Real Fed Funds (fed funds - core CPI)

-6

-4

-2

0

2

4

6

8

10

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

-6

-4

-2

0

2

4

6

8

10

FOMC Statement:Statutory Dual Mandate:1. Maximum Employment (5.5% U.R.)

(March projection)2014 = 6.2%2015 = 5.8%

2. Price Stability (2.0% PCE Inflation)(March projection)

2014 = 1.6%2015 = 1.8%

Fed Actions to lower rates and stimulate economy:1. Purchase $25 billion/month agency MBS2.Purchase $30 billion/month longer-term Treasury notes3.Reinvest principal payments of agency debt and MBS4.Roll over maturing Treasury securities

Keep fed funds rate at 0-0.25% until:1.Labor market improves2.2-yr P/P expectations > 2.5%

Federal Reserve's Balance of RisksGDP and Core PCE Price Index

(Percent Change From Quarter One Year Ago)

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

04:1 05:1 06:1 07:1 08:1 09:1 10:1 11:1 12:1 13:1 14:1

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

PCE GDPSource: Bureau of Economic Analysis

The New Monetary Policy Tools

Conventional monetary policy has reached its limit - (0-0.25 federal funds rate)

Broader use of Fed’s balance sheet to achieve objectives

New policies are intended to influence financial conditions- Purchase longer-term Treasuries (lower long-term interest rates, term spreads).- Purchase private assets (agency MBS, consumer ABS): offset credit shock, lower credit spreads, increase

credit availability- Working in conjunction with expansionary fiscal policy.- Monitor credit conditions to gauge success- But no explicit targets

Quantitative easing of a different sort- Policies will inject large amounts of reserves- But goal is not the level of reserves

No single measure to summarize Fed actions- Watch the H.4.1- Makes communications challenging- Policy commitment language

Governance issues- All decisions made by FOMC- Even though 13(3) programs under authority of Board

Monetary policy options to prevent deflation and increase inflation expectations1. Quantitative easing: print money to buy long-term government debt2. Buy private-sector debt3. Change expectations by announcing it will keep short-term rates low

for a long time4. Raise its long-run inflation target (encourage borrowing, discourage cash hoarding)5. Reduce the interest rate paid on excess reserves.6. Move from inflation targeting (rate of change) to price level targeting

Fed’s Exit Strategy From Accommodative Policies

Inflationary Scenario:Economic recovery => banks find profitable lending opportunities => reserves => credit =>

money supply => aggregate demand => inflation

Countervailing Policy Measures/Tools That Tighten Monetary Policy1. Improving private credit conditions => decrease use of Fed’s short-term lending facilities.2. Maturing Fed-held securities will reduce reserves.3. Raise interest rate paid on bank reserves – currently 0.25% - held at Fed to reduce incentive

of banks to lend out reserves. This reserve/deposit interest rate effectively places a floor under short-term market interest rates.

Four options to reduce bank reserves, raise short-term interest rates and limit credit/money growth:

1. Arrange large-scale reverse repurchase agreements, RRPs, with financial market participants. RRPs involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

2. Treasury could sell bills and deposit the proceeds with the Federal Reserve (Supplementary Financing Program).

3. Offer term deposits (CDs) to banks so reserves would not be available for federal funds market.

4. Sell long-term securities into the open market.

Taylor Rule, NAIRU and the Phillips Curve

Taylor RuleFed funds rate target = inflation rate + equilibrium real fed funds rate

+ 1/2 (inflation gap)

+ 1/2 (output gap)

Phillips Curve Theory–Change in inflation influenced by output relative to potential output, and other factors

–Potential GDP is a function of the natural rate of unemployment

–Natural rate of unemployment - the rate of unemployment where there is no tendency for inflation to change

–NAIRU thought to be 5%

–Output gap is an indicator of future inflation

if unemployment rate < NAIRU => GDP growth > potential GDP =>inflation if unemployment rate > NAIRU => GDP growth < potential GDP =>inflation

Taylor Rule and Fed Funds Rate

Falling Home Prices

Negative Equity(Home worth lessthan mortgage)

Homeowners “Walk Away” orInvoluntary Foreclosures

Increase

Mortgage Payments Decline

Value of MBSDeclines

Banks IncurLosses

Bank Capital(Loanable Funds)

Declines

Vicious Cycles of the Mortgage Crisis

Economic ActivitySlows

& UnemploymentIncreases

Banks RestrictLending

Increased Supply of Homes

•Self-reinforcing spiral•Feedback Loop•Multiplier Effect•Sum of an Infinite Geometric Series

Monetary Policy Intervention•Lower fed funds interest rate•New lending facilities

Not self correcting

Chapter 16: Goals of Monetary Policy

1. High EmploymentEmployment Act of 1946, Humphrey–Hawkins Act 1978 “high employment consistent with

stable prices”. Full employment (natural rate of unemployment) frictional/structural = 5%

2. Economic Growthr => I => (Y/L) => Y/Y

3. Price Stability (Most important goal)Stable P/P => clear price-signal effect => I uncertainty => Y/Y

4. Interest Rate Stabilityr stability => I uncertainty => I => Y/Y

5. Financial Market Stability stability => financial intermediation => efficiency of capital => Y/Y

6. Foreign Exchange Market Stability (/$) => U.S. exports less competitive => X => GDP (/$) => U.S. exports more competitive => X => pricing power => P/P

Goals often in conflictY => U.R. => wages => P/P => i => OMP => MB => M1 => P/P

Econ 330 Chapter 16 Homework

Due Thursday, April 3 (hand in prior to exam)

Chapter 16Questions & Applied Problems 3, 7, 13, 22, 23, 25