The changing operational face of monetary policy

???Cleveland? Yes, I spent a week there one day.??? As someone who proudly called Cleveland home for seventeen years, that one???s not usually one of my favorites. But lately, I have to say, I???m getting to know the feeling. Financial markets? Yes, I spent a year there one month.

I could have in mind any number of developments, but what I???m thinking about today is the announcement on October 6 that the Federal Reserve would commence paying interest on funds that depository institutions hold on reserve with the central bank. Initially, the interest rate that applied to these balances was the target federal funds rate less 10 basis points (or 0.10 percentage points) on required reserves and 75 basis points (or 0.75 percentage points) on excess reserves. On October 22, the Board of Governors of the Federal Reserve announced that the rate paid on excess reserves would be raised to 35 basis points below the funds rate target. Last week the Fed announced that, henceforth, ???the rate on required reserve balances will be set equal to the average target federal funds rate over the reserve maintenance period. The rate on excess balances will be set equal to the lowest FOMC target rate in effect during the reserve maintenance period.???

This last change may seem small and technical ??? and I guess in a sense it is ??? but it is one with some fairly consequential implications. I could explain, but I could hardly do better than the prescient article appearing in the FRBNY Economic Policy Review, written by New York Fed economists Todd Keister, Antoine Martin, and James McAndrews. If you???re a teacher ??? or otherwise have to explain this stuff to the uninitiated ??? the authors provide three mighty nice graphs. First the traditional stuff:

???We begin by examining the total demand for reserve balances by the U.S. banking system. In our stylized framework, this demand is generated by a combination of two factors. First, banks face reserve requirements. If a bank???s final balance is smaller than its requirement, it pays a penalty that is proportional to the shortfall. Second, banks experience unanticipated late-day payment flows into and out of their reserve account after the interbank market has closed. A bank???s final reserve balance, therefore, may be either higher or lower than the quantity of reserves it chooses to hold in the interbank market. This uncertainty makes it difficult for a bank to satisfy its requirement exactly and generates a ???precautionary??? demand for reserves.

???First, note that if the market interest rate were above the penalty rate, there would be an arbitrage opportunity: banks could borrow reserves at the (lower) penalty rate and lend them at the (higher) market interest rate??? As a result, the demand curve is flat . . . at the level of the penalty rate for sufficiently small levels of reserve balances???
 
???If the market interest rate were exactly zero, however, there would be no opportunity cost of holding reserves. In this limiting case, there is no cost at all to a bank of holding additional reserves above the fully insured amount. The demand curve is therefore flat along the horizontal axis after this point.???

Then, on to the system that became effective in the United States on October 6.

???Many central banks use what is known as a symmetric channel (or corridor) system for monetary policy implementation. Such systems are used, for example, by the European Central Bank (ECB) and by the central banks of Australia, Canada, England, and (until spring 2006) New Zealand. The key features of a symmetric channel system are standing central bank facilities that lend to and accept deposits from commercial banks???

???The new feature in Exhibit 2 is that the demand curve does not decrease all the way to the horizontal axis, but instead becomes flat at the deposit rate. In other words, the deposit rate forms a floor below which the demand curve will not fall.???

Finally, what of the world as it is today?

???Starting from the symmetric channel system presented in Exhibit 2, suppose that the central bank makes two modifications. First, the deposit rate is set equal to the target rate, instead of below it. In other words, in this system the central bank targets the floor of the channel, rather than some point in the interior. Second, the reserve supply is chosen so that it intersects the flat part of the demand curve generated by the deposit rate (Exhibit 3), rather than intersecting the downward-sloping part of the curve. Supply and demand will then cross exactly at the target rate, as desired.

???The key feature of this system is immediately apparent in the exhibit: the equilibrium interest rate no longer depends on the exact quantity of reserve balances supplied. Any quantity that is large enough to fall on the flat portion of the demand curve will implement the target rate??????

I haven???t thus far offered explanations for why these changes might be desirable and how they relate to the broader context of monetary policy generally. More on that tomorrow.

By David Altig, senior vice president and director of research at the Federal Reserve Bank of Atlanta

- David Altig

More on the changing operational face of monetary policy

This week I???m begging your forbearance as we take a bit of a detour into the operational weeds of monetary policy. The geek factor is high, I know, but there truly have been some historic changes afoot over the past months.

To review, effective Nov. 6???as noted in Wednesday???s blog post ???the Federal Reserve unwrapped a new approach to its daily operations in overnight interbank markets (in which the federal funds rate is determined). Rather than sending you scurrying down the page, here???s the deal in a nutshell:

1. The federal funds rate is the interest rate at which depository institutions borrow and lend to each other, on an overnight basis, balances (or reserves) deposited with the Fed.

2. The Fed???actually the folks who implement Open Market Operations at the Federal Reserve Bank of New York???manages the federal funds rate to an FOMC-set target by altering the total quantity of reserves available to the banking system.

3. In the old days (pre-October 6 when the Fed first began paying interest on reserves using a different interest-rate regime), these reserves paid no interest. Banks, as a consequence had every incentive to economize on their reserve balances. As a consequence of that fact, depository institutions would respond to an injection of reserves by trying to sell them off. That might work for one bank, but not the banking system as a whole, and in the end the banks would collectively have to be ???persuaded??? to hold the additional reserve balances. The persuading factor would, of course, be a lower federal funds rate.

4. In the new regime (post-November 6), banks can deposit reserve balances with the Federal Reserve, earning exactly the interest rate they would receive by taking those reserves and lending them out in the federal funds rate market. Beyond some point, then, an increase in reserves should have no impact on the federal funds rate, as banks should simply absorb any injection of reserves into the system. In other words, the Fed can expand the monetary base without changing the federal funds rate.

So, here???s today???s question: Why might it be a good idea, paraphrasing Keister, Martin, and McAndrews , to divorce money from the federal funds rate? Here???s your answer, courtesy of the Board of Governors??? ???FAQ sheet??? :

The inability to pay interest on balances held to satisfy reserve requirements essentially imposes a tax on depository institutions equal to the interest that might otherwise have been earned by investing those balances in an interest-bearing asset. Paying interest on required reserve balances effectively eliminates this tax???

Paying interest on excess balances should help to establish a lower bound on the federal funds rate by lessening the incentive for institutions to trade balances in the market at rates much below the rate paid on excess balances. Paying interest on excess balances will permit the Federal Reserve to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System???s macroeconomic objectives of maximum employment and price stability.

Keister et al. expand on the idea:

The value of the payments made during the day in a central bank???s large-value payments system is typically far greater than the level of reserve balances held by banks overnight???

As a result, banks??? overnight reserve holdings are too small to allow for the smooth functioning of the payments system during the day. When reserves are scarce or costly during the day, banks must expend resources in carefully coordinating the timing of their payments. If banks delay sending payments to economize on scarce reserves, the risk of an operational failure or gridlock in the payments system tends to increase. The combination of limited overnight reserve balances and the much larger daylight demand for reserves thus creates tension between a central bank???s monetary policy and its payments policy. The central bank would like to increase the total supply of reserve balances for payment purposes, but doing so would interfere with its monetary policy objectives.

Monetary policy, in this instance, presumably means manipulating the federal funds rate, and with that the story looks more or less complete: Having removed the opportunity cost to banks of holding reserves, expansion of reserves for payments policy reasons can be accomplished without changing the fed funds rate target, and conversely the funds rate target can be changed without compromising the provision of total reserves.

I say more or less complete for a couple of reasons. The first has been highlighted by Jim Hamilton (among others): Thus far, the interest rate on excess reserves has failed to put a floor on the effective federal funds rate. Suffice it to say the puzzle has not yet been resolved:

The second issue, which has not yet generated much commentary, is exactly how we should be thinking about this separation of the federal funds rate from the provision of reserves. There is a tendency to think of monetary policy as purely linked to the federal funds rate and its direct influence on the cost of funds and, hence, capital. But as Chairman Bernanke has noted , the issue may be a bit more complicated:

Another area of pressing current interest derives from [Milton Friedman's proposition] that monetary policy works by affecting all asset prices, not just the short-term interest rate. This classical monetarist view of the monetary transmission process has become highly relevant in Japan, for example, where the short-term interest rate has reached zero, forcing the Bank of Japan to use so- called quantitative easing methods. The idea behind quantitative easing is that increases in the money stock will raise asset prices and stimulate the economy, even after the point that the short-term nominal interest rate has reached zero. There is some evidence that quantitative easing has beneficial effects (including evidence drawn from the Great Depression by Chris Hanes and others), but the magnitude of these effects remains an open and hotly debated question.

A natural corollary to that proposition would be that a large expansion of the monetary base might well constitute a change in monetary policy properly construed, even when the federal funds rate target remains unchanged. That is, the separation of money and monetary policy may not be quite as irreconcilable as it seems at first blush.

Of course, as the Chairman said, it???s an open question, and will no doubt be hotly debated. Stay tuned.

- David Altig

What do we know about infrastructure spending?

Recently, there???s been a great deal of discussion about developing, legislating, and implementing a second fiscal stimulus. One of the prominent components mentioned in the recent stimulus discussion is investing in infrastructure to create jobs.

The appeal of this category of spending is fairly obvious, as it represents one aspect of a stimulus package that might be expected to have a long-term benefit to the economy. A criticism has been that infrastructure spending is too slow in implementation to be a good source of short-term stimulus, but Martin Neil Baily, senior fellow at the Brookings Institution, has a couple of responses to that argument :

?????? I am also aware of the objection to using infrastructure investment as a stabilization policy because it can be too slow to work. There are two ways in which this problem could be overcome: First, there is great need for improved maintenance of the infrastructure, including crumbling roads that need repair and bridges that may age prematurely or even collapse because they have not been looked after??? Second, there are state and local projects that are being cancelled because of the short term budget pressures. Sustaining such projects would avoid layoffs that would otherwise take place.???

So far, so good, but then the question turns to whether public investment on infrastructure really is a good long-term social investment. As always seems to be the case, the details can be tricky. A few years back, Bates College economist and Jerome Levy Institute Scholar David Aschauer provided a good roadmap of the essential issues . There is a lot of empirical analysis in Professor Aschauer???s paper, but here is the bottom line:

?????? three questions pertaining to economic growth may be asked: Does how much public capital you have matter? Does how you finance public capital matter? and, Does how you use public capital matter? The empirical results presented in this article allow affirmative answers to each of these questions. Specifically, 10% increases in either the quantity or the efficiency of public capital are estimated to increase output per capita by 2.9% over 2 decades while a 10% increase in external public debt is estimated to decrease output per capita by 1.7% over the same time frame??? The main lesson to be drawn from these findings is that in formulating economic development policies, countries are well advised to pay as much attention to how public capital is financed and used as to how much public capital is accumulated.???

Aschauer???s study was based on aggregate, cross-country data. In a Brookings Institution piece published about the same time as David???s, New York Fed economist Andrew Haughwout considered the evidence from our state and local Main Streets :

???Analysis of the effect of state and local government investment on state-level economic growth has provided a range of estimates, and debate about the exact magnitude of the effect continues. But most authors now seem to agree that modest increases in state public capital stocks would not dramatically raise state economic growth. In other words, that increasing public investment will not add much to a given state's ability to create jobs and wealth.

???Economists have been hesitant to give the policy advice, "Don't do it," because they recognize that some projects may have a beneficial economic effect even if the average one doesn't. They also realize that the productivity evidence does not take into account the direct household benefit of having a better infrastructure stock.???

More than most of the currently popular stimulus ideas, the benefits of increased infrastructure spending really do seem to depend critically on the specifics. Best to think about those specifics sooner rather than later.

By David Altig , senior vice president and research director, Federal Reserve Bank of Atlanta

- David Altig

Thoughts on reading the October CPI

Here is what we know about the October consumer price index (CPI). The overall index declined at an annualized rate of about 11 percent for the month???it???s sharpest fall since 1947. A plunge in gasoline prices played a big part in the decline, but that isn???t the whole story. The traditional ???core??? CPI, which excludes food and energy prices, also declined in October (at an annualized rate of about 1 percent). This is the first decline in the core CPI since 1982.

Let me offer an opinion on what may be behind these numbers. The drop-off in consumer prices seems to have been prompted by a number of factors, including some pass-through from sharply lower commodity prices, a stronger dollar (which makes import prices cheaper), and very soft consumer spending.

But here???s what I don???t know. Is the October CPI a sign of ???deflation"? (and it would appear that many of you are interested in finding an answer to this question ). Before you answer the question for me, consider the following: In order to be ???deflation??? the decline in prices has to be sustained and broadly based. And I???m not sure I can give you much guidance on how long the decline must be in order for it to qualify as sustained, and I sure can???t tell you how broadly-based a general decline in prices is. Consider the distribution of CPI component price changes in figure 1. About one-third of the prices in the CPI market basket declined last month, which is a fairly large percentage of the index. On the other hand, about one-third of the price index was rising in excess of 3 percent last month.

One of the things I like to consider when thinking about how ???sustainable??? and ???general??? the monthly CPI data are is to consider the behavior of the trimmed-mean estimators of the CPI. A trimmed-mean estimator is the weighted average of the CPI after some proportion of the extreme values of the index are ???trimmed??? away. The idea of the trimmed-mean estimator is that extreme price changes are not representative of prices in general. Moreover, there is ample evidence that the more extreme the price change, the less sustained it is likely to be.

We can trim any proportion of the data away. In fact, we can trim it all away such that only the median price change remains (this is the Cleveland Fed???s median CPI series.) Consider figure 2, which shows all the various trimmed mean estimators of the October CPI data, from a CPI that trims very little of the index to one that trims away most of the index. How much trimming provides the best perspective from which to judge how sustainable and general the monthly price data are? In the past, I???ve argued that two indicators stand out, the 16 percent trimmed-mean CPI (trimming 8 percent of the most extreme highs and 8 percent of the most extreme lows from the data) and the median CPI. I???ve highlighted these values in figure 2. While the overall CPI posted a sharp decline, the 16 percent trimmed-mean CPI posted a rather slight 0.6 percent decline, and the median CPI rose 1.8 percent.

But, admittedly, knowing which trim of the data best represents how sustainable and general a monthly price report is, is not very clear. So let me offer up a range for you to consider: the interquartile range of the trimmed-mean estimators. An interquartile range is merely the spread between the 75th and the 25th percentile of the estimators. As such, it provides a relatively stable spread of the estimators from which to gauge the range over which prices are ???generally??? rising (or falling.) Figure 3 shows the interquartile range of the various CPI trimmed-mean estimators monthly since 2004 compared to the traditional core CPI. The interquartile range of the October CPI data is from 0.5 percent to 1.5 percent, shown as the last vertical line in figure 3, and 1.5 percentage points above the core measure.

So when the boss asks me what I thought of the October CPI report and what does that single number tell us about inflation (or deflation), my answer is this: The overall and the core CPI posted declines for the month and clearly there is significant, rather broadly based downward pressure on retail prices. But as I cut the data, it looks to me that the October CPI data is pointing to an inflation rate somewhere in the 0.5 percent to 1.5 percent range.

By Mike Bryan , vice president in the Atlanta Fed???s research department

- David Altig