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12 03 2015 | by Victor Xing | Central Banks

Federal Reserve’s policy tools and their efficacy

If the Federal Reserve does indeed begin policy normalization (as is widely expected) in two weeks, this would be a well-telegraphed move, especially given the barrage of FED communications over the past three days.  Investors will likely pay close attention to FED’s “policy tools” to gauge their efficacy in affecting financial conditions.

FED’s policy tools: ON RRP and IOER

policy tools - mechanics
Source: Federal Reserve Board of Governors

It would be very interesting to see the FED’s Overnight Reverse Repurchase Agreement(ON RRP) in action with constrains lifted (Fed to Temporarily Lift Cap on Reverse-Repo Program When Liftoff Arrives).  This tool has only been in test-mode (with a cap) so far, moving effective funds rate in small increments.  All eyes will be on the program to see whether the FED can effectively drain massive amount of liquidity without creating significant distortion (by design, this program will dwarf other forms of short-term borrowing when active – a feature/side-effect that the FED is keenly aware of).

In practice, the Federal Reserve Bank of New York trading desk would come to the market and offer to sell securities held on the FED’s balance sheet to GSEs (including Federal Home Loan Banks), depository institutions (banks), and money market funds (please see Expanded Counterparties).  In exchange, the Desk would buy back these securities at a higher price (thus creating an effective interest rate) on the next day (“overnight”).  Because these counter parties represent the universe of participants transacting on the federal funds market, the Desk’s open market operations via ON RRP would effectively create a floor of the funds rate (please see below)


Financial conditions and “Greenspan’s Conundrum”

The FED’s rate hike is aimed at tightening financial conditions (higher borrowing cost, lower equity valuation, strengthen the dollar, and widen credit spreads).  However, long-term borrowing cost tend to be correlated amongst developed economies.  Therefore, if global long-term rates were to decline (further dis-inflationary pressure in Europe, another wave of economic slowdown in China, etc), there would be a limit on how far higher U.S. long-term rates would go.  This scenario happened during the 2004 to 2006 hiking cycle – the FED slammed on the brakes… and nothing happened.  Long term borrowing cost did not materially push higher, and mortgage rates remained attractive to fuel the housing bubble – the credit crunch from the bubble burst finally tightened financial conditions, but the speed which it happened devastated the U.S. economy.

This was captured in the financial conditions index (blue line) – the FED wanted the index to rise in response to higher short-term rates, but other factors (Japan’s QE was one reason) kept long-term borrowing cost low, and financial conditions far looser than they should be.  In effect, FED failed to achieve its objective – perhaps not enough pressure was applied to the policy tools.

policy tools - funds rate and financial conditions
Source: Bloomberg

New York Fed President Dudley summarized this phenomenon (also called Greenspan’s Conundrum) in his December 2014 speech:

If the linkage from the federal funds rate to financial market conditions were stable over time, there would be no need to focus on financial market conditions.  In a world in which the linkage was solid and unchanging, adjustments to the short-term interest rate and communication about future policy would have a predictable and reliable effect on financial market conditions.  Central bankers, then, could keep their focus narrowly on their policy rate.

However, as has been very clear, especially in recent years, this linkage is not stable.  Thus, how much one pushes on the short-term interest rate lever depends, in part, on how financial market conditions respond to such adjustments.  Imagine driving a car where the connection between the gas pedal and the engine speed was variable and uncertain.  The driver would have to constantly monitor and adjust the pressure on the gas pedal to achieve the desired speed.  Similarly, we will have to monitor and adjust short-term interest rates to achieve financial market conditions consistent with achieving our labor market and inflation objectives.  All else equal, less responsiveness implies larger interest rate adjustments and vice versa.

Quickly, let me give two examples that illustrate how variable this linkage can be.  First, during the 2004-07 period, the FOMC tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps.  However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher.  Moreover, the availability of mortgage credit eased, rather than tightened.  As a result, financial market conditions did not tighten.

As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate.  With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector.

In essence, the “longer-term interest rates and other financial conditions” below is the critical link which transmits FED policy (including FED’s effective control of short-term rates) into the real economy.

policy tools - with the objective of affecting financial conditions
Source: Federal Reserve Board of Governors

There is one policy tool that the FED can deploy to effectively control long-term interest rates (effective but not pretty) – the balance sheet.  This is to sell assets purchased during QE (thus unwind QE’s effects), rapidly tightening financial conditions.  Or if the FED sees economic conditions deteriorating but long-term borrowing costs does not fall in response to FED rate cuts, then the FED can technically create more bank reserves (“print money”) via more asset purchases, pushing down long-term bond yields.


Federal Reserve policy normalization consists of several phases, and a December liftoff will be closely monitored for its efficacy in the real economy via the financial conditions channel (and whether the policy tools work as expected).  Using President Dudley’s example, a liftoff is merely putting foot on the brakes when the car is going 90 (or use Vice Chair Fischer’s example, merely easing off the accelerator).  FED policymakers will have to react if the car goes from 90 to 0 – a highly undesirable scenario, or still goes at 90 – a possible repeat of 2004 – 2006 cycle.  Right now the expectation is the car going from 90 to 80, but base-case scenarios rarely play out in macroeconomics.

We indeed live in interesting times!


Original Quora article

Next article12 03 2015 | by Victor Xing | Central Banks

Will the FED raise rates in December or March 2016?