Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Understanding Monetary Policy Implementation

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Understanding Monetary Policy Implementation

Article excerpt

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Over the last two decades, central banks around theworld have adopted a common approach to monetary policy that involves targeting the value of a short-term interest rate. In the United States, for example, the Federal Open Market Committee (FOMC) announces a rate that it wishes to prevail in the federal funds market, where commercial banks lend balances held at the Federal Reserve to each other overnight. Changes in this shortterm interest rate eventually translate into changes in other interest rates in the economy and thereby influence the overall level of prices and of real economic activity.

Once a target interest rate is announced, the problem of implementation arises: How can a central bank ensure that the relevant market interest rate stays at or near the chosen target? The Federal Reserve has a variety of tools available to influence the behavior of the interest rate in the federal funds market (called the fed funds rate). In general, the Fed aims to adjust the total supply of reserve balances so that it equals demand at exactly the target rate of interest. This process necessarily involves some estimation, since the Fed does not know the exact demand for reserve balances, nor does it completely control the supply in the market.

A critical issue in the implementation process, therefore, is the sensitivity of the market interest rate to unanticipated changes in supply and/or demand. If small estimation errors lead to large swings in the interest rate, a central bank will find it difficult to effectively implement monetary policy, that is, to consistently hit the target rate. The degree of sensitivity depends on a variety of factors related to the design of the implementation process, such as the time period over which banks are required to hold reserves and the interest rate, if any, that a central bank pays on reserve balances.

The ability to hit a target interest rate consistently plays a critical role in a central bank's communication policy. The overall effectiveness of monetary policy depends, in part, on individuals' perceptions of the central bank's actions and objectives. If the market interest rate were to deviate consistently from the central bank's announced target, individuals might question whether these deviations simply represent glitches in the implementation process or whether they instead represent an unannounced change in the stance of monetary policy. Sustained deviations of the average fed funds rate from the FOMC's target in August 2007, for example, led some media commentators to claim that the Fed had engaged in a "stealth easing," taking actions that lowered the market interest rate without announcing a change in the official target.1 In such times, the ability to hit a target interest rate consistently allows the central bank to clearly (and credibly) communicate its policy to market participants.

Under most circumstances, the Fed changes the total supply of reserve balances available to commercial banks by exchanging government bonds or other securities for reserves in an open market operation. Occasionally, the Fed also provides reserves directly to certain banks through its discount window. In some situations, the Fed has developed other, ad hoc methods of influencing the supply and distribution of reserves in the market. For example, during the recent period of financial turmoil, the market's ability to smoothly distribute reserves across banks became partially impaired, which led to significant fluctuations in the average fed funds rate both during the day and across days. In December 2007, partly to address these problems, the Fed introduced the Term Auction Facility (TAF), a bimonthly auction of a fixed quantity of reserve balances to all banks eligible to borrow at the discount window. In principle, the TAF has increased these banks' ability to access reserves directly and, in this way, has helped ease the pressure on the market to redistribute reserves and avoid abnormal fluctuations in the market rate. …

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