clear that the
Federal Reserve faced a tension between the need to provide liquidity to ease money market
strains and the need to keep control of the interest rate target within its earlier framework.
Demand for dollar liquidity increased in many money markets and some of that demand
came from banks headquartered outside of the United States. A by-product of the Federal
Reserve's efforts to provide liquidity to the financial system is that the supply of reserves,
which can only be held by banks, increased. Reducing money market strains may require
injecting more reserves than banks want to hold at the target rate, creating an excess that
can lead to a decrease in interbank money market rates. This tension is a potential feature of
implementation frameworks that rely on scarcity of reserves. If reserves become less scarce,
and if you cannot pay interest on reserves, you will lose control of the interest rate that you
are trying to steer. Francesco Papadia's presentation later today will illustrate some of the
flexibility that the European Central Bank (ECB) had in its framework in 2007 relative the
Fed.
It might be difficult to recall, but for the period prior to mid-December 2008, the Desk was
directed to hit a point target for the federal funds rate significantly above zero. The Federal
Reserve did not have authority to pay interest on reserves until October 2008, so maintaining
a scarcity of reserves was the only method available to control the federal funds rate. If the
Desk had allowed reserves to increase above predicted demand at the target rate, the traded
rate would have fallen well below the target rate set by the Federal Open Market Committee
(FOMC).
To maintain scarcity and thus control, the Desk had to "sterilize" operations aimed at easing
strains in money markets; that is, it had to offset any injection of reserves by removing an
approximately equivalent amount from the system. One possibility would have been for the
Fed to borrow from its traditional counterparties, the primary dealers. But dealers are usually
borrowers in our money markets, not lenders, meaning they had limited capacity for these
kinds of transactions, especially during the crisis. Knowing that fact, we designed the
System's securities portfolio to accommodate some amount of sterilization. The portfolio was
composed of a substantial stock of short-dated Treasury securities, so that, as these
securities matured, the supply of reserves would shrink. Draining reserves in that way takes
time, however, and the amount of liquidity that would have been needed to ease the strains
in our financial markets far exceeded the amount that could be supplied while still keeping
control of the federal funds rate.5
Another way to drain reserves is by selling assets. The
Desk did some of that in response to the crisis, but, for a variety of reasons, including
operational constraints and concerns that sales of securities could have counterproductive
effects, the amounts were small. Other tools that can be used to drain reserves, which were
developed later, are a Term Deposit Facility and term reverse repos with extended
counterparties.6
Providing liquidity to financial markets at the onset of the crisis was important to ensure that
the stance of monetary policy would be transmitted to the real economy. One simple
measure of the stance of policy is that the average of trading in the overnight interbank
market is very close to the FOMC's target rate. However, this simple measure can provide a
misleading picture. The experience of the crisis suggests that transmission of the appropriate
stance can be impaired even when temporary open market operations keep the effective fed
funds rate at the target. Recall that in this period the fed funds and Eurodollar markets
exhibited a bifurcated structure with many foreign banks paying considerably more to borrow
than U.S. banks. As Marvin Goodfriend will discuss, part of this was due to appropriate
market pricing of credit risk, but other aspects reflected segmentation in the money markets
that was exacerbated by a pronounced lack of dollar liquidity. Some of this decline in money
market functioning was not reflected in the effective fed funds rate as it was measured at that
time.7
The situation today is very different for a number of reasons. The Federal Reserve has the
authority to pay interest on reserves. Many countries that run a "corridor" system of monetary
policy implementation have had this authority for a long time and could transition from
reserves scarcity to a state of more plentiful supply of liquidity while maintaining adequate
control of their interest rate, as I noted was the experience for the European Central Bank.
In addition, the Desk has augmented an old tool, reverse repurchase agreements, or RRPs
for short, that allow an expanded set of counterparties to invest with the Federal Reserve
either at a fixed interest rate or up to certain quantity.8 With the advent of interest on
reserves, RRP, and the Term Deposit Facility mentioned previously, policymakers have more
tools for influencing market interest rates, and sterilization is no longer necessary to control
rates with large amounts of excess reserves.
Perhaps the most important development is the successful liftoff of the federal funds rate in
December. Although we don't know yet whether the interest rate control exhibited to date
with the new tools will continue at different settings of the target range, so far, things have
gone as well as could have been expected.
While other countries have operated a "floor" system before, no country with as complex a
financial system as the United States, with its wide variety of bank and nonbank institutions,
had ever attempted to raise interest rates with such a large supply of excess reserves. The
success of the new tools so far has been important for instilling confidence that policymakers
can control overnight interest rates at levels appropriate to meet their goals. It also means
that, in future, the Federal Reserve will not have to face the same technical constraint that
leads to a conflict between easing strains in broad money markets and controlling the policy
rate whether it uses a floor or corridor system. This could make the Federal Reserve System
more agile and better able in future circumstances to provide the elastic currency that has
been one of our stated purposes since the Federal Reserve Act became law more than a
century ago.
Until a few months ago, many conversations about the long-run framework for monetary
policy implementation considered at least two options; on the one hand, we had the old
system based on reserve scarcity inducing competition for reserves, and, on the other hand,
we had a theory about how competition in a range of money markets would pull market rates
up in line with the interest rates administered by the Federal Reserve. The old system
certainly had flaws, many of which were exposed during the crisis, but it had worked
reasonably well. And a system that works reasonably well is often more appealing than one
that exists only in theory. The successful liftoff has brought theory into practice, and the
results have been good so far.
I am not claiming that the current framework is perfect, or that it is necessarily better than the
old framework augmented with the new tools used to directly absorb excess reserves, but it
is useful to have flexibility in how to implement monetary policy. We have now seen in
practice that changes in administered rates can effectively move market rates - both
because effective competition helps bring administered and market rates closer together and
because the mere existence of administered-rate facilities, like the RRPs I mentioned earlier,
can affect competition between private borrowers and investors even when these facilities
see little usage. As we learn more about the practical aspects of using these mechanisms to
influence money market rates in the United States, a much wider range of potential operating
frameworks becomes viable. It will now be important to make sure that all the costs and
benefits of different approaches are considered carefully to get the most effective framework
for monetary policy implementation.
In particular, there are important trade-offs that may need to be considered in a framework
that can flexibly provide liquidity for monetary policy implementation and broader
transmission. It is possible, for example, that financial market participants may anticipate that
the central bank will make liquidity plentiful during times of stress and that this could reduce
their incentives to manage their liquidity conservatively. For banks, new Basel III liquidity
regulation, such as the liquidity coverage ratio and the net stable funding ratio, partially
mitigates this concern. Nevertheless, these regulations do not apply to all participants in U.S.
money markets. Paul Tucker's presentation will discuss a number of the broader costs and
benefits of such potential flexibility for the role of central banks in democratic societies.
Another important aspect of the future framework is that it should be as transparent as
possible. Market participants can make better decisions if they have a clear understanding of
the way the central bank operates and can anticipate its actions in a wide range of
circumstances. Indeed, it is well understood that in the case of coordination failures, a
commitment to maintaining liquid markets can prevent illiquidity from occurring, in some case
without even having to intervene. For example, during the crisis, some money market
participants did "hoard" liquidity and refuse to lend to other institutions because they were
concerned that they might need the liquidity for themselves. This behavior led to a situation
where liquidity was in short supply because all market participants expected it to be.9 A
central bank can help create conditions where market participants contribute to market
liquidity because they believe that market will remain liquid.
There are many other considerations and trade-offs, but let me wrap up by saying that to
make sure we learn the right lessons from the experience of the last few years, we surely
benefit from drawing on a wide range of perspectives, including those of academics, current
and former central bankers, and market participants - people like you, who "live and breathe"
this somewhat technical topic. It is also valuable to share the findings more broadly to
enhance discourse on the subject.
I hope that you will be frank in your assessment of the things that worked well or did not work
well in the Federal Reserve's framework, and perhaps in other systems. There is much to
learn from a robust discussion of our different experiences. These lessons will be an input
into our thinking as we examine the long-run framework.