Magazine article Economic Trends

Eurodollar Futures, Taylor Rules, and the Conduct of Future Monetary Policy

Magazine article Economic Trends

Eurodollar Futures, Taylor Rules, and the Conduct of Future Monetary Policy

Article excerpt

09.10.10

When interest rates are zero and policymakers would like to lower rates further, the usual monetary policy operations are no longer effective. Traditional open market operations, in which the Fed swaps collateral into or out of the financial system for cash, can't affect rates--or economic activity--because short-term bonds and excess bank reserves are perfect substitutes in a zero-interest-rate environment. The substitutability means that when the Fed buys short-term debt from banks, that does not insure that the money banks are receiving in payment will be lent out. Instead, banks simply substitute the T-bills that were on their balance sheet (which effectively earn zero percent interest) with excess reserves. When open market operations (with short-term bills) only increase the balances of excess reserves, the operations will be ineffective in increasing prices and output. This substitutability is one reason that the level of excess reserves exploded during the recent recession.

Monetary authorities must instead find alternative ways of stimulating the economy and increasing inflation. One policy option is to signal the future path of interest rates. Monetary policy is not given by just today's funds rate but the path of future funds rates as well. By promising low rates not just today, but also in the future, long-term rates can also be reduced. This reduction in long-term rates increases investment and thus output.

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In order to achieve lower expected long-term interest rates, the Fed needs to convey a message to the markets that alters their expectations for the policy rate path going forward. Some elements of the Fed's recent Federal Open Market Committee (FOMC) statements might suggest that it is sending such a message. In the last several statements, the FOMC said: "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate ... exceptionally low levels of the federal funds rate for an extended period."

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But the lines omitted in that excerpt are very important, as they seem to indicate that the reason the funds rate will be low is because of "economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations." If low rates are solely due to the fact that the Fed will continue to respond to inflation, output, and the output gap as it typically does, then the Fed's statement will not stimulate the economy since it is not affecting the anticipated course of future policy. …

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