Innovative Federal Reserve Policies During the Great Financial Crisis

Douglas D Evanoff, George G Kaufman, A G Malliaris

• Publisher: WSPC
• Year: 2018
• eBook ISBN: 9789813236608
• Topic: Economics
• Subtopic: Finance
• Index: Economics

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This book, Innovative Federal Policies During the Great Financial Crisis, contains discussions of unconventional monetary policies, policy changes to address systemic and payments systems risks, new macroprudential policies, the 'stretching' of the financial safety net, changes in the Fed's liquidity funding facility (the discount window), use of the Fed's balance sheet as a tool of monetary policy, and alternative means to deal with real-estate asset bubbles and potential financial instability.

The 10 chapters in this book offer a unique analysis of several innovative approaches by the Federal Reserve that contributed to the stabilization of the US economy following the Great Recession. What unique policies were implemented? Toward what goal? Were they effective? Were there unintended consequences? Additionally, but less thoroughly, events in the Euro market are also discussed, and policies (and their impact) of the ECB are critiqued.

Based on papers presented at the 91st Annual Conference of the Western Economic Association International Meetings in Portland, Oregon, 2016, Innovative Federal Policies During the Great Financial Crisis adds significantly to the debate over why innovative or unconventional policies were needed, how they were implemented and how effective they were.

--> Sample Chapter(s)
Chapter 1: Unconventional Monetary Policy in Theory and in Practice --> Contents:

• Unconventional Monetary Policy in Theory and in Practice (Martina Cecioni, Giuseppe Ferrero, and Alessandro Secchi )
• Monetary Policy with a Large Balance Sheet: Lessons from the Financial History of the United States (Ellis W Tallman)
• The Federal Reserve's Balance Sheet as a Financial-Stability Tool (Robin Greenwood, Samuel Hanson, and Jeremy Stein)
• Lessons from the US Experience with Quantitative Easing (Eric Rosengren)
• Macroprudential Regulation: Different Strokes for Different Folks (Gillian Garcia)
• The Costs and Benefits of Shrinking the Fed's Discount Window (Harvey Rosenblum)
• Stretching the Financial Safety Net to its Breaking Point (Edward J Kane)
• Housing and Other Price Bubbles: The Buildup, the Burst, and the Impact (George G Kaufman, A G Malliaris and Richard W Nelson)
• What Caused the Great Recession in the Eurozone? (Robert L Hetzel)
• The Shadow Financial Regulatory Committee's Views on Systemic and Payments System Risks (Robert A Eisenbeis)

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--> Readership: Finance and economics professionals, and academics and research economists. -->
Monetary Policy;Financial History;United States of America;Federal Reserve;Housing;Macroprudential Regulation;Quantitative Easing;Financial-Stability Tool;Recession;Financial Crisis0 Key Features:

• This book puts together the papers presented at a conference that offers an extremely impressive list of financial scholars and industry experts representing most of the thought leaders in financial regulation, providing an evaluation of the most significant financial regulatory changes in nearly a century and discussion of unintended consequences from recent regulatory reform
• To complement the various aspects of innovative policies discussed at the WEA conference, additional papers covering related issues and written by experts in the field were also invited for inclusion in the volume

Chapter One

Unconventional Monetary Policy in Theory and in Practice

Martina Cecioni, Giuseppe Ferrero, and Alessandro Secchi^∗

Bank of Italy

Abstract

In this chapter, after discussing the theoretical underpinnings of unconventional monetary policy measures, we review the existing empirical evidence on their effectiveness, focusing on those adopted by central banks, particularly the Federal Reserve. These measures operate in two ways — through the signaling channel and through the portfolio balance channel. In the former, the central bank uses communication to steer interest rates and to restore confidence in the financial markets; the latter hinges on the imperfect substitutability of assets and liabilities in the balance sheet of the private sector and postulates that the central bank’s asset purchases and liquidity provision lower financial yields and improve funding conditions in some markets. Our review of the empirical literature suggests that the unconventional measures were effective and that their impact on the economy was sizeable. However, a large degree of uncertainty surrounds the precise quantification of these effects.

1.Introduction

In normal times, central banks implement monetary policy by steering official interest rates and explaining to the public how a particular monetary stance in a given economic environment should contribute to achieving the final goals. To this purpose, central banks may decide to share with the public their views about the future evolution of some key macroeconomic variables or even their policy intentions.

Monetary policy decisions and announcements are first transmitted to the interbank market (the market for central bank reserves). When market conditions are quiet, central banks’ monopolistic power in the provision of reserves allows them to steer interest rates in the interbank market accurately.

In such an environment, the provision of liquidity to the banking system is a mechanical exercise and liquidity management operations are designed exclusively to implement the desired level of short-term interest rates. In particular, the provision of liquidity does not contain any information about the monetary policy stance beyond that included in the official interest rate.¹ Moreover, during normal times, the central bank is only concerned about injecting the banking system with the appropriate amount of reserves while their distribution among depository institutions takes place through the interbank market.

The monetary impulse is then transmitted through different channels to all the other financial markets.² In particular, it also affects credit market conditions and long-term interest rates, which are key elements in the public’s investment-consumption decisions through this conventional transmission mechanism.

However, implementing monetary policy is a much more complex exercise during a financial crisis, as the transmission mechanism can be severely impaired by disruptions in the financial markets. First, the increase in the volatility of the demand for reserves and the limited redistribution of liquidity among depository institutions may adversely affect the central bank’s ability to control short-term interest rates in the interbank market. Second, disruptions in other segments of the financial market may hamper the transmission of the monetary impulse across the full spectrum of financial assets. Finally, when the effect of the crisis on the real economy is large, the zero lower bound for interest rates may become a binding constraint for monetary policy decisions.³ In these situations, central banks may need to resort to unconventional measures to regain control on the economy.

There is not a universally accepted definition of a non-standard monetary policy measure; indeed, the difference between a conventional and an unconventional tool might, in some cases, be quite tenuous.⁴ We include in the set of unconventional measures any policy intervention that aims to rectify a malfunctioning of the monetary transmission mechanism or to provide further stimulus to the economy when the official interest rates reach the zero bound. We therefore classify as non-standard tools all the measures implemented during the global financial crisis that addressed liquidity shortages, including of depository institutions and of other important segments of the financial market, the direct purchase of private and public securities, and the adoption of particular forms of communication designed to restore a more normal functioning of the markets and influence expectations about future official interest rates.

During the global financial crisis, recourse to these measures varied across countries. This reflected the differences in the structure of the respective financial systems, in the severity of market disruptions, and the role of central banks’ judgment. During unconventional times, this last factor contributes more because of the lack of both sound theory and empirical evidence on the effectiveness of non-standard measures (Trichet, 2010). To fill this gap, and to increase our understanding of the mechanisms through which unconventional monetary measures influence the economy, the profession intensified its research activities in this area.

In this chapter, we touch on measures adopted in the U.S. during the global financial crisis, we provide a review of the main theoretical underpinnings that support the use of unconventional measures, and we survey the evidence on their effectiveness. While these measures may have prevented a collapse of the financial system and a deeper contraction of the real economy as a result of the global crisis, a clearer understanding of the contribution of each of them is a necessary step towards defining an “optimal unconventional tool-box” to deal with future crises.

The theoretical literature on the functioning of unconventional policy tools identifies two transmission channels.

The signaling channel enables the central bank to use communication to restore confidence in the markets and influence private expectations about future policy decisions. This channel may be particularly useful when official interest rates reach the zero lower bound and the central bank needs to provide further stimulus to the economy.

The purchase of both public and private securities and the provision of credit to financial and non-financial institutions affect the economy through the portfolio-balance channel, which operates when assets and liabilities in the balance sheets of the private sector are imperfectly substitutable. The central bank can exploit this channel when it wants to alleviate tensions in particular segments of the financial markets, when it seeks to reduce yields more widely, and when it decides to counteract the impact of financial frictions on funding conditions.

Our review of the theoretical and empirical evidence suggests that the unconventional measures have been effective in influencing financial and macroeconomic variables. However, considerable uncertainty surrounds the quantification of these effects.

The chapter is organized as follows. Section 2 analyses the theoretical support for the effectiveness of the unconventional measures adopted in the U.S. up to mid-2011. Section 3 surveys the empirical evidence, and Section 4 concludes.

2.Unconventional Monetary Policy in Theory

In this section, we describe two channels through which the unconventional monetary policy is transmitted to the economy — the signaling and the portfolio-balance channel.

2.1.The signaling channel

The signaling channel is activated through central bank’s communications informing the public about its intentions regarding the future evolution of short-term interest rates, or the implementation of other measures targeted at counteracting market dysfunctions. The efficacy of this channel relies on the credibility of the central bank and on the extent to which private expectations and confidence affect macroeconomic and financial market conditions.

Not all forms of communication that exploit the signaling channel should be seen as “unconventional” measures. Since the 1990s, it has become increasingly clear that managing expectations is a crucial task of monetary policy; therefore, communication aimed at sharing with the public central bank views about the macroeconomic outlook and, in some cases, about the future evolution of short-term interest rates has evolved into a standard tool of monetary policy.⁵ Thus, communication should be considered an unconventional tool of monetary policy only when it is used by a central bank to convey information or pursue objectives that go beyond its standard practice.⁶

In the literature, the signaling channel has been highlighted as the mechanism to escape the zero lower bound on official interest rates. Krugman (1998) claims that when the zero lower bound binds, the central bank should follow an “irresponsibility principle”, that is, convince the market that it will allow prices to raise so to increase inflationary expectations. Eggertsson and Woodford (2003) embed this result in the New Keynesian (NK) framework, concluding that not only is the signaling channel (or, as they call it, the management of expectations) crucial, but it is the only channel that is effective. In the NK model, long-term interest rates, on which firms’ and households’ consumption, investment, and borrowing decisions are based, depend entirely on financial market participants’ expectations about the future path of short-term rates.

During the financial crisis, the Fed provided forward guidance about the likely path of the federal funds rate to promote economic recovery and price stability. However, the central bank did not explicitly commit to the irresponsibility principle advocated by Krugman (1998), and announced that the future official interest rate path would depend on the evolution of the macroeconomic outlook.⁷ Clarida (2012) argues that this type of commitment, if not properly qualified, may in practice be confused by the public with a policy of discretion (“policy rates are expected to be low because and so long as output and inflation are expected to be low”) which, in the case of perfect information, is not expected to exert any influence on long-term interest rates. On the contrary, Walsh (2008) shows that when the central bank is endowed with superior information, the provision of forward guidance about future interest rates is welfare-improving, even when monetary policy is discretionary.

Time inconsistency may severely limit the effectiveness of the announcement of an interest rate path — a change in the size and composition of its balance sheet may help to overcome this obstacle. For instance, large purchases of long-term securities may strengthen the promise to keep short-term rates low for some time owing to the adverse effect that an increase in official interest rates would have on the health of the central bank’s balance sheet (Bernanke, Reinhart and Sack, 2004). The central bank could also enforce its commitment about future official interest rates by entering into more explicit contingent contracts with market participants. Tinsley (1998), for example, suggests that by selling shorthorizon bond put options, the credibility of the central bank’s policy would be enforced by binding contractual arrangements with private sector agents, who will be compensated for any future deviations from the policy terms designated in the contingent contracts.

The practical relevance of these mechanisms is questioned by Rudebusch (2011), who estimates that, notwithstanding its large bond purchases, the Fed’s losses due to an increase in short-term interest rates would be almost negligible. Moreover, these losses would only be realized on the share of the portfolio of long-term securities that is not held to maturity. These estimates and the fact that the central bank is not a private institution with profitability as its main objective suggest that the effectiveness of such a device in preventing short-term rate increases by the central bank is arguable.

Communication aimed at reassuring markets on the central bank’s active role during episodes of financial turbulence can also help to restore the functioning of the monetary transmission mechanism. For example, the announcement of the intention to intervene in illiquid markets provides a signal to market participants that the central bank stands ready to contrast undue volatility in asset prices and provide liquidity in case of necessity. By assuring markets about the central bank’s role of lender of last resort and by providing an implicit guarantee of the intermediation role of the central bank, the announcement itself may influence market behavior even before any action is taken.⁸ The information released, concerning the size, speed and, more in general, the terms of the intervention, is crucial for the effectiveness of the signaling channel. The central bank’s optimal degree of transparency must trade...

Table of contents

• Cover Page
• Title
• Copyright
• Preface and Acknowledgements
• About the Editors
• About the Contributors
• Contents
• Chapter 1 Unconventional Monetary Policy in Theory and in Practice
• Chapter 5 Macroprudential Regulation and Supervision: Different Strokes for Different Folks
• Chapter 6 The Costs and Benefits of Shrinking the Fed’s Discount Window
• Chapter 7 Stretching the Financial Safety Net to its Breaking Point
• Chpater 8 Housing and Other Price Bubbles: The Buildup, the Burst, and the Impact
• Chapter 9 What Caused the Great Recession in the Eurozone?
• Chapter 10 The Shadow Financial Regulatory Committee’s Views on Systemic and Payments System Risks