1Giorgio Di Giorgio

9th EBES Conference, January 2013

Monetary Policy Challenges:How Central Banks Have Changed

Their Modus Operandi

2

Outline

• Motivation

• Focus on Assessing Conduct of ECB vs FED during the crises, considering

• Policy Targets and Instruments

• The Changing Operating Frameworks for Policy Management

• Talk will be mostly “institutional” and broad enough to be hopefully appreciated by non-specialists

• The Future of Monetary Policy

3

Motivation In the last years, Central Banks have been important actors to avoid

• A second Great Depression

• Deeper and more painful banking crises

• Dismissal of the Euro project

• …..Mario Draghi named Man of the Year 2012 by the FT

• Also, theory of monetary policy severely challenged by the crisis despite robust progresses made in previous 2 decades

• …the practice of monetary policy not always “perfectly” managed

• “Independence” of central banks at risk

4

Definition: A Monetary Policy Regime

Giorgio Di Giorgio

Set of policy targets, tools, operating procedures, indicators and transmission mechanisms useful to understand the action of central banks and its interaction with relevant dynamics of other economic and financial variables.

Policy targets: final, intermediate and operative

Instruments: OMOs, Official Interest Rates, Mandatory Reserves ….plus new and unconventional tools

Operating procedures: technical features for policy interventions (auction rules, definition of collateral and counterparties, timing….)

Indicators: statistical measures considered useful

Transmission mechanism: higlight different channels by which a given policy instrumental change affects financial and real variables dynamics until producing desirable movements in the final policy targets.

5

Final Policy Targets

Giorgio Di Giorgio

FED : no hierarchy, no numerical definition- Growth- Price stability- Full use of resources (including labor)- Financial stability (micro and macro)- long term real interest rate smoothing- real exchange rate smoothing

ECB : strict hierarchy, precise definiton of Price stability (medium term inflation rate computed on the percentage change of HCPI lower but close to 2%)

However: in the language of the Theory of Monetary Policy a similar Loss Function to min would apply: L = E {(y-y*)2 + β(p-p*)2}With y = output, p = inflation and * indicating a target valueβ a policy preference parameter

6

Intermediate and operating targets

Giorgio Di Giorgio

Variables in the monetary (bank reserves) market

Relevant features: easy to measure, strictly controllable and in stable relation with final policy targets. 2-step or 3-step Approach to monetary control. (B. Friedman, 1990)

Choice depends on relevance of different shocks affecting the economy, and on the dominant final policy target: (W. Poole, 1970)

Monetarist/Keynesian academic debate inherited in the mon policy conduct:

FED: Operating target is control of fed funds rateECB: at the beginning, M3 growth (loose intermediate target). After 2003, implicit move to hybrid operating target (flexible interest rate targeting)

7

Policy Instruments pre crisis

• FED:• Discount Lending, individual loans to about 7500

counterparts, wide range of collateral accepted, at fixed but higher than market interest rate (discount rate): “stigma effect”.

• Open Market Operations, on a daily basis, outright or temporary (repos and reverse repos), fully (but narrowly) collateralized with a limited number of counterparts (20 primary dealers), conducted at the FRBNY at a bid price.

• ECB: • 2 Standing Facilities: operations on demand of counterparts,

(about 2400): • marginal lending facility at a fixed penalty rate (roof) on a wide range of

collateral; • central bank’s deposit facility at a lower than market rate (floor). MLF and

CBD create the so called “Official Interest Rate Corridor”

• OMO usually vis a vis about 500 counterparts, but potentially up to1700, fully but widely collateralised:

The FED Control Model (from 2003 to 2007)

i_ff

RNBR

i_dRs

Rd

The ECB control model

R

i_ml

i_dRd

Rs

10

Central Bank responded differently to the Subprime Crisis

• First phase: uncoordinated response, with ECB injecting massive liquidity, FED cutting rates and providing new facilities (existing ones really not effective).

• Second phase: focus on deposit insurance expansion… but ECB increased rates in July 08!

• Third phase: strongly coordinated response and cut of rates after Lehman.

• Fourth phase: different views back (zero versus positive policy rates), but quantitative easing and unconventional monetary policy undertaken (managing of expectations, purchase of long term gov bonds and of corporate bonds)

• As a result, the FED balance sheet tripled from 900 billion dollars in 2007 to 2800 in 2011 (when QE2 ended). The ESCB balance increased even more, but only more recently and as a consequence of the Sovereign Debt Crisis.

FED balance sheet (bn $)

700

1.000

1.300

1.600

1.900

2.200

2.500

2.800

3.100

07 08 09 10 11 12

ECB balance sheet (bn euro)

1.100

1.300

1.500

1.700

1.900

2.100

2.300

2.500

2.700

2.900

3.100

07 08 09 10 11 12

After the second LTRO the ECB balance is bigger than the FED’s by about 1tr USD and amounts to 30% of the Eurozone GDP (against 19% of USA GDP for the Fed).

ECB: 3.023 bn €($ 3.990 bn) 30% of GDP

ECB: 3.023 bn €($ 3.990 bn) 30% of GDP

FED: $2.969 bn19% of GDP

FED: $2.969 bn19% of GDP

The Balance Sheets of ECB and FED in local currency and w.r.t. GDP

FED and ECB balance sheet as % of GDP

4%6%

8%10%12%

14%16%18%20%

22%24%26%

28%30%

07 08 09 10 11 12

ECB

FED

12

The different composition in the balance sheets of FED and ECB illustrates two different approaches in the crisis management.

The direct purchase of securities represents 88% of the FED’s balance sheet, while the ECB has adopted an approach of direct support towards credit institutions (and thus only indirect towards government bonds).

The different composition in the balance sheets of FED and ECB illustrates two different approaches in the crisis management.

The direct purchase of securities represents 88% of the FED’s balance sheet, while the ECB has adopted an approach of direct support towards credit institutions

FED balance sheet

Securities held outright

88%

Other assets (gold, fx liquidity

sw aps, …)11%

Lending to credit

institutions1%

ECB balance sheet

Other assets (gold and gold receivables, fx

liquidity sw aps...), 42%

Securities held outright, 21%

Lending to credit

institutions, 37%

13

14

Monetary policy assesment: Fed vs BCE

FEDBefore the crisis: too much expansive, policy rates too low (Taylor rule abandoned?, see Taylor, 2007)

When crisis starts: interpretation doubts (liquidity versus counterparty risk) and lack of instruments: response quite ineffective

During the crisis: good on i-rates and instrumental innovation but “indipendence” perception at risk - and lack of coherence (Bear Sterns, GSEs e AIG versus Lehman) - caused reputational problems

Exit strategies: communication problems about change of instruments (interest on reserves vs fed funds rate) , how many QEs?

ECBLate (and with mistakes) in the early phases.More pragmatic conduct when crisis became “domestic”then….super Mario....(currently a success but critical voices are out there).However, the operative model proved to be a success (as a matter of fact it has been exported on the other side of the Atlantic)

15

Fed Introduced New Instruments for Liquidity provision and Financial Stability after the crisis

• TAF (Term Auction Facilities) for all deposit institutions, introduced in Dec.2007, combining features of OMO and DL: wider collateral accepted at bid prices in (anonymous) exchange of cash.

• TSLF (Term Securities Lending Facilities), for primary dealers introduced in March 2008, temporary (28 days) swaps of Fed holdings of Tbills with troubled assets

• PDCF (Primary Dealers Credit Facility), introduced in March 2008 after the loan exceptionally provided to Bear Sterns, extends overnight (widely) collateralized loans at the discount rate to primary dealers.

• And…..Term Discount Window Facility (August 2007), Term Security Lending Facility Options Program (July 2008), ABCP money market fund liquidity facility (September 2008) Commercial paper funding facility (October 2008)…..

• Plus: interest paid on reserves. US moved to a corridor strategy too

16

ECB: from minor “technical” changes to a “cultural” revolution

• After having moved in June 2000 to variable interest rate tenders, from October 2008 the ECB introduced fixed rate auctions for OMO with full allotment.

• During the crisis: OMO have increased maturity substantially, widened collateral accepted and augmented the number of counterparts admitted

• Sovereign debt problems and stressed conditions in the banking sector have post-poned full return to normality. Until June 2010, the Eurosystem purchased euro-denominated covered bonds under the Covered Bond Purchase Programme (CBPP) and, from May 2010 to September 2012 it has conducted interventions in debt markets under the Securities Markets Programme (SMP).

• In November 2011 and February 2012, 2 large LTROs launched injecting massive liquidty (more than 1 bln Euro) at the policy rate for up to 3 years.

• Corridor amplitude has been also varied (in October 2008 reduced to 100 basis points, back to 200 in January 2009, 150 from May 2009).

• In late July 2012, Draghi’s “believe me…it will be enough” changed market attitudes towards the single currency.

• In September 2012, definitve announcement of Monetary Outright Transactions, unlimited (but conditional and sterilized) program of acquisition of bonds of fiscally fragile countries in the Eurozone.

17

The Future of Monetary Policy

• After the crisis FED and ECB look more similar from an operational point of view. Their policy regime is based on a “corridor” strategy and a wider set of open market operations as policy instruments, used to pursue operating targets in the market for “bank reserves”.

• Although more similar in their operating environment, monetary policy will still differ in US and the Euro area given the different role assigned to final policy targets.

• Same final targets are somehow although “implicitly” changing:

• new reference to unemployment in the US,

• more pragmatical conduct in the Eurozone,

• “flexible” inflation targeting in the UK.

18

The Future of Monetary Policy

• The underlying theoretical framework somehow resisted (Woodford, 2003, Clarida Galì and Gertler, 1999, Galì, 2007): a New Keynesian DSGE model in continuous refinement, based on optimization, market clearing, monopolistic competition, nominal (and real) rigidities.

• Open economy extensions available (Benigno and Benigno, 2003, Galì and Monacelli, 2008, Di Giorgio and Nisticò, 2007)

• Labor and financial frictions considered in recent versions (Woodford, 2010, Curdia and Woodford, 2010, Gertler and Kiyotaki, 2011). Still work to do but no solid alternative yet presented.

• There is a new financial stability challenge. A policy target difficult to define and to measure, possibly in tension with other ones (Stein, 2011, Di Giorgio and Rotondi, 2011)

• Academic researchers and central bank staff are working on this

• More Literature hints are available for interested readers!

THANK YOU FOR YOUR ATTENTION!!