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Central bank markets officials ponder new world of policy implementation

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Central bank markets officials ponder new world of policy implementation

The views and opinionsexpressed in this piece are those of the author and do not necessarily representthe views of S&P Global Market Intelligence.

The financial crisis has transformed central bankingaround the world, and officials at the Federal Reserve are still grappling withthe full ramifications of the overhauled toolbox they now possess for implementingmonetary policy.

Current and former central bankers discussedthe success and the implications of the changes in monetary and market policiessince the financial crisis during a workshop hosted last week by the Federal ReserveBank of New York. Most of the attendees came from the market operations groups ofmajor central banks from around the world. And as the officials charged with carryingout policy decisions, they agreed that the aggressive quantitative easing undertakenby the Federal Reserve and other central banks had helped to sustain economic activityin the wake of the global meltdown during the last decade. For the Fed, it has alsocompletely changed the way it puts the Federal Open Market Committee's decisionsinto action.

"The current [implementation] framework inthe United States looks very different than the pre-crisis framework," SimonPotter, executive vice president and head of the markets group for the New YorkFed said, as he opened the conference by outlining the dramatic changes in the FederalReserve's approach to controlling its key targeted fed funds rate. Prior to thecrisis, the Fed's markets desk manipulated reserve levels to move its key rate.Because of stress in money markets and other dollar liquidity demand pressures asthe crisis gained force, however, excess reserves in the system rose dramaticallyand forced the central bank to "sterilize" its injections of liquidityso that the central bank did not lose control of the fed funds rate.

This complicated the process of controlling itsrate, and the bank began to develop approaches for targeting rates — tools it isnow employing to normalize policy. "With the advent of interest on reserves,[reverse repurchase agreements] and the Term Deposit Facility … policymakers havemore tools for influencing market rates, and sterilization is no longer necessaryto control rates with large amounts of excess reserves," Potter explained.

Indeed,for the central bank in the U.S. and those around the world, the financial crisisof the first decade of the 21st century may prove nearly as important as the crisisof the first decade of the 20th century, which spurred the re-establishment of acentral bank in the U.S. in the form of the Federal Reserve. While perhaps not thatmomentous, the evolution of the Fed's implementation toolkit after the most recentcrisis raises a host of questions for policymakers.

The firstquestion, and one that has shown promising early returns, is how well the Fed'snew approach to controlling rates will work in reality. Potter said during his speechthat "so far things have gone as well as could have been expected … the successfulliftoff has brought theory into practice, and the results have been good so far."

Otherofficials throughout the day marveled at the extent to which the Fed's markets officialshave been able to mostly keep the fed funds rate near the dead center of the targetrange of 25 basis points to 50 basis points. The discussion at the event was underChatham House Rules, and not for direct attribution, but it was clear that officialswere heartened by the ability of the Fed to consistently stay within its targetrange while employing its new tools.

One areaof particular interest was interest on excess reserves, which some attendees saidmay be having a stronger upward impact on the fed funds rate than previously expected.Paying interest on reserves also constitutes a dilemma for the central bank, though,which demonstrates the new complexities of the world for the Fed. While interestreserves is an essential part in the bank's normalization approach and control ofmarket rates they also could be viewed as a subsidy from the Fed, according to oneattendee, offsetting the costs of liquidity measures like the supplementary leverageratio.

Thatmeans one interpretation of interest paid on reserves is that it acts as a directcountermeasure to the regulations the central bank's supervisory wing has been chargedwith implementing and enforcing. The central bank officials wrestled with the desirabilityand ramifications of that analysis, as well as the new balance sheet policies thatopen up far more aggressively interventionist avenues for policy. While they reachedfew hard conclusions, it was clear that even the officials who are at the cuttingedge of these operations are still grappling with the full depth and consequencesof the changes.