Image page
Download
1 / 60

Image page - PowerPoint PPT Presentation


  • 59 Views
  • Uploaded on

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

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about ' Image page' - zeph-mcdonald


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
Image page
Image page

Real Fed Funds Rate

(r)

Monetary Policy

ResponseSchedule (MPR)

Macro 101

Michael R. Rosenberg

October 2010

r*

Financial Conditions

Schedule

p*

FC*

Inflation Rate

(p)

Financial Conditions(FC)

The Role of Financial Conditions in the Transmission Mechanism of Monetary Policy

y*

IS Curve (Investment/Savings Schedule)

Philips Curve(Inflation/Output Schedule)

Economic Output

(y)

Financial Shock

Real (Output) Shock

Relative Price Shock

Change inPolicy Rate

Change in Financial Conditions

Change in Economic Activity

Change in Inflation


Bulleted page
Bulletedpage

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

Real (Output) Shock

Relative Price Shock

Change inPolicy Rate

Change in Economic Activity

Change in Inflation

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


Bulleted page1
Bulletedpage

A New Focus on Financial Conditions

“Monetary policy works in the first instance by affecting financial conditions, including the levels of interest rates and asset prices. Changes in financial conditions in turn influence a variety of decisions by households and firms, including choices about how much to consume, to produce and to invest.”

Federal Reserve Chairman Ben S. Bernanke, March 2, 2007


Bulleted page2
Bulletedpage

Financial Shock

Real (Output) Shock

Relative Price Shock

Change inPolicy Rate

Change in Financial Conditions

Change in Economic Activity

Change in Inflation

Adding Financial Conditions to the Transmission Mechanism of Monetary Policy


Bulleted page3
Bulletedpage

How Financial Conditions Typically Respond to Federal Reserve Policy Changes

Change in Financial Conditions

Change in Money-Market Rates

Change in Government Bond Yields

Change inCredit Spreads

Change in PolicyRate

Change in Economic Activity

Change in Inflation

Change in Asset Prices

Change in Bank Lending Conditions


Bulleted page4
Bulletedpage

Monetary Policy Transmission Mechanism

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

Source: Federal Reserve

6


Bulleted page5
Bulletedpage

Tracking Financial Conditions –Bloomberg’s Financial Conditions Index


Bulleted page6
Bulletedpage

Bloomberg’s Financial Conditions Index

Significantly Above Normal

Normal

Significantly Below Normal

Source: Bloomberg

BFCIUS index <go>


Bloomberg Financial Conditions Index as a Leading Indicator of Bank Lending Conditions

U.S. Bank Willingness to Lend(Smoothed Index)

Financial Conditions(Smoothed Index)

Bank Lending Conditions

Financial ConditionsIndex

Source: Bloomberg


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

U.S. Real GDP Growth (yoy % chg.)(Smoothed)

Financial Conditions+(Smoothed Index)

Real GDP Growth

Financial Conditions

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


Bulleted page7
Bulleted of Real GDP Growthpage

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


Bulleted page8
Bulleted of Real GDP Growthpage

The Federal Reserve’s Policy Objectives and the Taylor Rule

Financial Shock

Real (Output) Shock

Relative Price Shock

Change inPolicy Rate

Change in Financial Conditions

Change in Economic Activity

Change in Inflation

InflationExpectations

Policy Rule(Taylor Rule)

Monetary Policy Objective


U.S. Monetary Policy Objective of Real GDP Growth

The Federal Reserve is charged with the dual responsibility of maintaining price stability and achieving maximum sustainable employment for the U.S. economy.

Maximum Sustainable Output

Price Stability

Maximum Sustainable Employment

Unemployment

Inflation

Output

Potential

Output

NAIRU

Fed’s Implicit

Inflation Target

p*

uN

Actual Output

Actual Inflation Rate

Actual Unemployment Rate

Time

Time

Time


Bulleted page9
Bulleted of Real GDP Growthpage

The Inflation/Output Tradeoff Curve

Output Gap Volatility

A

Std. Dev. (Y-Y*)3

The Efficient Policy Frontier

C

Std. Dev. (Y-Y*)2

B

Std. Dev. (Y-Y*)1

Std. Dev. (p-p*)2

Std. Dev. (p-p*)3

Inflation GapVolatility

Std. Dev. (p-p*)1

14


Bulleted page10
Bulleted of Real GDP Growthpage

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?


Bulleted page11
Bulleted of Real GDP Growthpage

The Taylor Rule and the Feedback Mechanism of Monetary Policy

John Taylor’s Federal Reserve Monetary-Policy Response Function

iTaylor = ( rN + p* ) + [ (1+a)(p – p*) + b(y – y*) ]

Taylor Rule PrescribedPolicy Rate

Neutral

Rate

Setting

Taylor Rule Recommended

Deviation from the

Neutral Rate Setting

=

+

rN = neutral real short-term interest rate

p = actual inflation rate

p* = central bank’s inflation target

y = actual level of output

y* = the economy’s potential level of output

a, b = central bank’s policy response coefficients

16


Bulleted page12
Bulleted of Real GDP Growthpage

The Taylor Rule Model in Real Terms

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

Taylor Rule PrescribedReal Policy Rate

Neutral

Real Rate

Setting

Taylor Rule Recommended

Deviation from the

Neutral Real Rate Setting

=

+

17


Bulleted page13
Bulleted of Real GDP Growthpage

A Modified Taylor Rule

Substituting the Unemployment Gap for the Output Gap

1) (y – y* ) = Okun (UN – U)

2) rTaylor = rN + [ a(p – p*) + b(Okun) (UN – U) ]

Taylor Rule PrescribedReal Policy Rate

Neutral

Real Rate

Setting

Taylor Rule Recommended

Deviation from the

Neutral Real Rate Setting

=

+

Okun = Okun Factor, which translates the unemployment gap into the output gap

y = actual level of output

y* = the economy’s potential level of output

UN= Neutral unemployment rate (NAIRU)

U = Actual unemployment rate

18


Bulleted page14
Bulleted of Real GDP Growthpage

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

Source: Bloomberg

TAYL <go>


Bulleted page15
Bulleted of Real GDP Growthpage

The Response of Fed Policy to Changes in Inflation

(%)


Bulleted page16
Bulleted of Real GDP Growthpage

The Response of Fed Policy to Changes in Unemployment

Fed Funds Rate less PCE Inflation Rate (%)

NAIRU less Unemployment Rate (%)


Bulleted page17
Bulleted of Real GDP Growthpage

The Transmission/Feedback Mechanism of Monetary Policy – A Graphical Model

Financial Shock

Real (Output) Shock

Relative Price Shock

Change inPolicy Rate

Change in Financial Conditions

Change in Economic Activity

Change in Inflation

Nominal Fed Funds Rate

MPR1(Aggressive)

Monetary-Policy Response Schedules

MPR2

(Passive)

i1

An aggressive response by the Federal Reserve (shown by MPR1) would raise the nominal Fed Funds rate by more than the rate of inflation, thereby raising the real Fed Funds rate.

Inflation Rate

p1

22


Bulleted page18
Bulleted of Real GDP Growthpage

The Transmission/Feedback Mechanism of Monetary Policy – A Graphical Model

Financial Shock

Real (Output) Shock

Relative Price Shock

Change inPolicy Rate

Change in Financial Conditions

Change in Economic Activity

Change in Inflation

Real Fed Funds Rate

Monetary-Policy Response Schedule

B

r 2

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

A

r 1

p1

p2

Inflation Rate


Bulleted page19
Bulleted of Real GDP Growthpage

Response of Financial Conditions to Changes in the Federal Reserve Policy Rate

Real Fed Funds Rate

A

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

r 1

B

r 2

Financial Conditions Schedule

FCON

FC 1

FC 2

Financial Conditions

24


Bulleted page20
Bulleted of Real GDP Growthpage

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

Real Fed Funds Rate

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

A

r 1

C

B

r 2

FCON2

FCON1

FC1

FC2

FC3

Financial Conditions

25


Bulleted page21
Bulleted of Real GDP Growthpage

An Adverse Shift in Financial Conditions and the Federal Reserve Policy Response

Financial Shock

Real (Output) Shock

Relative Price Shock

Change inPolicy Rate

Change in Financial Conditions

Change in Economic Activity

Change in Inflation

Real Fed Funds Rate

Adverse shift in the Financial Conditions Schedule from FCON1 to FCON 2

B

A

r 1

The Fed responds to a financial shock by lowering the real Fed Funds rate from r1 to r 2, which improves Financial Conditions from FC2 back to its original level of FC1

r 2

C

FCON 2

FCON 1

26

Financial Conditions

FC 2

FC 1


Bulleted page22
Bulleted of Real GDP Growthpage

Response of Economic Activity to Changes in Financial Conditions

Financial Shock

Real (Output) Shock

Relative Price Shock

Change inPolicy Rate

Change in Financial Conditions

Change in Economic Activity

Change in Inflation

Output Gap

New Keynesian Investment-Savings (IS) Schedule

B

(y-y*)2

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

A

(y-y*)1

27

Financial Conditions

FC 1

FC 2


Bulleted page23
Bulleted of Real GDP Growthpage

How Responsive is Output to Changes in Financial Conditions?

Output Gap

IS1

B

(y-y*)2

IS2

(y-y*)3

C

A

(y-y*)1

The response of economic activity to changes in financial conditions is a function of the slope of the IS schedule.

Financial Conditions

FC 1

FC 2

28


Bulleted page24
Bulleted of Real GDP Growthpage

Response of Inflation to Changes in the Output Gap

Financial Shock

Real (Output) Shock

Relative Price Shock

Change inPolicy Rate

Change in Financial Conditions

Change in Economic Activity

Change in Inflation

Inflation

New Keynesian Phillips Curve (PC)

B

p2

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

A

p1

(y-y*)1

(y-y*)2

29

Output Gap


Bulleted page25
Bulleted of Real GDP Growthpage

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


Bulleted page26
Bulleted of Real GDP Growthpage

Real Fed Funds Rate

(r)

Monetary Policy

ResponseSchedule (MPR)

Quadrant

II

Quadrant

I

r*

Financial Conditions

Schedule

p*

FC*

Inflation Rate

(p)

Financial Conditions(FC)

y*

IS Curve (Investment/Savings Schedule)

Philips Curve(Inflation/Output Schedule)

Quadrant

III

Quadrant

IV

Economic Output

(y)

Fitting the Pieces Together

A Four Quadrant Diagram of the Monetary Policy Transmission/Feedback Mechanism (under normal conditions)

31


Bulleted page27
Bulleted of Real GDP Growthpage

The Effects of an Unwarranted Cut in the Real Fed Funds Rate

Real Fed Funds Rate

(r)

Monetary Policy

ResponseSchedule (MPR)

r2

(6)

(5)

Quadrant

II

Quadrant

I

r*

Financial Conditions

Schedule

(1)

Fed reduces the

Real Fed Funds rate

from r* to r1

r1

(2)

(9)

FC1

p1

p2

p*

FC*

FC2

Inflation Rate

(p)

Financial Conditions(FC)

(8)

y2

(7)

y*

(3)

(4)

IS Curve (Investment/Savings Schedule)

y1

Philips Curve(Inflation/Output Schedule)

Quadrant

III

Quadrant

IV

Economic Output

(y)

32


Bulleted page28
Bulleted of Real GDP Growthpage

Real Fed Funds Rate

(r)

A financial shock shifts the Financial Conditions Schedule

from FCON* to FCON’

Monetary Policy

ResponseSchedule (MPR)

Quadrant

II

Quadrant

I

r*

(1)

(8)

Financial Conditions

Schedule

r1

(5)

(4)

FCON*

FCON’

p2

p*

FC*

FC2

Inflation Rate

(p)

Financial Conditions(FC)

y2

(2)

(3)

(6)

(7)

y*

IS Curve (Investment/Savings Schedule)

Philips Curve(Inflation/Output Schedule)

Quadrant

III

Quadrant

IV

Economic Output

(y)

The Consequences of the Fed Not Responding Immediately to a Financial Shock

33


Bulleted page29
Bulleted of Real GDP Growthpage

Real Fed Funds Rate

(r)

Monetary Policy

ResponseSchedules

A financial shock shifts the Financial Conditions Schedule

from FCON* to FCON’

MPR*

MPR’

Quadrant

II

Quadrant

I

r*

Financial Conditions

Schedules

(1)

r1

The Fed responds to the shock by immediately reducing the neutral Real Fed Funds rate from r* to r1 , This is shown as a downward shift in the Monetary Response Schedule from MPR* to MPR’.

(2)

FCON*

FCON’

FC2

p*

FC*

Inflation Rate

(p)

Financial Conditions(FC)

(3)

(4)

y*

IS Curve (Investment/Savings Schedule)

Philips Curve(Inflation/Output Schedule)

Quadrant

III

Quadrant

IV

Economic Output

(y)

The Consequences of a Rapid Response by the Federal Reserve Rapid Response to a Financial Shock

34


Bulleted page30
Bulleted of Real GDP Growthpage

Real Fed Funds Rate

(r)

A financial shock shifts the Financial Conditions Schedule

from FCON* to FCON1

MPR*

Monetary Policy

ResponseSchedule

Quadrant

II

Quadrant

I

r*

(4)

(1)

Financial Conditions

Schedules

r1

FCON*

FCON1

p*

FC*

FC2

Inflation Rate

(p)

Financial Conditions(FC)

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

(2)

(3)

y*

IS*

IS Curve (Investment/Savings Schedules)

Philips Curve(Inflation/Output Schedule)

IS1

Quadrant

III

Quadrant

IV

Economic Output

(y)

The Effects of Fiscal Stimulus at a Time When the Real Economy is Being Hit by a Negative Financial Shock

35


Bulleted page31
Bulleted of Real GDP Growthpage

Real Fed Funds Rate

(r)

Kinked Monetary Policy

ResponseSchedule

Initial deterioration in financial conditions and shift in the Financial Conditions Schedule

from FCON* to FCON1

Real policy rate rises when deflation sets in and the nominal policy rate is zero

( + )

(4)

Quadrant

II

Quadrant

I

( 0 )

(1)

Financial Conditions

Schedules

( - )

(7)

Real policy rate moves into negative territory when expected inflation rises and the nominal policy rate is zero

FCON*

FCON1

( - ).

( + )

( 0 )

FC*

FC2

Inflation Rate

(p)

Financial Conditions(FC)

y2

y1

(3)

(2)

y*

Philips Curves(Inflation/Output

Schedule)

IS Curve (Investment/Savings Schedules)

IS*

PC*

Quadrant

III

Quadrant

IV

Economic Output

(y)

The Monetary Policy Transmission Mechanism When the Policy Rate is Zero and There Is a Threat of Deflation

36


Bulleted page32
Bulleted of Real GDP Growthpage

Real Fed Funds Rate

(r)

Kinked Monetary Policy

ResponseSchedule

Initial deterioration in financial conditions and shift in the Financial Conditions Schedule

from FCON* to FCON1

Real policy rate rises when deflation sets in and the nominal policy rate is zero

( + )

(4)

Quadrant

II

Quadrant

I

( 0 )

(1)

Financial Conditions

Schedules

(6)

( - )

Real policy rate moves into negative territory when expected inflation rises and the nominal policy rate is zero

(7)

FCON*

FCON1

( - ).

( + )

( 0 )

FC*

FC2

Inflation Rate

(p)

Financial Conditions(FC)

(3)

(5)

(2)

(9)

Philips Curves(Inflation/Output

Schedule)

y*

(8)

IS*

PC1

IS Curve (Investment/Savings Schedules)

PC*

Engineered rise in

expected inflation

Quadrant

III

Quadrant

IV

Economic Output

(y)

Negating the Real Economy Effects of a Financial Shock by Engineering a Rise in Expected Inflation

37


Bulleted page33
Bulleted of Real GDP Growthpage

Monetary Policy Works by Affecting Financial Conditions, Even When the Policy Rate is Zero

Alter Size and Composition of Central Bank’s Balance Sheet

Quantitative Easing Channel

Change inPolicy Rate

Traditional Channel

Change in Financial Conditions

Change in Economic Activity

Change in Inflation Rate

Commit to Keep Policy Rate Low for a Considerable Period

Expectations Management Channel

38


Bulleted page34
Bulleted of Real GDP Growthpage

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

Change inShort-Term Policy Rate

Traditional Channel

Change in Financial Conditions

Change in Economic Activity

Change in Inflation Rate

Change in Long-Term Interest Rate

NewApproach

39


Bulleted page35
Bulleted of Real GDP Growthpage

Federal Reserve Large-Scale Asset Purchases and the Monetary Policy Transmission Mechanism When the Short-Term Policy Rate is Zero

Lower long-term interest rates act to improve Financial Conditions.

Fed purchases of Treasury bonds lowers the supply of publicly held bonds and thereby acts to lower long-term interest rates

Real Long-Term Interest Rate

Real Long-Term Interest Rate

BS2

BS1

BD

Supply of Bonds

“New” Monetary Response Schedules

Financial Conditions/Interest Rate Schedule

Demand for Bonds

i1

i1

A

A

A

i2

i2

B

B

B

Financial Conditions

FC2

FC1

p1

Inflation

Outstanding Stock of Government Debt

Transmission of Policy

Policy Implementation


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

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


Bulleted page36
Bulleted Asset Purchase Program on Long-Term Interest Rates page

Risk-Taking Channel of Monetary Policy

Policymakers need to take into account the effect of a change in policy rates on the price of risky assets and the level of risk taking

Financial Conditions

Change in Economic Activity

Change in Inflation

Change inPolicy Rate

Price of Risky Assets

Change in Risk Taking

Asset Price Bubble


Bulleted page37
Bulleted Asset Purchase Program on Long-Term Interest Rates page

Risk-Taking Channel of Monetary Policy

If the policy rate is pushed “too low for too long”, it could lead to excessive risk-taking and overly easy financial conditions.

Real Fed Funds Rate

Monetary-Policy Response Schedules

Risk-Taking Schedule

MPR1

MPR2

MPR3

r1

A

A

r2

B

B

r3

C

C

p1

Financial Conditions

FC3

FC2

FC1

Inflation


Image page1
Image page Asset Purchase Program on Long-Term Interest Rates

Monetary Policy and Risk Taking (1-2)

Do easy monetary policies contribute to lax lending practices that contribute to a buildup of financial imbalances?

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

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


Image page2
Image page Asset Purchase Program on Long-Term Interest Rates

Monetary Policy and Risk Taking (3-4)

Do easy monetary policies contribute to lax lending practices that contribute to a buildup of financial imbalances?

Low interest rates boost asset prices and, in turn, collateral values. Higher collateral values modifies the perceived risk of default on the part of borrowers, which encourages banks to extend more credit at favorable rates.

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


Image page3
Image page Asset Purchase Program on Long-Term Interest Rates

Monetary Policy and Risk Taking (5-8)

Do easy monetary policies contribute to lax lending practices that contribute to a buildup of financial imbalances?

Low interest rates alter traditional risk indicators such as Value at Risk, which in turn may alter risk-taking behavior.

Low interest rates encourage fund managers to take on more risk to boost absolute returns.

Central-bank communications (for example, “measured pace or “extended period”) may alter risk perceptions and encourage risk taking.

Low interest rates lead investors to take on more illiquid positions to generate higher returns.


Image page4
Image page Asset Purchase Program on Long-Term Interest Rates

Monetary Policy and Risk Taking(9-11)

Do easy monetary policies contribute to lax lending practices that contribute to a buildup of financial imbalances?

Federal Reserve may respond asymmetrically to changes in asset prices – easing in response to asset price declines and essentially ignoring asset price gains (the Greenspan put).

Credit ratings improve when interest rates are low, which in turn leads to narrower credit spreads.

Low interest rates for long periods boost house prices, which encourages household speculation in the housing market


Image page5
Image page Asset Purchase Program on Long-Term Interest Rates

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.


Bulleted page38
Bulleted Asset Purchase Program on Long-Term Interest Rates page

The Taylor Rule on Bloomberg

TAYL <go>


Bulleted page39
Bulleted Asset Purchase Program on Long-Term Interest Rates page

Fraction of Time the Real Federal Funds Rate Is Negative by Decade

Decade of Asset Bubbles

Decade of High Inflation

Source: Board of Governors of the Federal Reserve System and Bureau of Economic Analysis;Note: the real Fed Funds rate equals the nominal Fed Funds rate minus the core PCE inflation rate.


Bulleted page40
Bulleted Asset Purchase Program on Long-Term Interest Rates page

Asset-Price Bubbles

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

(Ratio)

Source: Bloomberg

51


U.S. Five-Year Note Yields minus U.S. Nominal GDP Growth Asset Purchase Program on Long-Term Interest Rates

(Percentage Points)

Long-term interest rates were too low relative to the level of economic activity throughout 2002-06

Source: Bloomberg

52


U.S. Real Corporate Baa Bond Yields Asset Purchase Program on Long-Term Interest Rates

(%)

Real Baa corporate bond yields were too low relative to the historical average through most of 2003-08

5% Average

Source: Bloomberg

53


Bulleted page41
Bulleted Asset Purchase Program on Long-Term Interest Rates page

OECD U.S. Financial Conditions Index


Image page6
Image page Asset Purchase Program on Long-Term Interest Rates

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 RulePrescribed Real Policy Rate

NeutralRateSetting

Taylor Rule Recommended Deviation from Neutral Rate Setting

=

+

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

Augmented Taylor RulePrescribed Real Policy Rate

Financial-Conditions-AdjustedNeutral Rate Setting

Taylor Rule Recommended Deviation from Neutral Rate Setting

=

+


Bulleted page42
Bulleted Asset Purchase Program on Long-Term Interest Rates page

Real Fed Funds Rate

(r)

Monetary Policy

ResponseSchedule

Easier financial conditions shifts the Financial Conditions schedule

from FCON* to FCON2

MPR*

Quadrant

II

Quadrant

I

Financial Conditions

Schedules

(2)

(1)

r*

FCON2

FCON*

p*

FC2

FC*

Inflation Rate

(p)

Financial Conditions(FC)

The improvement in financial conditions results in an increase in output from

y* to y2

Globalization results in a shift in the U.S. Philips Curve schedule from PC* to PC2 which offsets the effect that an increase in output from y* to y2 would normally have on inflation.

y*

(3)

(4)

y2

(5)

IS Curve (Investment/Savings Schedule)

PC*

Philips Curves(Inflation/Output Schedules)

PC2

Quadrant

III

Quadrant

IV

Economic Output

(y)

Should the Federal Reserve Respond to Easier Financial Conditions if Domestic Inflation Remains in Check? (1)

56


Bulleted page43
Bulleted Asset Purchase Program on Long-Term Interest Rates page

Real Fed Funds Rate

(r)

Monetary Policy

ResponseSchedules

Easier financial conditions shifts the Financial Conditions Schedule

from FCON* to FCON2

MPR2

MPR*

Quadrant

II

Quadrant

I

(2)

r2

(1)

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

Financial Conditions

Schedules

r*

FCON2

FCON*

p*

FC2

FC*

Inflation Rate

(p)

Financial Conditions(FC)

Because of the Fed’s response to the improvement in Financial Condition, output remains at y*.

(3)

(4)

y*

Philips Curves(Inflation/Output Schedules)

IS Curve (Investment/Savings Schedule)

PC*

PC2

Quadrant

III

Quadrant

IV

Economic Output

(y)

Should the Federal Reserve Respond to Easier Financial Conditions if Domestic Inflation Remains in Check? (2)

57


Bulleted page44
Bulleted Asset Purchase Program on Long-Term Interest Rates page

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 Real Value

Dollar’s Long-Run Equilibrium Value

+

U.S./Foreign Real Interest Rate Spread

-

U.S./Foreign Relative Risk Premium

=

58


Bulleted page45
Bulleted Asset Purchase Program on Long-Term Interest Rates page

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

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

rUS - rF = (rNUS - rNF) + [ ]

Taylor Rule PrescribedU.S. Real Policy Rate

Taylor Rule PrescribedForeign Real Policy Rate

U.S.- Foreign Relative Taylor Rule PrescribedForeign Real Policy Rate

Foreign Neutral

Rate

Setting

U.S. Neutral

Rate

Setting

U.S.- Foreign RelativeNeutral Rate

Setting

+

+

+

Taylor Rule Recommended

Deviation from the

Foreign Neutral Rate Setting

Taylor Rule Recommended

Deviation from the

U.S. Neutral Rate Setting

U.S.-Foreign Relative Taylor Rule Recommended

Deviation from the Neutral Rate Settings

=

=

=

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

(1)

(2)

Relative Taylor Rule Response Coefficients xRelative Inflation and Output Gaps

(3)

59


Bulleted page46
Bulleted Asset Purchase Program on Long-Term Interest Rates page

The Monetary Policy Transmission/Feedback Mechanism and Its Impact on Real Interest Rate Differentials and the Exchange Rate

60


ad