IOER

The Fed's successful tightening

No one should be surprised that the Fed is tightening monetary policy and expects to tighten significantly further over coming years. Unemployment is less than 5 percent, consistent with normal use of resources. Inflation is approaching the FOMC’s 2 percent objective. And policy rates remain below what simple guides would suggest as normal.

A key issue facing policymakers today is whether the Fed’s new operational framework is working effectively to tighten financial conditions without creating unnecessary volatility. While the FOMC’s actions are occurring in a familiar macroeconomic environment, the legacy of the crisis makes raising rates anything but routine. The key difference is the size of the Fed’s balance sheet. Unlike past episodes, when commercial bank reserves were relatively scarce, today they are abundant.

This difference—reflecting a balance sheet that is over four times its pre-crisis level—creates technical challenges for the Fed. The traditional approach of using modest open-market operations (through repurchase agreements of a few billion dollars) to control the federal funds rate—became ineffective as reserves grew abundant. This meant developing an entirely new operational framework. The good news is that—up to now—the challenges of policy setting with abundant reserves have been very clearly met. While this may seem mundane, it is no small achievement. Much like plumbing, had the Fed’s new system failed, everyone would have noticed. At the same time, there are still challenges to face, so we’re not completely out of the woods....

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Rewriting the textbook: covered interest parity

For decades, textbooks on international economics and finance built a part of their scaffolding on the foundation of a relationship called covered interest parity (CIP). CIP postulates that, in a world of free capital flows, currency-hedged returns on equivalent-risk assets will equalize across countries. For example, the return to investing in a 1-year U.S. Treasury bill will equal the return to purchasing euros, investing the proceeds in a 1-year German Government liability, and purchasing a contract guaranteeing the future euro/dollar exchange rate at which the euros will be converted back to dollars a year later. In practice, the CIP relationship was such a reliable feature of international fixed-income markets that for decades one could think of banks operating a nearly costless CIP machine to perform what many viewed as a riskless arbitrage.

Then, one day, the CIP machine broke down. It first stopped working in the Great Financial Crisis (GFC) of 2007-2009, when counterparty and liquidity risks both skyrocketed, raising the possibility of defaults and losses in executing the trades necessary. That is, CIP was not a riskless arbitrage.

As a wave of recent research highlights, the conventional, pre-crisis model of the CIP machine remains impaired even as the counterparty and liquidity risks that characterized the GFC have receded....

 

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How the Fed tightened

Back in August, we explained the mechanics of how the Fed can tighten policy in today’s world of abundant bank reserves. Now that the first policy tightening under the new framework is behind us, we can review how the Fed did it, if there were any surprises, and what trials still lie ahead.

So far, the new process has been extraordinarily smooth – a tribute to planning by the Federal Open Market Committee (FOMC) and to years of testing by the Market Desk of the Federal Reserve Bank of New York (FRBNY). But it’s still very early in the game, so uncertainties and challenges surely remain.

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How the Fed will tighten

Before the financial crisis, tightening monetary policy was straightforward. The Federal Open Market Committee (FOMC) would announce a rise in the target for the federal funds rate in the overnight interbank lending market, and the open market desk would implement it with a small reduction in the quantity of reserves in the banking system.

Matters are no longer so simple. The unconventional policies designed first to avert a financial and economic collapse, and then to spur growth and employment, have left the banking system with reserves that are so abundant that it would be impossible to tighten policy in the conventional manner.

So, as the FOMC moves to "normalize" monetary policy after years of extraordinary accommodation, how, precisely, will the Fed tighten monetary policy? ...

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Regulatory quakes and tremors

If there were a regulatory Richter scale that measured the shaking of the financial system, the 2010 Dodd-Frank Act would register about 8, while the 2011 Basel III framework might be a bit above 7.  (For reference, the 1906 San Francisco earthquake was a 7.8). Fortunately, this shaking is mostly for the better – helping to make the financial system more resilient in the long run.

The new “Bailout Prevention Act” of Senators Vitter and Warren also might be an 8 on the shaking scale, but it would be a true disaster, because it undermines the Fed’s role as crisis lender of last resort. In contrast, the Senate Banking Committee’s new discussion draft of a “Financial Regulatory Improvement Act of 2015” is probably a 2 or a 3. If enacted, it will be “felt slightly by some people” but probably won't do much damage...

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