Transcript DALAL ALARBEED Effective Monetary Policy in a Low Interest Rate

Effective Monetary Policy in a Low
Interest Rate Environment
BY:
DALAL ALARBEED
James Bullard
• The president and chief executive officer of
the Federal Reserve Bank of St. Louis.
(position he has held since 2008)
• He participates in the Federal Open Market
Committee (FOMC).
• He called for the FOMC to adopt statecontingent policy, which is policy that is
adjusted based on the state of the economy.
Introduction
Mr. Bullard discussed his vision for a shift in
monetary approach similar to the one brought to
the world by Paul Volcker in 1979. Mr. Bullard
argued that a shift was necessary and that the era
of interest rate rules is in abeyance
The End of Interest Rate Rules
 In December 2008, the Policy rates of most Central
Banks were at historically low levels:
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Federal funds rate: 0.00 – 0.25%
Benchmark rate of the European Central Bank: 1.5%
Bank of England: 0.5%
Bank of Japan: 0.1%
 Thus, with policy rates at or near zero, it would seem
that the World’s central banks have little or no scope
for further policy response.
So … What to do?
 Keeping stabilization policy active and aggressive in
the current global recession requires a shift in
thinking.
 A shift away from a focus on short-term nominal
interest rates and toward quantitative approaches is
more appropriate, at least for now.
Monetary Growth and Expected Inflation
 At very low nominal interest rates, the expected rate
of inflation plays a larger role.
 Declines in the expected rate of inflation, with
nominal rates fixed, show up as increases in the real
rate of interest.
real interest rate = nominal interest rate - expected inflation
 One key to current stabilization policy is therefore to
influence the expected rate of inflation.
Monetary Policy with an ‘M’
 Conventional monetary policy has been known as a
central bank establishing an effective target for a
short-term nominal interest rate.
 However, with policy rates at or near zero, nominal
interest rate targeting is no longer an option.
 Thus, central banks lose their ability to use interest
rate movements to signal their policy moves to the
public.
This creates uncertainty in the economy
Monetary Policy with an ‘M’
 One way of providing a credible nominal anchor for
the economy is to set quantitative targets for monetary
policy, beginning with the growth rate of the monetary
base.
 However, the lack of precision may stand in the way of
determining how rapidly to expand the base.
 Persistent
monetary growth can prevent further
disinflation and rise real interest rates even while
further reductions in the nominal interest rate are no
longer possible.
Persistent Vs. Temporary Growth
in the Monetary Base
MB = CC + Deposits
 Increases in the monetary base are either:
Type
Temporary
Persistent
Influence on the
rate of inflation
No
Yes
The increase is
associated with:
Lender-of-last-resort
programs
• Treasury securities
• Mortgage-backed securities
• Agency debt
Persistent Vs. Temporary Growth
in the Monetary Base
 In the US, the size of the monetary base doubled over a
four-month period beginning in September 2008.
 However, the increase in the base is in part a byproduct
of Federal Reserve programs to assist credit markets and
carry out its lender-of-last-resort function.
(Temporary)
 The persistent components are likely to have greater
inflationary consequences going forward because these
components are unlikely to shrink as much or as quickly
as the others.
A Clear Inflation Objective
 Uncertainty and the implications for inflation could be
reduced with the announcement of a specific inflation
objective.
 A credible plan would also name an explicit inflation objective
to help control the currently very diffuse expectations of
medium-term inflation.
 By making the long-run inflation objective explicit, the Fed
could help provide a credible commitment that the growth of
the monetary base will slow as deflation risks draw back.
 Moreover, it would reduce inflation risk premiums in interest
rates and promote efficient resource allocation.
The Future of Financial Intermediation
 Maintaining price stability is surely one of the most
important ways that a central bank can promote the
stability of the financial system.
 The ongoing financial crisis demonstrates, however,
that price stability alone will not guarantee financial
stability.
 The crisis has revealed important problems in our
system of financial regulation and oversight.
The Future of Financial Intermediation
 Present system was not designed to control broad macro-
economic risks posed by large and complex financial
organizations with global operations.
 The governments are unlikely to permit such firms to fail,
which creates a “too-big-to-fail” problem.
 Thus, it creates a moral hazard: Firms whose liabilities
are guaranteed have an incentive to take greater risks.
 It also creates uncertainty because it leaves the nature of
the intervention in the event of failure unspecified.
The Future of Financial Intermediation
 There is a need for improvement in the current system.
 The improvement would be to design a resolution
regime with the following features:
it should be explicit and well understood by all players.
 the nature of government assistance should be clear.
 it should be credible!!
 it should be made clear which firms would use this
alternative resolution regime and which firms would use
bankruptcy court.
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Conclusion
 The financial crisis has challenged our thinking about both
monetary policy and financial regulation.
 A shift away from interest rate rules and toward
quantitative approaches is crucial.
 We need a clearly stated, credible policy which indicates
how the central bank plans to respond to macroeconomic
events.
 The crisis has clearly exposed faults in the structure of
financial regulation and supervision.
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