1. An Overview of US monetary Policy: The implication of quantitative easing<br />Daniel Booth<br />
2. Executive Summary<br /><ul><li>The Federal Reserve indirectly set the Fed Funds target rate by varying the level of banking reserves through Repos (increase cash reserves) and Reverse Repos (reduce cash reserves).
3. The Federal Reserve has started paying interest on reserves to allow for the unsterilized expansion (quantitative easing) of banking reserves.
4. Large-scale quantitative easing, reduces economic 'tail risk,' is not consistent with prior deflationary periods, and should led to a near term improvement in the current situation.
5. The reduction in balance sheet distress should benefit assets that have the widest illiquidity premia. Low risk and relatively high spread assets (e.g. High Grade Credit), which are accepted as Federal Reserve collateral, currently offer the most attractive investment opportunity.
6. With the Fed monetizing debt, investors should begin to gradually switch out of securities vulnerable to rising inflation (sovereign bonds) and into inflation protected (TIPs) securities.</li></ul>2<br />
7. <ul><li>The Fed funds rateis the rate paid on unsecured loans of reserve balances at Federal Reserve Banks between depository institutions. Banks keep reserve balances at the Federal Reserve Banks to meet (a) reserve requirements & (b) clear financial transactions. Transactions in the fed funds market enable depository institutions with reserve balances in excess of their reserve requirements to lend funds to other institutions with reserve deficiencies. Fed funds transactions therefore neither increase nor decrease total bank reserves but redistribute bank reserves. The Federal Reserve sets a target level for the fed funds rate but the actual rate is determined by market participants and not "set" by the Fed. However, the Fed does use Open Market Operations (OMO) to change the supply of reserve balances in the system and influence the level of fed funds rate.
8. Open Market Operations (OMO) is where the Fed enters into repos and reverse repos to increase or decrease the level of reserve balances (cash) in the banking system, thereby influencing short-term interest rates (i.e. an increase in excess reserves will lower Fed funds rate).
9. Fed Repo (purchase securities / sell cash) is a collateralized loan to a primary dealer via competitive auction with dealers bidding on money and supplying general collateral (e.g. US Treasury, Agency bonds) with a haircut. Here the Fed will credit the dealers reserve account with cash and therefore increases total banking reserves.
10. Fed Reverse Repo (sell securities / purchase cash) where the Fed borrows money from a primary dealer with dealers offering an interest rate at which they would lend to the Fed versus Fed’s general collateral (i.e. Treasury bills) and this decreases total banking reserves.
11. Discount Windowis where Fed extends collateralized loans to depository institutions at the primary credit rate (1.25%), for well-capitalized banks, or the secondary credit rate (1.75%) for other banks. The Fed can also influence monetary conditions by changing the terms and conditions for borrowing at the discount window.
12. Federal Reserve Bank of New York (‘The Desk’) is responsible for the implementation of the Feds programs. As a prelude to quantitative easing the Desk released an academic paper in Sept 08 called ‘Divorcing Money from Monetary Policy.’</li></ul>An Overview of the Implementation of US Monetary Policy. <br />3<br />
13. Ben Bernanke is a leading academic on the 1930s US Great Depression and the 1990s Japanese deflation and is currently implementing the policies he has previously prescribed. In January 2004 he wrote a paper entitled ‘Conducting Monetary Policy at Vey Low Short-Term Interest Rates’, with an extract shown below:<br /> “When the short-term policy rate is at or near zero, the conventional means of effecting monetary ease - lowering the target for the policy rate - is no longer feasible, but monetary policy is not impotent…(there are) three alternative (but potentially complementary) monetary strategies for stimulating the economy that do not involve changing the current value of the policy rate: <br />1) Providing assurance to financial investors that short rates will be lower in the future than they currently expect <br />2) Changing the relative supplies of securities (such as Treasury notes and bonds) in the marketplace by shifting the composition of the central bank's balance sheet.<br />3) Increasing the size of the central bank's balance sheet beyond the level needed to set the short-term policy rate at zero (‘quantitative easing’).<br /> A quite different argument for engaging in alternative monetary policies before lowering the overnight rate all the way to zero is that the public might interpret a zero instrument rate as evidence that the central bank has "run out of ammunition." That is, low rates risk fostering the misimpression that monetary policy is ineffective. As we have stressed, that would indeed be a misimpression, as the central bank has means of providing monetary stimulus other than the conventional measure of lowering the overnight nominal interest rate.”<br />Conducting Monetary Policy at Very Low Short-Term Interest Rates by Ben Bernanke<br />4<br />
14. Divorcing Money from Monetary Policy by the Fed Reserve<br /> Central banks operate in a way that creates a tight link between money and monetary policy, as the supply of reserves must be set precisely in order to implement the targeted interest rate. Because reserves play other key roles in the economy, this link can generate tensions with central banks’ other objectives, particularly in periods of acute market stress. An alternative approach to monetary policy implementation can eliminate the tension between money and monetary policy by “divorcing” the quantity of reserves from the interest rate target.<br /> For example by paying interest on reserve balances at its target interest rate, a central bank can increase the supply of reserves without driving market interest rates below target. This “floor system” approach allows the central bank to set the supply of reserve balances according to the payment or liquidity needs of financial markets.<br /> <br />The deposit rate is set equal to the target rate and the reserve supply is chosen so that it intersects the flat part of the demand curve generated by the deposit rate. The equilibrium interest rate no longer depends on the exact quantity of reserve balances supplied. Any quantity that is large enough to fall on the flat portion of the demand curve will implement the target rate. In this way, a floor system “divorces” the quantity of money from the interest rate target and, hence, from monetary policy. This divorce gives the central bank two separate policy instruments: (i) the interest rate target can be set according to the usual monetary policy concerns, while (ii) the quantity of reserves can be set independently.<br />5<br />
15. Communication from the Federal Reserve Bank of New York<br />6<br />
16. A Comparison of Federal Funds Target Rate versus Effective Rate<br />Below you can see that the ‘Effective’ Fed Funds rate has tracked the ‘Targeted’ Fed Funds rate very closely except for (a) a few days after 9/11 when the Fed flooded the banking system with cash to offset financial payment delays and (b) the recent sharp divergence, which started in October and coincided with the doubling of the Feds balance sheet (see graph overleaf).<br />7<br />
17. Federal Reserve Balance Sheet<br />The Fed started to provide excessive liquidity to the banking sector in October and this liquidity drove down the effective Fed Funds rate below the targeted rate. The gradual implementation of an interest rate deposit floor, on required and excess reserves, should narrow the spread between the effective and target rate as there is no rational economic explanation for a depository institutions assuming counterparty risk by making overnight loans to other depository institutions (O/N Fed Funds) at an interest rate below that paid by the Fed. This should led to the effective separation of the target rate and the supply of capital at the predefined floor. <br />8<br />
18. Investment Implications<br />9<br />
19. Overview of US Government Efforts <br />The range of current US liquidity programs ($7.5 tn maximum) designed to stimulate the $14.5 tn US economy are shown on the left. <br />Summary:<br /> <br />* US Recession will not turn into a Depression.<br /> <br />* US Recovery will occur sooner than expected.<br /> <br />* US paradigm shift into an inflationary environment.<br />10<br />