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Image page. Real Fed Funds Rate (r). Monetary Policy Response Schedule (MPR). Macro 101 Michael R. Rosenberg October 2010. r*. Financial Conditions Schedule. p *. FC*. Inflation Rate ( p ). Financial Conditions (FC).

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  1. Image page Real Fed Funds Rate (r) Monetary Policy ResponseSchedule (MPR) Macro 101 Michael R. Rosenberg October 2010 r* Financial Conditions Schedule p* FC* Inflation Rate (p) Financial Conditions(FC) The Role of Financial Conditions in the Transmission Mechanism of Monetary Policy y* IS Curve (Investment/Savings Schedule) Philips Curve(Inflation/Output Schedule) Economic Output (y) Financial Shock Real (Output) Shock Relative Price Shock Change inPolicy Rate Change in Financial Conditions Change in Economic Activity Change in Inflation

  2. Bulletedpage New Keynesian Model’s Perspective on the Transmission Mechanism of Monetary Policy Real (Output) Shock Relative Price Shock Change inPolicy Rate Change in Economic Activity Change in Inflation No Role for Changes in Financial Conditions in the Transmission of Monetary Policy

  3. Bulletedpage A New Focus on Financial Conditions “Monetary policy works in the first instance by affecting financial conditions, including the levels of interest rates and asset prices. Changes in financial conditions in turn influence a variety of decisions by households and firms, including choices about how much to consume, to produce and to invest.” Federal Reserve Chairman Ben S. Bernanke, March 2, 2007

  4. Bulletedpage Financial Shock Real (Output) Shock Relative Price Shock Change inPolicy Rate Change in Financial Conditions Change in Economic Activity Change in Inflation Adding Financial Conditions to the Transmission Mechanism of Monetary Policy

  5. Bulletedpage How Financial Conditions Typically Respond to Federal Reserve Policy Changes Change in Financial Conditions Change in Money-Market Rates Change in Government Bond Yields Change inCredit Spreads Change in PolicyRate Change in Economic Activity Change in Inflation Change in Asset Prices Change in Bank Lending Conditions

  6. Bulletedpage Monetary Policy Transmission Mechanism Simulated Effect of a 100 Basis-Point Decline in the Fed Funds Rate Source: Federal Reserve 6

  7. Bulletedpage Tracking Financial Conditions –Bloomberg’s Financial Conditions Index

  8. Bulletedpage Bloomberg’s Financial Conditions Index Significantly Above Normal Normal Significantly Below Normal Source: Bloomberg BFCIUS index <go>

  9. Bloomberg Financial Conditions Index as a Leading Indicator of Bank Lending Conditions U.S. Bank Willingness to Lend(Smoothed Index) Financial Conditions(Smoothed Index) Bank Lending Conditions Financial ConditionsIndex Source: Bloomberg

  10. Bloomberg Financial Conditions Index as a Leading Indicator of Real GDP Growth U.S. Real GDP Growth (yoy % chg.)(Smoothed) Financial Conditions+(Smoothed Index) Real GDP Growth Financial Conditions Source: Bloomberg; Note BFCIUS+ Index, which takes into account asset-price bubbles.

  11. Bulletedpage Financial Conditions Indices Bloomberg Financial Conditions Index Citi Financial Conditions Index Deutsche Bank Financial Conditions Index Goldman Sachs Financial Conditions Index Federal Reserve Bank of Kansas City Financial Stress Index Macroeconomic Advisors Monetary and Financial Conditions Index OECD Financial Conditions Index

  12. Bulletedpage The Federal Reserve’s Policy Objectives and the Taylor Rule Financial Shock Real (Output) Shock Relative Price Shock Change inPolicy Rate Change in Financial Conditions Change in Economic Activity Change in Inflation InflationExpectations Policy Rule(Taylor Rule) Monetary Policy Objective

  13. U.S. Monetary Policy Objective The Federal Reserve is charged with the dual responsibility of maintaining price stability and achieving maximum sustainable employment for the U.S. economy. Maximum Sustainable Output Price Stability Maximum Sustainable Employment Unemployment Inflation Output Potential Output NAIRU Fed’s Implicit Inflation Target p* uN Actual Output Actual Inflation Rate Actual Unemployment Rate Time Time Time

  14. Bulletedpage The Inflation/Output Tradeoff Curve Output Gap Volatility A Std. Dev. (Y-Y*)3 The Efficient Policy Frontier C Std. Dev. (Y-Y*)2 B Std. Dev. (Y-Y*)1 Std. Dev. (p-p*)2 Std. Dev. (p-p*)3 Inflation GapVolatility Std. Dev. (p-p*)1 14

  15. Bulletedpage Policy Rule (Monetary Response Function) Setting the Parameters of the Monetary Policy Response Function • What level of the Fed’s policy rate will enable the monetary authorities to meet its price-stability and maximum-sustainable-employment objectives? • How much should the Fed’s policy rate rise or fall if the rate of inflation exceeds or falls short of the Fed’s implicit inflation target and/or if the level of employment exceeds or falls short of the economy’s maximum sustainable level? • How much weight should the Fed give to its two policy objectives if and when they come into conflict with one another?

  16. Bulletedpage The Taylor Rule and the Feedback Mechanism of Monetary Policy John Taylor’s Federal Reserve Monetary-Policy Response Function iTaylor = ( rN + p* ) + [ (1+a)(p – p*) + b(y – y*) ] Taylor Rule PrescribedPolicy Rate Neutral Rate Setting Taylor Rule Recommended Deviation from the Neutral Rate Setting = + rN = neutral real short-term interest rate p = actual inflation rate p* = central bank’s inflation target y = actual level of output y* = the economy’s potential level of output a, b = central bank’s policy response coefficients 16

  17. Bulletedpage The Taylor Rule Model in Real Terms rTaylor = rN + [ a(p – p*) + b(y – y*) ] Taylor Rule PrescribedReal Policy Rate Neutral Real Rate Setting Taylor Rule Recommended Deviation from the Neutral Real Rate Setting = + 17

  18. Bulletedpage A Modified Taylor Rule Substituting the Unemployment Gap for the Output Gap 1) (y – y* ) = Okun (UN – U) 2) rTaylor = rN + [ a(p – p*) + b(Okun) (UN – U) ] Taylor Rule PrescribedReal Policy Rate Neutral Real Rate Setting Taylor Rule Recommended Deviation from the Neutral Real Rate Setting = + Okun = Okun Factor, which translates the unemployment gap into the output gap y = actual level of output y* = the economy’s potential level of output UN= Neutral unemployment rate (NAIRU) U = Actual unemployment rate 18

  19. Bulletedpage Taylor Rule Estimates of the Fed Funds Rate –1990-2010 Source: Bloomberg TAYL <go>

  20. Bulletedpage The Response of Fed Policy to Changes in Inflation (%)

  21. Bulletedpage The Response of Fed Policy to Changes in Unemployment Fed Funds Rate less PCE Inflation Rate (%) NAIRU less Unemployment Rate (%)

  22. Bulletedpage The Transmission/Feedback Mechanism of Monetary Policy – A Graphical Model Financial Shock Real (Output) Shock Relative Price Shock Change inPolicy Rate Change in Financial Conditions Change in Economic Activity Change in Inflation Nominal Fed Funds Rate MPR1(Aggressive) Monetary-Policy Response Schedules MPR2 (Passive) i1 An aggressive response by the Federal Reserve (shown by MPR1) would raise the nominal Fed Funds rate by more than the rate of inflation, thereby raising the real Fed Funds rate. Inflation Rate p1 22

  23. Bulletedpage The Transmission/Feedback Mechanism of Monetary Policy – A Graphical Model Financial Shock Real (Output) Shock Relative Price Shock Change inPolicy Rate Change in Financial Conditions Change in Economic Activity Change in Inflation Real Fed Funds Rate Monetary-Policy Response Schedule B r 2 An increase in inflation will prompt the Fed to raise the real Fed Funds rate, all else being equal. A r 1 p1 p2 Inflation Rate

  24. Bulletedpage Response of Financial Conditions to Changes in the Federal Reserve Policy Rate Real Fed Funds Rate A Financial Conditions improve as the Fed’s real policy rate declines r 1 B r 2 Financial Conditions Schedule FCON FC 1 FC 2 Financial Conditions 24

  25. Bulletedpage Pass-Through Effect of Policy-Rate Changes on Financial Conditions Real Fed Funds Rate The response of Financial Conditions to changes in policy rates is a function of the slope of the Financial Conditions Schedule. A r 1 C B r 2 FCON2 FCON1 FC1 FC2 FC3 Financial Conditions 25

  26. Bulletedpage An Adverse Shift in Financial Conditions and the Federal Reserve Policy Response Financial Shock Real (Output) Shock Relative Price Shock Change inPolicy Rate Change in Financial Conditions Change in Economic Activity Change in Inflation Real Fed Funds Rate Adverse shift in the Financial Conditions Schedule from FCON1 to FCON 2 B A r 1 The Fed responds to a financial shock by lowering the real Fed Funds rate from r1 to r 2, which improves Financial Conditions from FC2 back to its original level of FC1 r 2 C FCON 2 FCON 1 26 Financial Conditions FC 2 FC 1

  27. Bulletedpage Response of Economic Activity to Changes in Financial Conditions Financial Shock Real (Output) Shock Relative Price Shock Change inPolicy Rate Change in Financial Conditions Change in Economic Activity Change in Inflation Output Gap New Keynesian Investment-Savings (IS) Schedule B (y-y*)2 An improvement in Financial Conditions leads to an increase in output (y) relative to an economy’s potential output(y*), all else being equal. A (y-y*)1 27 Financial Conditions FC 1 FC 2

  28. Bulletedpage How Responsive is Output to Changes in Financial Conditions? Output Gap IS1 B (y-y*)2 IS2 (y-y*)3 C A (y-y*)1 The response of economic activity to changes in financial conditions is a function of the slope of the IS schedule. Financial Conditions FC 1 FC 2 28

  29. Bulletedpage Response of Inflation to Changes in the Output Gap Financial Shock Real (Output) Shock Relative Price Shock Change inPolicy Rate Change in Financial Conditions Change in Economic Activity Change in Inflation Inflation New Keynesian Phillips Curve (PC) B p2 An increase in output (y) relative to an economy’s potential output(y*) leads to an increase in inflation, all else being equal. A p1 (y-y*)1 (y-y*)2 29 Output Gap

  30. Bulletedpage How Responsive is Inflation to Changes in the Output Gap? Inflation PC1 B p2 PC2 p3 C A p1 The response of inflation to changes in economic activity is a function of the slope of the Phillips Curve. (y-y*)1 (y-y*)2 Output Gap 30

  31. Bulletedpage Real Fed Funds Rate (r) Monetary Policy ResponseSchedule (MPR) Quadrant II Quadrant I r* Financial Conditions Schedule p* FC* Inflation Rate (p) Financial Conditions(FC) y* IS Curve (Investment/Savings Schedule) Philips Curve(Inflation/Output Schedule) Quadrant III Quadrant IV Economic Output (y) Fitting the Pieces Together A Four Quadrant Diagram of the Monetary Policy Transmission/Feedback Mechanism (under normal conditions) 31

  32. Bulletedpage The Effects of an Unwarranted Cut in the Real Fed Funds Rate Real Fed Funds Rate (r) Monetary Policy ResponseSchedule (MPR) r2 (6) (5) Quadrant II Quadrant I r* Financial Conditions Schedule (1) Fed reduces the Real Fed Funds rate from r* to r1 r1 (2) (9) FC1 p1 p2 p* FC* FC2 Inflation Rate (p) Financial Conditions(FC) (8) y2 (7) y* (3) (4) IS Curve (Investment/Savings Schedule) y1 Philips Curve(Inflation/Output Schedule) Quadrant III Quadrant IV Economic Output (y) 32

  33. Bulletedpage Real Fed Funds Rate (r) A financial shock shifts the Financial Conditions Schedule from FCON* to FCON’ Monetary Policy ResponseSchedule (MPR) Quadrant II Quadrant I r* (1) (8) Financial Conditions Schedule r1 (5) (4) FCON* FCON’ p2 p* FC* FC2 Inflation Rate (p) Financial Conditions(FC) y2 (2) (3) (6) (7) y* IS Curve (Investment/Savings Schedule) Philips Curve(Inflation/Output Schedule) Quadrant III Quadrant IV Economic Output (y) The Consequences of the Fed Not Responding Immediately to a Financial Shock 33

  34. Bulletedpage Real Fed Funds Rate (r) Monetary Policy ResponseSchedules A financial shock shifts the Financial Conditions Schedule from FCON* to FCON’ MPR* MPR’ Quadrant II Quadrant I r* Financial Conditions Schedules (1) r1 The Fed responds to the shock by immediately reducing the neutral Real Fed Funds rate from r* to r1 , This is shown as a downward shift in the Monetary Response Schedule from MPR* to MPR’. (2) FCON* FCON’ FC2 p* FC* Inflation Rate (p) Financial Conditions(FC) (3) (4) y* IS Curve (Investment/Savings Schedule) Philips Curve(Inflation/Output Schedule) Quadrant III Quadrant IV Economic Output (y) The Consequences of a Rapid Response by the Federal Reserve Rapid Response to a Financial Shock 34

  35. Bulletedpage Real Fed Funds Rate (r) A financial shock shifts the Financial Conditions Schedule from FCON* to FCON1 MPR* Monetary Policy ResponseSchedule Quadrant II Quadrant I r* (4) (1) Financial Conditions Schedules r1 FCON* FCON1 p* FC* FC2 Inflation Rate (p) Financial Conditions(FC) A fiscal stimulus shifts the IS Curve from IS* to IS1, negating the deterioration in financial condition, and output remains at y* (2) (3) y* IS* IS Curve (Investment/Savings Schedules) Philips Curve(Inflation/Output Schedule) IS1 Quadrant III Quadrant IV Economic Output (y) The Effects of Fiscal Stimulus at a Time When the Real Economy is Being Hit by a Negative Financial Shock 35

  36. Bulletedpage Real Fed Funds Rate (r) Kinked Monetary Policy ResponseSchedule Initial deterioration in financial conditions and shift in the Financial Conditions Schedule from FCON* to FCON1 Real policy rate rises when deflation sets in and the nominal policy rate is zero ( + ) (4) Quadrant II Quadrant I ( 0 ) (1) Financial Conditions Schedules ( - ) (7) Real policy rate moves into negative territory when expected inflation rises and the nominal policy rate is zero FCON* FCON1 ( - ). ( + ) ( 0 ) FC* FC2 Inflation Rate (p) Financial Conditions(FC) y2 y1 (3) (2) y* Philips Curves(Inflation/Output Schedule) IS Curve (Investment/Savings Schedules) IS* PC* Quadrant III Quadrant IV Economic Output (y) The Monetary Policy Transmission Mechanism When the Policy Rate is Zero and There Is a Threat of Deflation 36

  37. Bulletedpage Real Fed Funds Rate (r) Kinked Monetary Policy ResponseSchedule Initial deterioration in financial conditions and shift in the Financial Conditions Schedule from FCON* to FCON1 Real policy rate rises when deflation sets in and the nominal policy rate is zero ( + ) (4) Quadrant II Quadrant I ( 0 ) (1) Financial Conditions Schedules (6) ( - ) Real policy rate moves into negative territory when expected inflation rises and the nominal policy rate is zero (7) FCON* FCON1 ( - ). ( + ) ( 0 ) FC* FC2 Inflation Rate (p) Financial Conditions(FC) (3) (5) (2) (9) Philips Curves(Inflation/Output Schedule) y* (8) IS* PC1 IS Curve (Investment/Savings Schedules) PC* Engineered rise in expected inflation Quadrant III Quadrant IV Economic Output (y) Negating the Real Economy Effects of a Financial Shock by Engineering a Rise in Expected Inflation 37

  38. Bulletedpage Monetary Policy Works by Affecting Financial Conditions, Even When the Policy Rate is Zero Alter Size and Composition of Central Bank’s Balance Sheet Quantitative Easing Channel Change inPolicy Rate Traditional Channel Change in Financial Conditions Change in Economic Activity Change in Inflation Rate Commit to Keep Policy Rate Low for a Considerable Period Expectations Management Channel 38

  39. Bulletedpage Federal Reserve Targeting Long-Term Rather than Short-Term Interest Rates Change inShort-Term Policy Rate Traditional Channel Change in Financial Conditions Change in Economic Activity Change in Inflation Rate Change in Long-Term Interest Rate NewApproach 39

  40. Bulletedpage Federal Reserve Large-Scale Asset Purchases and the Monetary Policy Transmission Mechanism When the Short-Term Policy Rate is Zero Lower long-term interest rates act to improve Financial Conditions. Fed purchases of Treasury bonds lowers the supply of publicly held bonds and thereby acts to lower long-term interest rates Real Long-Term Interest Rate Real Long-Term Interest Rate BS2 BS1 BD Supply of Bonds “New” Monetary Response Schedules Financial Conditions/Interest Rate Schedule Demand for Bonds i1 i1 A A A i2 i2 B B B Financial Conditions FC2 FC1 p1 Inflation Outstanding Stock of Government Debt Transmission of Policy Policy Implementation

  41. Estimating the Impact of the Federal Reserve's Large-Scale Asset Purchase Program on Long-Term Interest Rates Source: Joseph Gagnon, "The World Needs Further Monetary Ease, Not an Early Exit", Peterson Institute for International Economics Policy Brief, December 2009.

  42. Bulletedpage Risk-Taking Channel of Monetary Policy Policymakers need to take into account the effect of a change in policy rates on the price of risky assets and the level of risk taking Financial Conditions Change in Economic Activity Change in Inflation Change inPolicy Rate Price of Risky Assets Change in Risk Taking Asset Price Bubble

  43. Bulletedpage Risk-Taking Channel of Monetary Policy If the policy rate is pushed “too low for too long”, it could lead to excessive risk-taking and overly easy financial conditions. Real Fed Funds Rate Monetary-Policy Response Schedules Risk-Taking Schedule MPR1 MPR2 MPR3 r1 A A r2 B B r3 C C p1 Financial Conditions FC3 FC2 FC1 Inflation

  44. Image page Monetary Policy and Risk Taking (1-2) Do easy monetary policies contribute to lax lending practices that contribute to a buildup of financial imbalances? Low interest rates encourage a higher level of leverage as banks and shadow banks often finance themselves with short-term liabilities. Low interest rates promote a “search for yield”. This tends to drive down risk premia across the credit spectrum.

  45. Image page Monetary Policy and Risk Taking (3-4) Do easy monetary policies contribute to lax lending practices that contribute to a buildup of financial imbalances? Low interest rates boost asset prices and, in turn, collateral values. Higher collateral values modifies the perceived risk of default on the part of borrowers, which encourages banks to extend more credit at favorable rates. Low interest rates for long periods contribute to lower asset-price volatility, which may alter the risk management practices of financial institutions.

  46. Image page Monetary Policy and Risk Taking (5-8) Do easy monetary policies contribute to lax lending practices that contribute to a buildup of financial imbalances? Low interest rates alter traditional risk indicators such as Value at Risk, which in turn may alter risk-taking behavior. Low interest rates encourage fund managers to take on more risk to boost absolute returns. Central-bank communications (for example, “measured pace or “extended period”) may alter risk perceptions and encourage risk taking. Low interest rates lead investors to take on more illiquid positions to generate higher returns.

  47. Image page Monetary Policy and Risk Taking(9-11) Do easy monetary policies contribute to lax lending practices that contribute to a buildup of financial imbalances? Federal Reserve may respond asymmetrically to changes in asset prices – easing in response to asset price declines and essentially ignoring asset price gains (the Greenspan put). Credit ratings improve when interest rates are low, which in turn leads to narrower credit spreads. Low interest rates for long periods boost house prices, which encourages household speculation in the housing market

  48. Image page Two Major Criticisms of Federal Reserve Policy • Criticism #1 -- Federal Reserve policy was too loose for too long from 2002-2006. Had the Fed not deviated from the Taylor Rule, the housing bubble and the subsequent crisis could have been avoided. • Criticism #2 -- Policymakers did not look beyond inflation and output gaps in setting short-term interest rates in the run-up to the financial crisis. Monetary policy should lean against asset-price movements, even at the cost of more variability in inflation and output.

  49. Bulletedpage The Taylor Rule on Bloomberg TAYL <go>

  50. Bulletedpage Fraction of Time the Real Federal Funds Rate Is Negative by Decade Decade of Asset Bubbles Decade of High Inflation Source: Board of Governors of the Federal Reserve System and Bureau of Economic Analysis;Note: the real Fed Funds rate equals the nominal Fed Funds rate minus the core PCE inflation rate.

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