The changing U.S. financial system : some implications for the monetary transmission mechanism

An important part of monetary policy is the monetary transmission mechanism, the process by which monetary policy actions influence the economy. While the transmission mechanism involves a number of channels, including exchange rates, bank credit, and asset prices, most economists consider interest rates to be the principal avenue by which monetary policy affects economic activity.> In recent decades, significant changes in the structure of financial markets and institutions in the United States may have altered the interest rate channel. Key developments include the deregulation of the financial system, the growth of capital markets as an alternative to bank intermediation, increased competition among intermediaries both domestically and internationally, and greater transparency by the Federal Reserve about monetary policy operations. These changes may have altered both the timing and magnitude of the response of interest rates to monetary policy. Indeed, the failure of long-term interest rates to respond to monetary policy easing during the past year has been cited in the financial press as an indication that monetary policy may now have less influence on interest rates than in the past.> Sellon examines how the changing financial system has affected the interest rate channel of monetary policy. He finds that the response of interest rates to monetary policy, rather than diminishing, has actually increased considerably over time. Indeed, bank lending rates on consumer and business loans and mortgage rates now appear to exhibit a much stronger and faster response to monetary policy actions than in the past. Moreover, institutional changes, such as the increased use of variable-rate loans and the availability of low-cost mortgage refinancing, may have altered the transmission mechanism, potentially broadening the influence of monetary policy on the economy.Monetary policy ; Financial markets ; Interest rates

Expectations and the monetary policy transmission mechanism

In principle, the monetary policy transmission mechanism can be described rather simply. When the Federal Reserve raises its target for the federal funds rate, other interest rates also rise—reducing interest-sensitive spending and slowing the economy. Conversely, when the federal funds rate target is lowered, other interest rates tend to fall—stimulating spending and spurring economic activity. While adequate for some purposes, this stylized description of the transmission mechanism is less helpful in explaining the complex relationship between interest rates and monetary policy that is actually observed in financial markets. It also provides little insight into the source of the Federal Reserve’s leverage over market interest rates. Indeed, how does control over a relatively insignificant interest rate—the overnight federal funds rate—allow the Federal Reserve to influence the whole spectrum of short-term and long-term market rates? Sellon describes a simple analytical framework that provides a better conceptual understanding of the monetary policy transmission mechanism and also helps explain the complex relationships between monetary policy and interest rates observed in financial markets. In this framework, financial market expectations about future monetary policy play a central role. Indeed, expectations about the path of future policy actions are the driving force in determining market interest rates. Consequently, understanding how financial markets construct this expected policy path and what factors cause the path to change is critical to understanding the transmission process and the behavior of interest rates. This framework also highlights the important role central bank communications play in the transmission mechanism and the evolution of market interest rates.Monetary policy ; Interest rates ; Transmission mechanism (Monetary policy)

Monetary policy transparency and private sector forecasts: evidence from survey data

In recent years, central banks around the world have greatly increased the monetary policy information they have provided the public. The Federal Reserve has taken a number of actions to promote transparency including, most recently, the announcement of enhancements to the FOMC's (Federal Open Market Committee) economic forecasts that are released to the public. ; The movement toward increased transparency arises largely from the view that increased transparency has important benefits, including more effective monetary policy. This view is based on theoretical and empirical research that has emphasized the importance of public expectations about monetary policy as a key factor in determining interest rates and other asset prices. In particular, this research suggests that improved predictability of monetary policy may reduce the volatility of asset prices and make monetary policy more effective by increasing a central bank's leverage over longer-term interest rates. ; Sellon uses information from the Blue Chip Long Range Financial Forecasts to examine whether longer-horizon predictability has been associated with increased transparency. The analysis suggests several interesting conclusions. First, consistent with previous studies using futures data, there has been a marked reduction in survey forecast errors at short-term horizons. But, the survey data suggest there has been much less improvement at longer horizons. Second, to the extent private sector longer-horizon forecasts of future monetary policy have improved in recent years, most of the improvement occurred from 2003 to 2006, when the Federal Reserve provided more explicit guidance about the future path of the federal funds rate. During this period, forecast errors over all horizons dropped remarkably. Indeed, this period appears to have driven most of the improvement in the Blue Chip survey forecasts seen over the entire 1986-2007 sample period. Third, the survey evidence reported in this article does not support the finding of some studies that forecasting improved suddenly after 1994. Fourth, the longer-horizon forecast errors have been largest when policy was being actively tightened or eased, especially during the 1990-92 and 2001-03 periods of extended policy easing. Finally, longer-horizon forecast errors appear to have diminished during periods of tightening, but not during periods of easing.

Monetary policy and the zero bound : policy options when short-term rates reach zero

In response to continuing weakness in economic activity, the Federal Reserve has lowered its target for the overnight federal funds rate from 6½ percent to 1 percent over the past two and one-half years. Recently, concern has been expressed in the news media and among academic economists and policymakers that additional steps to ease monetary policy could cause the federal funds rate target to hit a lower limit of zero percent. In this event, it would not be possible to lower the target any further, and the Federal Reserve would have to alter its procedures for implementing monetary policy to provide additional policy stimulus. ; Sellon examines how monetary policy can be conducted when short-term interest rates reach the zero bound and whether policy is likely to be effective in this situation. He suggests that concerns about the zero bound as a constraint on monetary policy are greatly exaggerated. Even when short-term interest rates are near zero, central banks will generally have considerable scope to expand bank credit and to lower longer-term interest rates. And, in the event the banking system does not function effectively or long-term rates also reach zero, further options are available to provide policy stimulus. ; Sellon also examines two historical episodes—the United States in the 1930s and Japan over the past decade—that have been cited as examples of how the zero bound might reduce the effectiveness of monetary policy. He suggests that the central problem in these situations was not the existence of a zero bound per se but, rather, a weakened banking system that limited the effectiveness of monetary policy.Monetary policy ; Interest rates

Monetary policy without reserve requirements : case studies and options for the United States

Over the past decade, the level of required balances held by depository institutions in the United States has declined dramatically. The decline in reserve balances has fueled a debate over the role of reserve requirements. On the one hand, proponents of reserve requirements argue that low reserve balances may complicate monetary policy operations and increase short-term interest rate volatility. On the other hand, critics of reserve requirements argue that lower reserve requirements remove a distortionary tax on depository institutions and need not complicate monetary policy operations. ; In this article, the authors examine how three countries - Canada, the United Kingdom, and New Zealand conduct monetary policy without using reserve requirements. The experience of these three countries provides insight into the linkages between the payments system and monetary policy and into the connection between reserve requirements and interest rate volatility. This insight is particularly helpful in understanding the implications of a further reduction of reserve balances in the United States.Monetary policy ; Bank reserves ; Monetary policy - Canada ; Monetary policy - Great Britain ; Monetary policy - New Zealand

Housing, housing finance, and monetary policy: an introduction to the Bank's 2007 Economic Symposium

Housing ; Housing - Prices ; Business cycles ; Monetary policy ; Consumer behavior

Bank lending and monetary policy: evidence on a credit channel

While there is widespread agreement that banks play a key part in the transmission of monetary policy actions to the economy, debate continues on whether bank lending plays a special part in the monetary transmission mechanism. If a special lending or credit channel exists, changes in the willingness and ability of banks to extend credit may have implications for the economy. Moreover, ongoing changes in the role of banks in financial markets may affect the credit channel and so alter the monetary transmission mechanism.> Recent research on a bank credit channel has focused on two questions. Are certain borrowers so dependent on bank lending that any change in banks' willingness to lend has an immediate effect on investment and spending decisions? And, do monetary policy changes directly constrain bank lending? Both conditions are necessary for bank lending to play a special role in the monetary transmission mechanism.> Morris and Sellon provide insight into the second question--whether bank lending is constrained by monetary policy. The authors analyze how banks adjust the amount and terms of business lending when monetary policy is tightened. The analysis differs from previous research by using a more precise measure of monetary policy actions, which allows a more accurate identification of episodes of monetary tightening. The authors suggest that bank business lending is not constrained by restrictive monetary policy. Thus, Morris and Sellon conclude, monetary policy does not operate through a special credit channel.Bank loans ; Monetary policy

Monetary policy actions and long-term interest rates

It is generally believed that monetary policy actions are transmitted to the economy through their effect on market interest rates. According to this standard view, a restrictive monetary policy by the Federal Reserve pushes up both short-term and long-term interest rates, leading to less spending by interest-sensitive sectors of the economy such as housing, consumer durable goods, and business fixed investment. Conversely, an easier policy results in lower interest rates that stimulate economic activity. Unfortunately, empirical studies and the observed behavior of interest rates appear to challenge the standard view of the monetary transmission mechanism and raise questions about the effectiveness of monetary policy.> Roley and Sellon attempt to reconcile theory and reality by reexamining the connection between monetary policy and long-term interest rates. Using a framework that emphasizes the importance of market expectations of future monetary policy actions, the authors argue that the relationship between policy actions and long-term rates is likely to vary over the business cycle as financial market participants alter their views on the persistence of policy actions. Accordingly, the standard view of the monetary transmission mechanism appears to provide an overly simplistic view of the policy process. In addition, by capturing the tendency of market rates to anticipate policy actions, the authors find a larger response of long-term rates to monetary policy actions than reported in previous research.Interest rates ; Monetary policy

The discount window : time for reform?

For many years, the Federal Reserve's discount window has played an important role in monetary policy. Discount window borrowing helps individual depository institutions manage their reserve accounts in the presence of unexpected deposit and payments flows. Improved reserve management, in turn, helps stabilize the overnight federal funds market by reducing the volatility of short-term interest rates. Moreover, announced changes in the Federal Reserve's discount rate have often signaled important shifts in the stance of monetary policy and have frequently been associated with large changes in market interest rates, exchange rates, and asset prices.> In the 1990s, however, fewer and fewer institutions have relied on the window to meet short-term credit needs. Consequently, the usefulness of the discount window in smoothing reserve imbalances and stabilizing interest rates may have been reduced. In addition, changes in monetary policy operating procedures and the formal announcement of monetary policy decisions by the Federal Reserve may have reduced the effectiveness of discount rate changes in influencing market interest rates and asset prices.> Hakkio and Sellon analyze the changing role of the discount window in monetary policy and examine the case for discount window reform. One alternative to the traditional discount window is a "Lombard-type" lending facility in which depository institutions can borrow more freely than under the current system but at a higher rate. While there appear to be good arguments in favor of modernizing the discount mechanism, a number of conceptual and practical issues must be addressed before implementing a Lombard-type lending facility. An additional consideration, going forward, is the projected reduction in the supply of Treasury debt over the next few years. A shrinking supply of Treasury securities could complicate the use of open market operations in providing reserves to the banking system and require the Federal Reserve to place greater emphasis on the discount window. Consequently, any redesign of the discount window would need to address this issue.Discount window ; Discount ; Monetary policy

Has financial market volatility increased?

Money market ; Stock market ; Interest rates ; Foreign exchange rates