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									                                                                  Real Fed Funds Rate
                                                                           (r)                     Monetary Policy
                                                                                                   Response
                                                                                                   Schedule (MPR)



Macro 101
                                                                              r*

                                    Financial
                                    Conditions
                                    Schedule

Michael R. Rosenberg
October 2010                                       FC*                                    p*
                                     Financial                                                      Inflation Rate
                                     Conditions                                                     (p)
                                     (FC)

The Role of Financial Conditions
in the Transmission Mechanism                                                  y*


of Monetary Policy                    IS Curve
                                      (Investment/Savings
                                      Schedule)                                                 Philips Curve
                                                                                                (Inflation/Output
                                                                        Economic Output         Schedule)
                                                                              (y)




                                                            Financial                 Real                    Relative
                                                             Shock                  (Output)                   Price
                                                                                     Shock                     Shock


                                   Change in                Change in               Change in                Change in
                                   Policy Rate               Financial              Economic                  Inflation
                                                            Conditions               Activity




                                                                                                                          1
                New Keynesian Model’s Perspective
                on the Transmission Mechanism of
                Monetary Policy

                                             Real (Output)         Relative Price
                                             Shock                 Shock



Change in                                    Change in             Change in
Policy Rate                                  Economic              Inflation
                                             Activity




              No Role for Changes in Financial Conditions in the
              Transmission of Monetary Policy




                                                                                    2
      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




                                                                   3
              Adding Financial Conditions to the
              Transmission Mechanism of
              Monetary Policy


                Financial    Real (Output)   Relative Price
                Shock        Shock           Shock



Change in       Change in    Change in       Change in
Policy Rate     Financial    Economic        Inflation
                Conditions   Activity




                                                              4
            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 in         Change in                  Change in   Change in
Policy            Credit                     Economic    Inflation
Rate              Spreads                    Activity


                  Change in
                  Asset
                  Prices


                  Change in
                  Bank Lending
                  Conditions


                                                                     5
                 Monetary Policy Transmission Mechanism



       Simulated Effect of a 100 Basis-Point Decline in the Fed Funds Rate


                                            Year 1      Year 2
                  Financial Conditions
                  10-Year Treasury Bond     -30 bp     -50 bp
                  Equity Prices             +8.8%      +12.7%
                  U.S. Dollar               -2.2%       -4.9%

                  Economic Activity
                  GDP                       +0.6%       +1.7%
                  Unemployment Rate        -0.2 ppt.   -0.7 ppt.
                  CPI Inflation             +0.2%       +0.6%



Source: Federal Reserve




                                                                             6
Tracking Financial Conditions –
Bloomberg’s Financial Conditions Index
         Bloomberg's U.S. Financial Conditions Index
                 Components and Weights
                                                  Weight
     Money Market
     Ted Spread                                    11.1%
     Commercial Paper/T-Bill Spread                11.1%
     Libor-OIS Spread                              11.1%
                                                   33.3%
     Bond Market
     Investment-Grade Corporate/Treasury Spread     6.7%
     Muni/Treasury Spread                           6.7%
     Swaps/Treasury Spread                          6.7%
     High Yield/Treasury Spread                     6.7%
     Agency/Treasury Spread                         6.7%
                                                   33.3%
     Equity Market
     S&P 500 Share Prices                          16.7%
     VIX Index                                     16.7%
                                                   33.3%


     Total                                         100%
                                                           7
                    Bloomberg’s Financial Conditions
                    Index



                              Significantly Above Normal


                                        Normal


                             Significantly Below Normal




                    Source: Bloomberg
BFCIUS index <go>                                          8
                           Bloomberg Financial Conditions
                           Index as a Leading Indicator of
                           Bank Lending Conditions

U.S. Bank Willingness to Lend                                                        Financial Conditions
(Smoothed Index)                                                                        (Smoothed Index)
2.0                                                                                                  2.0


1.0
                                                                                                     0.0

0.0
                                                                                                     -2.0
           Bank
-1.0
           Lending
           Conditions                                             Financial                          -4.0
-2.0                                                              Conditions
                                                                  Index
                                                                                                     -6.0
-3.0

                                                                                                     -8.0
-4.0


-5.0                                                                                                 -10.0
    1992     1994       1996       1998      2000   2002   2004        2006      2008         2010

                    U.S. Bank Willingness to Lend                 U.S. Financial Conditions


 Source: Bloomberg


                                                                                                             9
                          Bloomberg Financial Conditions
                          Index as a Leading Indicator of
                          Real GDP Growth

U.S. Real GDP Growth (yoy % chg.)                                                   Financial Conditions+
(Smoothed)                                                                              (Smoothed Index)
6.0                                                                                                  4.0


4.0                                                                                                  2.0


2.0                                                                                                  0.0

           Real GDP
0.0        Growth                                                  Financial                         -2.0
                                                                   Conditions

-2.0                                                                                                 -4.0


-4.0                                                                                                 -6.0


-6.0                                                                                                 -8.0
    1992    1994       1996         1998   2000   2002      2004        2006       2008       2010

                   U.S. Real GDP (yoy %)                   U.S. Financial Conditions (Plus)


 Source: Bloomberg; Note BFCIUS+ Index, which takes into account asset-price bubbles.


                                                                                                            10
     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




                                                                 11
                The Federal Reserve’s Policy
                Objectives and the Taylor Rule


                Financial    Real (Output)   Relative Price
                 Shock          Shock           Shock



Change in       Change in     Change in       Change in         Inflation
Policy Rate     Financial     Economic         Inflation      Expectations
                Conditions     Activity



 Policy Rule
(Taylor Rule)




 Monetary
  Policy
 Objective




                                                                             12
                                    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.




            Price Stability                    Maximum Sustainable Output              Maximum Sustainable Employment
Inflation                                 Output                                  Unemployment
                                                                      Potential
                                                                       Output


                                Fed’s
                               Implicit                                                                          NAIRU
 p*                           Inflation                                           uN
                                Target                    Actual
              Actual                                      Output                                    Actual
             Inflation                                                                           Unemployment
               Rate                                                                                  Rate


                                Time                                    Time                                      Time




                                                                                                                  13
                The Inflation/Output Tradeoff Curve


            Output Gap
             Volatility




                          A
Std. Dev. (Y-Y*)3



                                          The Efficient Policy
                                               Frontier




Std. Dev. (Y-Y*)2                   C



                                                       B
Std. Dev. (Y-Y*)1


                    Std. Dev. Std. Dev.           Std. Dev.      Inflation Gap
                     (p-p*)1   (p-p*)2             (p-p*)3         Volatility



                                                                                 14
                 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?



                                                                               15
    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 =      Neutral     +     Taylor Rule Recommended
 Prescribed          Rate                 Deviation from the
 Policy Rate        Setting              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
     The Taylor Rule Model in Real
     Terms



  rTaylor     =      rN    +    [ a(p – p*) + b(y – y*) ]

Taylor Rule   =    Neutral  +   Taylor Rule Recommended
Prescribed        Real Rate         Deviation from the
Real Policy        Setting       Neutral Real Rate Setting
   Rate




                                                             17
             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     =     Neutral  +    Taylor Rule Recommended
   Prescribed           Real Rate          Deviation from the
   Real Policy           Setting        Neutral Real Rate Setting
      Rate


    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
               Taylor Rule Estimates of the Fed
               Funds Rate –1990-2010




            Source: Bloomberg                     19
TAYL <go>
               The Response of Fed Policy to
               Changes in Inflation

(%)
25



20



15



10



5



0
 1970   1975     1980        1985   1990   1995       2000           2005   2010

                 Fed Funds Rate            Core PCE Inflation Rate




                                                                                   20
                    The Response of Fed Policy to
                    Changes in Unemployment

Fed Funds Rate less PCE Inflation Rate (%)                           NAIRU less Unemployment Rate (%)
6                                                                                                       2

5                                                                                                       1

4                                                                                                       0

3                                                                                                       -1

2                                                                                                       -2

1                                                                                                       -3

0                                                                                                       -4

-1                                                                                                      -5

-2                                                                                                      -6
     1986   1988   1990     1992   1994      1996   1998   2000   2002   2004   2006   2008    2010

                          Real Fed Funds Rate                       Unemployment Gap




                                                                                                             21
   The Transmission/Feedback Mechanism of
   Monetary Policy – A Graphical Model
                 Financial            Real                 Relative
                  Shock             (Output)                Price
                                     Shock                  Shock



Change in        Change in         Change in              Change in
Policy Rate      Financial         Economic                Inflation
                 Conditions         Activity




   Nominal Fed                             MPR1
   Funds Rate
                                        (Aggressive)



                                Monetary-Policy
                                  Response               MPR2
                                  Schedules            (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.




                      p1                       Inflation Rate
                                                                       22
   The Transmission/Feedback
   Mechanism of Monetary Policy –
   A Graphical Model
                      Financial              Real                  Relative
                       Shock               (Output)                 Price
                                            Shock                   Shock



Change in            Change in             Change in               Change in
Policy Rate          Financial             Economic                 Inflation
                     Conditions             Activity




     Real Fed Funds Rate
                                                 Monetary-Policy
                                                   Response
                                                   Schedule


                                  B
       r2

                                             An increase in inflation
                           A                 will prompt the Fed to
       r1                                    raise the real Fed Funds
                                             rate, all else being equal.




                           p1         p2               Inflation Rate
                                                                                23
        Response of Financial Conditions to
        Changes in the Federal Reserve
        Policy Rate
Real Fed Funds
     Rate




                   A      Financial Conditions
  r1                    improve as the Fed’s real
                          policy rate declines




                                  B
  r2

                                            Financial
                                           Conditions
                                            Schedule


                                              FCON

                 FC 1          FC 2    Financial Conditions


                                                              24
     Pass-Through Effect of Policy-Rate
     Changes on Financial Conditions


 Real Fed
Funds Rate




                               The response of
r1               A             Financial Conditions to
                               changes in policy rates is
                               a function of the slope of
                               the Financial Conditions
                               Schedule.

r2                    C            B




                           FCON2          FCON1

               FC1   FC2       FC3        Financial
                                         Conditions




                                                            25
                 An Adverse Shift in Financial Conditions
                 and the Federal Reserve Policy Response
                                  Financial             Real               Relative
                                   Shock              (Output)              Price
                                                       Shock                Shock



              Change in           Change in           Change in            Change in
              Policy Rate         Financial           Economic              Inflation
                                  Conditions           Activity




                             Real Fed
                            Funds Rate




                                                                     Adverse shift in the
                                                 B               A   Financial Conditions
The Fed responds to a        r1                                      Schedule from FCON1 to
financial shock by lowering                                          FCON 2
the real Fed Funds rate
from r1 to r 2, which        r2                                  C
improves Financial
Conditions from FC2 back
to its original level of FC1


                                                                       FCON 2     FCON 1

                                               FC 2        FC 1              Financial        26
                                                                            Conditions
   Response of Economic Activity to Changes
   in Financial Conditions
               Financial               Real               Relative
                Shock                (Output)              Price
                                      Shock                Shock



Change in      Change in            Change in             Change in
Policy Rate    Financial            Economic               Inflation
               Conditions            Activity




  Output Gap
                                                New Keynesian
                                                 Investment-
                                                 Savings (IS)
                                                   Schedule




                            B
(y-y*)2                            An improvement in
                                   Financial Conditions leads
                                   to an increase in output (y)
                   A               relative to an economy’s
(y-y*)1                            potential output(y*), all else
                                   being equal.




                 FC 1       FC 2                 Financial
                                                Conditions             27
          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.




                    FC 1    FC 2         Financial
                                        Conditions




                                                                  28
   Response of Inflation to Changes in the
   Output Gap
                 Financial                Real              Relative
                  Shock                 (Output)             Price
                                         Shock               Shock



Change in       Change in               Change in           Change in
Policy Rate     Financial               Economic             Inflation
                Conditions               Activity




    Inflation

                                               New Keynesian
                                               Phillips Curve
                                                     (PC)




     p2                      B         An increase in output (y)
                                       relative to an economy’s
                                       potential output(y*) leads to
     p1              A                 an increase in inflation, all
                                       else being equal.




                (y-y*)1      (y-y*)2                Output Gap
                                                                         29
     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
                Fitting the Pieces Together
          A Four Quadrant Diagram of the Monetary Policy
    Transmission/Feedback Mechanism (under normal conditions)

                             Real Fed Funds Rate
                                      (r)
                                                              Monetary Policy
                                                              Response
                                                              Schedule (MPR)


   Quadrant                                                            Quadrant
   II                                  r*                              I

Financial Conditions
Schedule




                       FC*                         p*
Financial Conditions                                                  Inflation Rate
(FC)                                                                  (p)




                                       y*

      IS Curve
      (Investment/Savings
      Schedule)                                         Philips Curve
                                                        (Inflation/Output Schedule)

  Quadrant                   Economic Output                           Quadrant
  III                        (y)                                       IV
                                                                                       31
                   The Effects of an Unwarranted Cut in the Real
                   Fed Funds Rate

                                     Real Fed Funds Rate
                                              (r)
                                                                                Monetary Policy
                                                                                Response
                                                                                Schedule (MPR)
                             (6)                  r2
                                                                            (5)
   Quadrant                                                                              Quadrant
   II                                             r*                                     I

Financial Conditions                                       (1)                    Fed reduces the
Schedule
                                                  r1                              Real Fed Funds rate
                   (2)                                       (9)                  from r* to r1




          FC1          FC*         FC2                 p2          p*      p1
Financial Conditions                                                                   Inflation Rate
(FC)                                                                                   (p)

                                                             (8)
                             (7)                  y2



                                                  y*
             (3)
      IS Curve                                                              (4)
                                                  y1
      (Investment/Savings
      Schedule)                                                         Philips Curve
                                                                        (Inflation/Output Schedule)

  Quadrant                               Economic Output                                Quadrant
  III                                    (y)                                            IV
                                                                                                        32
                  The Consequences of the Fed Not Responding
                  Immediately to a Financial Shock

                                        Real Fed Funds Rate
                                                 (r)
A financial shock shifts the                                                    Monetary Policy
Financial Conditions Schedule                                                   Response
from FCON* to FCON’                                                             Schedule (MPR)


      Quadrant                                                                            Quadrant
      II                        (1)                  r*                                   I
                                                                     (8)
   Financial Conditions
   Schedule
                                                     r1
                        (5)                                    (4)


   FCON*

     FCON’
                       FC*            FC2                 p2         p*
   Financial Conditions                                                                 Inflation Rate
   (FC)                                                                                 (p)


                                (2)                  y2
                                                               (3)

                       (6)                                           (7)
                                                     y*

       IS Curve
       (Investment/Savings                                                Philips Curve
       Schedule)                                                          (Inflation/Output Schedule)


     Quadrant                               Economic Output                              Quadrant
     III                                    (y)                                          IV
                                                                                                         33
                 The Consequences of a Rapid Response by the
                 Federal Reserve Rapid Response to a Financial
                 Shock
                                      Real Fed Funds Rate
                                                                                  Monetary Policy
                                               (r)
A financial shock shifts the                                                      Response
                                                                             MPR* Schedules
Financial Conditions Schedule
from FCON* to FCON’                                                             MPR’


      Quadrant                                                                         Quadrant
      II                                        r*                                     I

   Financial Conditions                                     (1)
                                                r1                         The Fed responds to the
   Schedules            (2)
                                                                           shock by immediately
                                                                           reducing the neutral Real Fed
                                                                           Funds rate from r* to r1 , This
   FCON*                                                                   is shown as a downward shift
                                                                           in the Monetary Response
     FCON’                                                                 Schedule from MPR* to MPR’.
                       FC*      FC2                               p*
   Financial Conditions                                                              Inflation Rate
   (FC)                                                                              (p)




                       (3)                                        (4)
                                                y*

         IS Curve
         (Investment/Savings
         Schedule)                                                     Philips Curve
                                                                       (Inflation/Output Schedule)

     Quadrant                         Economic Output                                 Quadrant
     III                              (y)                                             IV
                                                                                                             34
                        The Effects of Fiscal Stimulus at a Time When
                        the Real Economy is Being Hit by a Negative
                        Financial Shock
                                                Real Fed Funds Rate
A financial shock shifts the                             (r)
Financial Conditions Schedule                                                     MPR*
from FCON* to FCON1
                                                                Monetary Policy
                                                                Response
                                                                Schedule
        Quadrant                                                                               Quadrant
        II                                                 r*                                  I
                                                                               (4)
                                          (1)
     Financial Conditions
     Schedules
                                                           r1


      FCON*

       FCON1
                                 FC*      FC2                             p*
      Financial Conditions                                                                   Inflation Rate
      (FC)                                                                                   (p)

A fiscal stimulus shifts
the IS Curve from IS* to
IS1, negating the
deterioration in financial               (2)
condition, and output                                                      (3)
remains at y*                                              y*

                  IS*
                             IS Curve
                   IS1                                                         Philips Curve
                             (Investment/Savings
                                                                               (Inflation/Output Schedule)
                             Schedules)

       Quadrant                                  Economic Output                              Quadrant
       III                                       (y)                                          IV
                                                                                                              35
                     The Monetary Policy Transmission Mechanism
                     When the Policy Rate is Zero and There Is a
                     Threat of Deflation
                                             Real Fed Funds Rate
                                                                                           Kinked Monetary Policy
Initial deterioration in financial                    (r)  Real policy rate rises          Response
conditions and shift in the                                    when deflation sets in      Schedule
Financial Conditions Schedule                                  and the nominal policy
from FCON* to FCON1                                            rate is zero
                                                         (+)             (4)
    Quadrant                                                                                       Quadrant
    II                                                                                             I
                                                         (0)
                                       (1)
 Financial Conditions
 Schedules                (7)
                                                          (-)
                                                                                              Real policy rate moves into
                                                                                              negative territory when
                                                                                              expected inflation rises and
 FCON*                                                                                        the nominal policy rate is
                                                                                              zero
      FCON1
                                FC*    FC2                      ( - ).         (0)   (+)
 Financial Conditions                                                                            Inflation Rate
 (FC)                                                                                            (p)

                                                          y2

                                      (2)                 y1     (3)

                                                          y*
                                                                                           Philips Curves
                        IS Curve                                                           (Inflation/Output
               IS*      (Investment/Savings                                                Schedule)
                        Schedules)
                                                                                     PC*

   Quadrant                                                                                        Quadrant
                                              Economic Output
   III                                        (y)
                                                                                                   IV
                                                                                                                             36
                       Negating the Real Economy Effects of a
                       Financial Shock by Engineering a Rise in
                       Expected Inflation
                                                  Real Fed Funds Rate
                                                                                                      Kinked Monetary Policy
Initial deterioration in financial                         (r)  Real policy rate rises                Response
conditions and shift in the                                         when deflation sets in            Schedule
Financial Conditions Schedule                                       and the nominal policy
from FCON* to FCON1                                                 rate is zero

                                                              (+)             (4)
      Quadrant                                                                                              Quadrant
      II                                                                                                    I
                                                              (0)
                                            (1)
  Financial Conditions
                                                               (-)                              (6)     Real policy rate moves into
  Schedules            (7)                                                                              negative territory when
                                                                                                        expected inflation rises and
                                                                                                        the nominal policy rate is
   FCON*                                                                                                zero

        FCON1
                                     FC*   FC2                       ( - ).         (0)         (+)
   Financial Conditions                                                                                     Inflation Rate
   (FC)                                                                                                     (p)



                                           (2)                        (3)                 (5)
                                                                                                      (9)
                                                                                                                Philips Curves
                                                               y*                                               (Inflation/Output
                                (8)
                                                                                                                Schedule)
                 IS*      IS Curve                                                                            PC1
                          (Investment/Savings
                          Schedules)
                                                                                           PC*
                                                                                                       Engineered rise in
     Quadrant                                      Economic Output              Quadrant               expected inflation
     III                                           (y)                          IV                                                     37
                      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




                 Traditional
                                    Change in    Change in     Change in
 Change in       Channel
                                    Financial    Economic    Inflation Rate
 Policy Rate
                                    Conditions    Activity




  Commit to           Expectations
 Keep Policy       Management Channel
Rate Low for a
Considerable
   Period




                                                                              38
                     Federal Reserve Targeting Long-
                     Term Rather than Short-Term
                     Interest Rates




                Traditional
                              Change in    Change in     Change in
Change in        Channel
                              Financial    Economic    Inflation Rate
Short-Term
                              Conditions    Activity
Policy Rate




                    New
  Change in       Approach
 Long-Term
Interest Rate




                                                                        39
                                               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                         Fed purchases of Treasury bonds lowers the supply of publicly
                             improve Financial Conditions.                                held bonds and thereby acts to lower long-term interest rates
                                    Real Long-Term                                  Real Long-Term
                                     Interest Rate                                   Interest Rate
                                                                                                                                  BS2       BS1
                                                                                                                                                    BD
                                                                                                                    Supply
                                                            “New” Monetary                                         of Bonds
             Financial                                        Response                                                                             Demand
         Conditions/Interest                                  Schedules                                                                           for Bonds
          Rate Schedule

                       A                  i1                       A                     i1                                             A



             B                            i2                       B                     i2                                   B




 Financial       FC2   FC1                                         p1        Inflation                                             Outstanding Stock
Conditions                                                                                                                        of Government Debt



                       Transmission of Policy                                                         Policy Implementation
                                                                                                                                                     40
            Estimating the Impact of the
            Federal Reserve's Large-Scale
            Asset Purchase Program on Long-
            Term Interest Rates


                                Estimated
                                Impact on                    Estimated
                                 10-Year                   Impact on U.S.
 Increase in Size              Government                     GDP after
     of LSAP                    Bond Yield                 Eight Quarters

         $1 trillion           -39 basis points                       +1.5%

         $2 trillion           -78 basis points                       +3.0%


Source: Joseph Gagnon, "The World Needs Further Monetary Ease, Not an Early Exit",
Peterson Institute for International Economics Policy Brief, December 2009.




                                                                                     41
                         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                 Price of               Change                     Change in     Change
     in                  Risky                     in                     Economic          in
Policy Rate             Assets                Risk Taking                  Activity     Inflation




                                                            Asset Price
                                                              Bubble




                                                                                                    42
                     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



                                    Risk-Taking                                   Monetary-Policy
                                     Schedule                               MPR1      Response
                                                                                     Schedules
                                                                                 MPR2
                                                                                       MPR3
                                       A          r1               A




                             B                    r2               B



              C                                   r3               C




 Financial    FC3             FC2      FC1                             p1                Inflation
Conditions


                                                                                                     43
            Monetary Policy and Risk Taking
            (1-2)
         Do easy monetary policies contribute to lax lending
         practices that contribute to a buildup of financial
         imbalances?


1.   Low interest rates encourage a higher level of leverage as
     banks and shadow banks often finance themselves with
     short-term liabilities.


2.   Low interest rates promote a “search for yield”. This tends to
     drive down risk premia across the credit spectrum.




                                                                      44
            Monetary Policy and Risk Taking
            (3-4)
         Do easy monetary policies contribute to lax lending
         practices that contribute to a buildup of financial
         imbalances?


3.   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.
4.   Low interest rates for long periods contribute to lower asset-
     price volatility, which may alter the risk management
     practices of financial institutions.




                                                                       45
            Monetary Policy and Risk Taking
            (5-8)
         Do easy monetary policies contribute to lax lending
         practices that contribute to a buildup of financial
         imbalances?


5.   Low interest rates alter traditional risk indicators such as
     Value at Risk, which in turn may alter risk-taking behavior.
6.   Low interest rates encourage fund managers to take on more
     risk to boost absolute returns.
7.   Central-bank communications (for example, “measured pace
     or “extended period”) may alter risk perceptions and
     encourage risk taking.
8.   Low interest rates lead investors to take on more illiquid
     positions to generate higher returns.


                                                                    46
             Monetary Policy and Risk Taking
             (9-11)
          Do easy monetary policies contribute to lax lending
          practices that contribute to a buildup of financial
          imbalances?


9.    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).
10.   Credit ratings improve when interest rates are low, which in
      turn leads to narrower credit spreads.
11.   Low interest rates for long periods boost house prices, which
      encourages household speculation in the housing market




                                                                      47
        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.




                                                               48
            The Taylor Rule on Bloomberg




                                           49
TAYL <go>
           Fraction of Time the Real Federal
           Funds Rate Is Negative by Decade

                                                                         Decade of Asset Bubbles

                   Decade of High Inflation
45%

40%

35%

30%

25%

20%

15%

10%

5%

0%
          1960s               1970s           1980s             1990s              2000s

 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.




                                                                                                      50
           Asset-Price Bubbles


       Ratio of the S&P Home Builders Index
                to the S&P 500 Index

(Ratio)
1.20


1.00


0.80


0.60


0.40


0.20


0.00
    1995     1997       1999   2001   2003   2005   2007   2009

    Source: Bloomberg




                                                                  51
                                U.S. Five-Year Note Yields minus
                                U.S. Nominal GDP Growth


(Percentage Points)
     8.0
                                                           Long-term interest
                                                           rates were too low
     6.0                                                 relative to the level of
                                                            economic activity
     4.0                                                  throughout 2002-06


     2.0

     0.0

    -2.0

    -4.0

    -6.0
         1992         1994   1996   1998   2000   2002      2004         2006       2008   2010

           Source: Bloomberg




                                                                                                  52
                            U.S. Real Corporate Baa Bond
                            Yields

 (%)
10
 9                                                Real Baa corporate bond
                                                     yields were too low
 8                                                relative to the historical
                                                  average through most of
 7                                                         2003-08
 6
 5
 4
               5% Average
 3
 2
 1
 0
 1993       1995     1997    1999   2001   2003        2005         2007       2009


       Source: Bloomberg




                                                                                      53
     -8.00
               -6.00
                                         -4.00
                                                          -2.00
                                                                           0.00
                                                                                  2.00
                                                                  Mar/95                 4.00
                                                                  Sep/95
                                                                  Mar/96
                                                                  Sep/96




                           IR
                                         CC




             FCI
                                                                  Mar/97




                   REXCH
                                SPREAD
                                                 WEALTH
                                                                  Sep/97
                                                                  Mar/98
                                                                  Sep/98
                                                                  Mar/99
                                                                  Sep/99
                                                                  Mar/00
                                                                  Sep/00
                                                                                            Index




                                                                  Mar/01
                                                                  Sep/01
                                                                  Mar/02
                                                                  Sep/02
                                                                  Mar/03
                                                                  Sep/03
                                                                  Mar/04
                                                                  Sep/04
                                                                  Mar/05
                                                                  Sep/05
                                                                  Mar/06
                                                                  Sep/06
                                                                  Mar/07
                                                                  Sep/07
                                                                  Mar/08
                                                                  Sep/08
                                                                  Mar/09
                                                                                            OECD U.S. Financial Conditions




54
                 The Taylor Rule Model and Financial
                 Conditions
Policymakers need to consider the risk-taking behavior of
market participants in setting policy


                      rTaylor = rN + [ a(r – r*) + b(y – y*) ]

                  Taylor Rule = Neutral +     Taylor Rule Recommended
                  Prescribed      Rate        Deviation from Neutral Rate
                Real Policy Rate Setting                 Setting




  rFCTaylor =        [ rN + l(FC – FC*) ] + [ a(r – r*) + b(y – y*) ]

  Augmented      =   Financial-Conditions-Adjusted   +      Taylor Rule Recommended
  Taylor Rule            Neutral Rate Setting               Deviation from Neutral Rate
  Prescribed                                                           Setting
Real Policy Rate




                                                                                          55
                 Should the Federal Reserve Respond to
                 Easier Financial Conditions if Domestic
                 Inflation Remains in Check? (1)
                                          Real Fed Funds Rate
                                                                                   Monetary Policy
                                                   (r)                               Response
 Easier financial conditions shifts the
    Financial Conditions schedule                                                    Schedule
         from FCON* to FCON2                                                   MPR*


       Quadrant                                                                       Quadrant
          II                                                                             I
 Financial
                  (2)       (1)                     r*
 Conditions
 Schedules

    FCON2

       FCON*          FC2   FC*                                       p*
     Financial Conditions                                                            Inflation Rate
             (FC)                                                                           (p)

The improvement
                                                                                Globalization results in a
    in financial
                                                                                 shift in the U.S. Philips
conditions results
                                                                               Curve schedule from PC*
 in an increase in
                                                                                to PC2 which offsets the
    output from
                                                    y*                          effect that an increase in
      y* to y2
                                                                               output from y* to y2 would
                                                                                    normally have on
                (3)                                                        (4)
                                                                                         inflation.
                                                    y2          (5)
                     IS Curve
                                                                             PC*           Philips Curves
               (Investment/Savings
                                                                                   (Inflation/Output Schedules)
                    Schedule)
                                                                PC2
      Quadrant                            Economic Output                            Quadrant
         III                                    (y)                                     IV
                                                                                                                  56
                    Should the Federal Reserve Respond to
                    Easier Financial Conditions if Domestic
                    Inflation Remains in Check? (2)
                                          Real Fed Funds Rate
                                                                                     Monetary Policy
                                                   (r)
 Easier financial conditions shifts the                                                Response
                                                                             MPR2
    Financial Conditions Schedule                                                      Schedules
         from FCON* to FCON2                                                     MPR*


       Quadrant                                                                         Quadrant
          II                 (2)                    r2          (1)                        I

    Financial Conditions                                                        The Fed responds to the
         Schedules                                  r*                          improvement in financial
                                                                               conditions by immediately
                                                                              raising the neutral Real Fed
                                                                             Funds rate from r* to r2 , This is
   FCON2
                                                                             shown as a upward shift in the
                                                                             Monetary Response Schedule
       FCON*        FC2          FC*                                  p*          from MPR* to MPR2.

    Financial Conditions                                                               Inflation Rate
            (FC)                                                                              (p)

 Because of the
Fed’s response to
the improvement
   in Financial
Condition, output          (3)                                         (4)
  remains at y*.                                    y*
                                                                                      Philips Curves
                                                                              (Inflation/Output Schedules)

                          IS Curve
                                                                              PC*
                    (Investment/Savings
                         Schedule)
                                                                 PC2
      Quadrant                            Economic Output                              Quadrant
         III                                    (y)                                       IV                      57
             The Taylor Rule and the
             Determination of Exchange Rates (1)

                 The Real Interest-Rate Differential Model
                    of Exchange-Rate Determination



  qHY        =      qHY        +      (rHY- rLY)      –      (fHY - fLY )


 Dollar’s    =    Dollar’s     +      U.S./Foreign    -   U.S./Foreign
Real Value       Long-Run             Real Interest       Relative Risk
                 Equilibrium          Rate Spread          Premium
                   Value




                                                                            58
                                        The Taylor Rule and the
                                        Determination of Exchange Rates (2)


      (1)            rUS        =             rNUS           +    [ a(pUS – p*US) + b(yUS – y*US) ]

                  Taylor Rule       =     U.S. Neutral       +           Taylor Rule Recommended
                  Prescribed                 Rate                            Deviation from the
                   U.S. Real                Setting                       U.S. Neutral Rate Setting
                  Policy Rate



      (2)            rF         =              rNF           +     [ a(pF – p*F) + b(yF – y*F) ]

                  Taylor Rule       =    Foreign Neutral +               Taylor Rule Recommended
                  Prescribed                  Rate                           Deviation from the
                 Foreign Real                Setting                     Foreign Neutral Rate Setting
                  Policy Rate



(3)
              rUS - rF        = (rNUS - rNF) +                   [ Relative Taylor Rule Response Coefficients x ]
                                                                       Relative Inflation and Output Gaps
             U.S.- Foreign      =       U.S.- Foreign    +          U.S.-Foreign Relative Taylor Rule Recommended
            Relative Taylor               Relative                      Deviation from the Neutral Rate Settings
            Rule Prescribed             Neutral Rate
             Foreign Real                  Setting                                                                  59
              Policy Rate
The Monetary Policy Transmission/Feedback
Mechanism and Its Impact on Real Interest Rate
Differentials and the Exchange Rate




                                                 60

								
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