Chapter 13 The Tools and Goals of Central Bank Monetary Policy.

Chapter 13

The Tools and Goals of Central Bank Monetary

Policy

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McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Learning Objectives

• To understand how the policy tools available to central banks work in carrying out a nation’s money and credit policies.

• To explore the strengths and weaknesses of the various monetary policy tools.

• To learn how the Federal Reserve System controls U.S. credit and interest rate levels.

• To see how central bank policy actions affect a nation’s economic goals.

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Introduction

• Central banks are given the task of regulating the money and credit system in order to achieve the economic goals of maximum employment, a stable price level, and sustainable economic growth.

• Although these objectives are not easy to achieve and often conflict, the central bank has powerful policy tools at its disposal.

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General versus Selective Credit Controls

• General credit controls affect the entire banking and financial system.

Examples: reserve requirements, the discount rate, open market operations

• Selective credit controls affect specific groups or sectors of the financial system.

Examples: moral suasion, margin requirements on the purchase of listed securities

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Reserve Requirements

• In the U.S., all depository financial institutions (including nonmembers) are required to conform to the deposit reserve requirements set by the Fed.

• Changes in reserve requirements are a very potent, though little-used tool.

• Indeed, reserve requirements have recently been reduced in the U.S., and eliminated in Canada, New Zealand, and the U.K.

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Reserve Requirements

• An increase in deposit reserve requirements decreases the deposit and money multipliers, slowing the growth

of money, deposits and loans reduces the amount of excess legal reserves - institutions

deficient in required legal reserves will have to sell securities, cut back on loans, or borrow reserves

increases interest rates, particularly in the money market, as depository institutions scramble to cover any reserve deficiencies

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Effects of Changes in Reserve Requirements on Deposits, Loans, and Investments

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Effects of Changes in Reserve Requirements on Deposits, Loans, and Investments

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Current Levels of Reserve Requirements

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The Discount Rate

• The discount rate is the interest rate that the Federal Reserve banks (and many other central banks as well) charge on loans they grant to other institutions (principally banks and security dealers).

• For the most part, these loans are regarded as temporary credit and a backup source of funds to the money market, where credit is usually much cheaper and easier to find.

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The Discount Rate

• In 2003, the Federal Reserve redesigned the discount windows:- Primary credit is extended only to sound depository institutions- Secondary credit is intended for borrowing institutions that do

not qualify for primary credit. This money cannot be used for asset expansion.

- Seasonal credit is usually available only to relatively small depositories that show a clear pattern of seasonal (intrayear) fluctuations in their deposits and loans.

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The Discount Rate

• Another recent significant change made by the Fed involved setting the discount rate on primary and secondary credit above the target interest rate on federal funds.

• This new discount-window policy ensures a “no hassle” supply of primary credit to sound depository institutions facing emergencies.

• The primary credit rate is also expected to serve as a cap for the prevailing market rate on federal funds.

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The Discount Rate

Discount Window Loans Granted, May 2004 (in millions of dollars)

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The Discount Rate

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The Discount Rate

• An increase in the discount rate reduces the volume of loans from the discount window (cost

effect) makes borrowing from the Fed less attractive (substitution

effect) signals that the Fed is pushing for tighter credit conditions

(announcement effect), and market participants may respond by curtailing their spending plans or by accelerating their borrowings (to secure the credit they need before interest rates move even higher)

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The Discount Rate

• Beginning in 1999, the Fed’s discount rate was set up to follow the federal funds interest rate.

• In 2003, the spread was set at 1 percentage point (100 basis points). so as to turn the discount rate and the discount window into a relatively passive tool in the conduct of U.S. monetary policy.

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Open Market Operations

• Open market operations in the U.S. consist of the buying and selling of U.S. government and other securities by the Federal Reserve System to affect the quantity and growth of legal reserves, and ultimately, general credit conditions.

• Open market operations are a most flexible policy tool, suitable for fine-tuning the financial markets.

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• The open market tool has two major effects. When the Fed is purchasing securities, the additional demand

for the securities in the market tends to increase their prices and lower their yields, so interest rates decline.

A Federal Reserve purchase of government securities increases the reserves of the banking system and expands its ability to make loans and create deposits, thereby increasing the growth of money and credit.

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• All trading in securities by the Federal Reserve System is carried out through the System’s Trading Desk, located at the Federal Reserve Bank of New York.

• The Desk is supervised by the manager of the System Open Market Account (SOMA).

• The manager is guided by policy directives from Federal Open Market Committee (FOMC) meetings and checked through conference calls.

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Federal Open Market Committee Statement

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Types of Federal Reserve Open Market Transactions

Outright or Straight Open Market Transaction(permanent change in the level of reserves held by depository institutions)

FederalReserve

bank

Fed buys securities

Dealer

Dealer’s bank

Securities

Reserves

FederalReserve

bank

Fed sells securities

Dealer

Dealer’s bank

Securities

Reserves

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RP or Reverse RP Transaction(temporary change in the level of reserves held by depository institutions)

RP: Fed buys securities temporarily

FederalReserve

bank

Dealer

Dealer’s bank

Securities

Reserves

Later on:

Reserves

Securities returned

Reverse RP: Fed sells securities temporarily

FederalReserve

bank

Dealer

Dealer’s bank

Securities

Reserves

Later on:

Reserves

Securities returned

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Run-Off Transaction(permanent reduction in the level of reserves held by depository institutions)

FederalReserve

bankSells more securities to raise more cash

Pays cash

Treasury

Maturing Treasury securities

Dealer

Dealer’sbank

Orders bank to pay for the new securities

Reserves

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Agency Transaction (Type A)(no change in the total level of reserves held by all depository institutions)

FederalReserve

customer

Places order for securities through a Federal Reserve bank

which then contacts dealer

Delivers securities

Dealer

Dealer’sbank

Orders payment to dealer

ReservesCustomer’s

bank

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Agency Transaction (Type B)(permanent reduction in the level of reserves held by depository institutions)

FederalReserve

customer

Places order for securities

Securities delivered from Fed’s own portfolio

FederalReserve

bank

Orders payment to Fed

ReservesCustomer’sbank

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• Defensive open market operations are technical adjustments in market conditions to preserve the status quo and to maintain the present pattern of interest rates and credit availability.

• In contrast, dynamic open market operations are designed to upset the status quo and to change interest rates and credit conditions to a level the Fed believes to be more consistent with its economic goals.

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Selective Credit Controls Used by the Fed

• Moral suasion refers to the use of “arm-twisting” or “jawboning” by central bank officials to encourage lending institutions and the public to conform with the spirit of its policies.

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• Margin requirements on the purchase of stocks and convertible bonds and on short sales of securities limit the amount of credit that can be used as collateral for a loan.

• Since 1974, the U.S. margin requirement on stocks, convertible bonds, and short sales has been 50% of the market value of the securities.

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Interest Rate Targeting

• In recent years, the Federal Reserve has given increasing weight to targeting the cost and availability of credit in the money market.

• The money market indicator that usually feels the first impact from Federal Reserve policy moves is the effective federal funds rate or daily average interest rate on federal funds transactions.

• Beginning in 1989 the Fed adopted a federal funds interest rate targeting procedure.

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• Borrowed reserves are loans made to depository institutions by the Federal Reserve banks. Nonborrowed reserves are legal reserves that belong to depository institutions.

• The Fed achieves its target through open market operations that impact primarily the nonborrowed reserves (and hence the total reserves) available to the banking system.

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D’

When the demand for reserves S’

The Fed supplies

more reserves

Such that the federal funds rate is maintained at the desired level

E’

Federal Funds

Interest Rate (%)

Supply of Reserves ($)

D S

E

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• Note that long-term capital market interest rates may not respond in the same way as short-term federal funds rate to the Fed’s activities in the financial marketplace.

• For example, higher inflationary expectations may push long-term interest rates upward as capital market investors seek compensation for the fear of greater inflation.

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The Federal Reserve and Economic Goals

The Goal of Controlling Inflation (& Deflation)• Inflation creates undesirable distortions in the allocation of

scarce resources.• In the 1990s, several central banks (such as New Zealand,

Canada, and U.K.) began setting target inflation rates or rate ranges.

• The U.S. has not set an explicit target, though it seeks to drive inflation so low that it does not affect business and consumer decisions.

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The Goal of Maximum Employment• The Employment Act of 1946 committed the U.S. government

to maximizing employment as a major national goal.

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The Goal of Sustainable Economic Growth• The Federal Reserve has declared that one of its most

important long-term goals is to keep the economy growing at a relatively steady and stable rate – that is, a rate high enough to absorb increases in the labor force and prevent the unemployment rate from rising but slow enough to avoid runaway inflation.

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Rates of Growth in Real U.S. GNP & GDP(Compounded Annual Rates of Change)

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The Trade-offs Among Central Bank Goals

• Not every nation makes it clear to its central bank what its priorities should be among different possible goals.

• The goals may also conflict with one another.- For example, controlling inflation may require the central bank

to slow down the domestic economy through restrictions on credit growth and higher market interest rates.

- However, this policy threatens to generate more unemployment and subdue economic growth.

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The Trade-offs Among Economic Goals

• However, there is growing research evidence that maximum employment, sustainable economic growth, and price stability can be compatible with one another in the longer run.

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The Limitations of Monetary Policy

• Central banks cannot completely control financial conditions or the money supply.- Changes in the economy feed back on the money supply and the

financial markets.- The structure of the economy is changing due to deregulation,

internationalization, technological developments, etc., such that changes in domestic interest rates may not be as potent a factor affecting the economy as they were a decade ago.

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Markets on the Net

• The Federal Reserve System at www.federalreserve.gov• Bank of Canada at www.bankofcanada.ca/en• Bank of England at www.bankofengland.co.uk/ • Bank of Japan at www.boj.or.jp• European Central Bank www.ecb.int• Federal Open Market Committee at

www.federalreserve.gov/fomc

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Markets on the Net

• Interest-Rate Targeting at www.federalreserve.gov/fomc• Reserve Bank of New Zealand at www.rbnz.govt.nz• The Discount Window at www.frbdiscountwindow.org

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Chapter Review

• Introduction to the Tools and Goals of Monetary Policy• General versus Selective Credit Controls• General Credit Controls of the Fed

- Reserve Requirements- The Federal Reserve’s Discount Rate- Open Market Operations

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Chapter Review

• Selective Credit Controls Used by the Fed- Moral Suasion by Central Bank Officials- Margin Requirements

• Interest Rate Targeting- The Federal Funds Rate- Fed Funds Targeting and Long-Term Interest Rates

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Chapter Review

• The Federal Reserve and Economic Goals- The Goal of Controlling Inflation- The Goal of Maximum Employment- The Goal of Sustainable Economic Growth

• The Trade-offs Among Central Bank Goals• The Limitations of Monetary Policy

Chapter 13 The Tools and Goals of Central Bank Monetary Policy.

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