1

Central banking before and after the crisis

Francesco Daveri

2

The issues

• Today’s monetary policies in place all around the world are super-expansionary

• What does “super-expansionary” mean in practice? Super-expansionary with respect to what?

• More generally, how does a Central Bank formulate its monetary policy? Which goals, which instruments?

• How is this policy actually implemented?

Policy rates at zero for a decade (not forever, though) ...

3

... But also the quantity of Central Banks’ money has exploded since 2008-q4 ..

4

Outline

Central banking in normal times

Tools? Goals?

Central banking in “abnormal” times During and after the crisis

5

6

The tools of central banks Open-Market Operations

The Fed conducts open-market operations when it buys Government bonds from or sells government bonds to the public: When the Fed buys government bonds, money supply increases. Money supply decreases when the Fed sells government bonds.

Reserve Requirements The Fed also influences money supply with reserve requirements. Reserve requirements are regulations on the minimum amount of reserves

that banks must hold against deposits. Changing the Reserve Requirement: The reserve requirement is the amount

(%) of a bank’s total reserves that may not be loaned out. Increasing (decreasing) the reserve requirement decreases (increases) money

supply

Changing the Discount Rate

The discount rate is the interest rate the Fed charges banks for loans. Increasing (decreasing) the discount rate decreases (increases) money supply

7

The open market operations of the Central Bank affect its balance sheet

The assets of the central bank are the bonds it holds. The liabilities are the stock of money in the economy. An open market operation in which the central bank buys bonds and issues money increases both assets and liabilities by the same amount.

Mortgages 430 Comm. paper 140 AB comm. Paper 24 Bear Stearns + AIG 105 Fannie and Freddie 82 Term facilities:

AB securities loans 15 auction facility 372

T. Bills 130 Discount window 40 FX swaps 176

Assets acquired by the Fed: Dec 2007 – September 2009: + 1.000 U.S. $ bn (unusual operations in red)

9

The role of monetary policy

We – as citizens - are normally concerned about inflation and growth (want low inflation and high growth).

Central bankers are delegated to achieve – a combination of - these goals

Monetary policy is supposed to keep GDP as close as possible to its long-run full employment level as well as inflation close to target (may be 2%)

Two kinds of shocks: Aggregate demand (eg. House prices or stockmarkets fall) Short run aggregate supply (eg. oil or commodity prices or

wages going up)

The central bankers’ problem of today: low growth in Europe and low inflation in EZ and Usa

10

Many worried about the risk of deflation

11

12

How monetary policy is implemented: the Taylor rule

In practice, most central bankers implement inflation targeting following an unofficial rule of thumb in setting the policy rate. This is the Taylor Rule (from John Taylor, Stanford economist):Rt = c (-*) + d (output gap)R = target policy rate (e.g. discount rate)* = long-term goals for inflation (2%?) = actual inflationc, d = positive constants, measuring CB response to deviations of inflation and output from their long-run values (output gap=y-y*)NOTE: Given the delays of effectiveness of monetary policy (it takes time for interest rate cuts to affect market rates), it is the EXPECTED inflation and output gap that matter for the Taylor rule

13

The four implications from the Taylor rule1: economy in long run equilibrium

1) If the economy is OK, do nothing.

As =* and y=y*, the economy is in its long-run equilibrium.

So R =0, i.e. the discount rate should stay constant

14

The four implications from the Taylor rule 2: Aggregate demand shock

2) As the economy overheats (eg positive AD shock), R should go up for two reasons: >* and GDP>GDP*.

The opposite if economy hit by negative AD shock

15

The four implications from the Taylor rule 3: Aggregate supply shock

3) When the economy is hit by a supply shock, the Taylor rule gives ambiguous indications on what to do with R

As >* R should go up YET as Gdp<Gdp* R should go down. Net effect on R depends on values of “c” and “d”•Estimates of “c” and “d” from past data on inflation, GDP, discount rates: c=1.5, d=0.5•In any case, c must be >1. When faced with inflationary shock, the CB goal is to cool the economy down. To do this, CB must raise R by more than the increase in . Otherwise, the real interest rate goes down (and the economy does not cool down)

16

The four implications from the Taylor rule 4: asset market shocks

4) What should central bankers do with asset (foreign exchange, stock, bond, housing) markets?

If CB follows Taylor rule, “do nothing” is a good policy, unless asset price behavior is a threat to stability of future inflation or GDP

17

The blue line shows

what the Fed

actually did

The Fed and the Taylor rule

What went wrong with monetary policy before the crisis?

Before the crisis: based on the Taylor rule, discount rates kept too low for too long (during the second half of the 1990s and 2001-04)

This conclusion stems from today’s hindsight, though

US productivity data (see next slide) were so good that most observers believed that a new Internet-based economy was around and therefore that the output gap was relatively low – so no need to raise the discount rate even when faced with very fast Gdp growth

18

Two productivity jumps

-3

0

3

6

1974 1979 1984 1989 1994 1999 2004

Per

cent

age

poin

ts

The dotted lines are averages for 1973:Q4-1995:Q4, 1995:Q4-2000:Q4 and 2000:Q4-2005:Q4. BLS (2/2/06).

73:Q4-95:Q4 = 1.5%95:Q4-00:Q4 = 2.5%00:Q4-05:Q4 = 3.2%

19

Monetary policy in “abnormal” times

Monetary policy in abnormal times MP during and after the crisis

20

21

The Fed during the crisis: aggressive movesSince August 2007, the Fed has responded aggressively to the

crisis.The Federal Open Market Committee (FOMC) began to ease

monetary policy in September 2007, reducing the target for the federal funds rate by 50 basis points.

As indications of economic weakness proliferated, the FOMC brought down its target for the fed funds rate by a total of 325 basis points by the spring of 2008.

This response stands out as very rapid.Once financial and economic crisis gained momentum, another

set of cuts for fed funds target rate by an additional 100 basis points in October 2008 half of that reduction was part of unprecedented coordinated

interest rate cut by six major central banks on October 8, 2008 (including China’s)

Dec 2008: further target rate cut to range of 0-25 basis pointsSince then, no major changes. Expectation of rate increases

looms, though.

22

What was new this time around: The Fed as a direct lender of last

resortDuring current crisis the Fed has been more active in another role: the lender of last resort

Before the crisis: Fed had “discount window” (a virtual teller window where banks could borrow money overnight at the “discount rate”, with discount rate>Fed funds rate). Idea: banks should try to borrow from each other first before coming to the Fed. Result: lending via discount rate was minimal.

During the crisis: banks unwilling to lend to each other and so the Fed kept widening the discount window to make it easier for banks to get funding

23

The Fed providing liquidity, then buying “toxic” assets in 2008-09

24

Why standard policies of the past have been insufficient this time

Yet providing liquidity to banks and primary dealers this time was not a solution. Liquidity is not enough when there are concerns about capital, asset quality, and credit risk. So limited willingness of “liquid” intermediaries to extend credit to each other

To address these issues, a second set of Fed policy tools provision of liquidity directly to borrowers and investors in key

credit markets through purchases of private and public bondsAll these tools go under the label of measures of «quantitative

easing” to expand credit further when policy rate has gone down to zero.

We have seen four waves of QE (see picture). The Fed has currently entered a new phase labeled «Tapering» (gradual decrease of purchases). It is NOT a shift to restrictive monetary policy but just a shift to less expansionary monetary policy.

25

Was it (all this activism) worth eventually?

Yes, super-expansionary monetary (and fiscal) policies have worked.

26

The daily volatility of the S&P 100 (US stock mkt index) declined dramatically …

27

• Vix Index = a measure of expected volatility in the Us stock exchange (S&P 500) in the next 30 days• Vix at its maximum level with Lehman bankruptcy. •Also jumps up when Greek crisis recognized to be pan-European issue (May 2010) and also with sovereign debt crisis (summer-fall 2011) • Figure shows that Vix has come down to more reassuring levels after ECB’s LTRO1 and 2. It may not last so low.

The interbank market, quickly back in business in 2009. Spreads dangerously up, recently

Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-090

50

100

150

200

250

300

350

400

U.S. dollar

Sterling

Swiss franc

Euro area

Three-month Libor – OIS Spreads

(basis points)

3-month Libor = variable, thus risky, rate. OIS = Overnight Indexed Swap; based on overnight rate, hence certain for fixed by Central Bank.The spread between the two rates is a measure of the functioning of the interbank mkt. If interbank mkt works well, spread is close to zero

28

Stock and commodity markets quickly recovering since early 2009. Yet Government bond yields start to seriously diverge in EZ

29

QE (Quantitative Easing) has workedSpreads between corporate and Government

bonds, on one side, and AAA rate on the other have fallen

30

15

iP

PB

B

$100 $

$ $

$100P

iB 1

Memo: Bond Prices and Bond YieldsLet’s take a closer look at the bond market. It is the PRICE of bonds

that is determined in the bond market. Yet from the bond price, the bond interest rate is determined in turn. Understanding the relation between the interest rate and bond prices will thus prove useful

Treasury bills, or T-bills are issued by the U.S. government promising payment in a year or less. If you buy the bond today you pay $PB. If you hold it for a year, the rate of return (or interest) on holding a $100 bond for a year is ($100 - $PB)/$PB. So the higher $PB the lower the rate of return (yield) on the bond

Starting from the interest rate, we can figure out the price of the bond using the same formula from which we learn that there is a negative relation between bond price and bond yields

How about the ECB?

32

The ECB during the crisis: Trichet’s measures ...

Under Trichet (former ECB chairman before Draghi), ECB more cautious than the Fed and the Bank of England • 2009: Fed & BoE slashed interest rates towards zero and started QE (buying government bonds with central-bank money)• ECB was reluctant to cut its main rate below 1%. Resisted idea of buying government bonds directly. The Maastricht Treaty forbids this.

Yet Trichet adopted his own non-standard measures. • Unlimited loans to commercial banks for up to 1 year against a broad range of collateral. Effect? Similar to Fed and BoE Quantitative Easing• A flood of liquidity from €442 billion auction of 1-year ECB loans in June 2009 pushed short-term interest rates close to US and UK levels• Banks used much of the cash to buy government bonds, drivingdown long-term interest rates

33

... And Draghi’s silent bazooka Then Draghi came in and, two years on, has repeated the trick. Faced with:• renewed recession;•a bank-funding crisis;•investor revulsion against all but the safest euro-zone Goverment bonds on December 8th, 2011, the ECB announced the following: “It would provide unlimited funds for 36 months at its main interest rate (which it cut to 1%), at two auctions. The first of these, on December 21st, attracted bids of €489 billion. (The second occurred on Feb 29, 2012). That doubled the amount lent for one year in June 2009, and has had similar effects. Overall, 1 trillion euros: 131% of total European bank bonds maturing in 2012 and 72% for 2012 and 2013 combined. European banks are now effectively pre-funded through to 2014. 

34

35

The ECB total assets: up with LTRO, then down as commercial banks repay their loans

The ECB “silent bazooka” has worked as well: sovereign bond

yield curve brought down

36

Overnight interest rates have fallen dramatically. Longer-term bond yields for investment-grade eurozone countries have dropped, too