EconSouth (First Quarter 2009)
Fed @ Issue
Snapping Rope and Breaking Bricks
I have a simple way of thinking about how monetary policy works. Imagine a long rope. At one of end of the rope are short-term, relatively riskless interest rates. Farther along the rope are yields on longer-term but still relatively safe assets. Off at the other end of the rope are multiple tethers representing mortgage rates, corporate bond rates, and auto loan rates—the sorts of interest rates that drive decisions by businesses and consumers.
In the textbook version of central banking, the monetary authority grabs the short end of this allegorical rope, where the federal funds rate resides, and gives it a snap. The motion ripples down and hopefully reaches longer-term U.S. Treasury rates, which then relay the action to other market interest rates, where the changes reverberate throughout the economy at large.
That's the story in normal times, and over the past year and a half the Federal Open Market Committee (FOMC) has done a fair bit of rope-snapping. In August 2007 the FOMC set the federal funds rate target—the overnight rate on loans made between banks—at 5.25 percent. As of December 2008, the rate target was lowered to a very low range of 0–0.25 percent. As the committee noted then (and reiterated in January), "weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."
These FOMC statements held another extremely important message: "The focus of policy going forward will be to support the functioning of financial markets and stimulate the economy." In a speech to the National Press Club on Feb. 18, Federal Reserve Chairman Ben Bernanke elaborated:
"Extraordinary times call for extraordinary measures. Responding to the very difficult economic and financial challenges we face, the Federal Reserve has gone beyond traditional monetary policy making to develop new policy tools to address the dysfunctions in the nation's credit markets."
One way to view the effects of those credit market dysfunctions is to imagine that someone had placed a series of bricks at strategic points along the segment of rope connecting short-term interest rates to broader market rates. With these bricks in place, it is simply not enough for a central bank to keep snapping short-term interest rates: The bricks—dysfunctions in the markets—will keep the impulse from being transmitted to the interest rates that are directly connected to market outcomes. Thus, a new set of policy instruments is needed, instruments that allow the monetary authority to circumvent blockages in the monetary transmission mechanism. Again, Chairman Bernanke's remarks on Feb. 18 make this clear:
"To address these issues, the Federal Reserve has developed a second set of policy tools, which involve the provision of liquidity directly to borrowers and investors in key credit markets. Notably, we have introduced facilities to purchase highly rated commercial paper at a term of three months and to provide backup liquidity for money market mutual funds. . . . In addition, the Federal Reserve and the Treasury have jointly announced a facility—expected to be operational shortly—that will lend against AAA-rated asset-backed securities collateralized by recently originated student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. Last week, in conjunction with the Treasury, we announced that we were prepared to expand significantly this facility, known as the Term Asset-Backed Securities Loan Facility, or TALF, to encompass other types of newly issued AAA-rated asset-backed securities, such as commercial mortgage-backed securities and private-label mortgage-backed securities, as well. If this program works as planned, it should lead to lower rates and greater availability of consumer, business, and mortgage credit.
"The Federal Reserve's third set of tools for supporting the functioning of credit markets involves the purchase of longer-term securities for the Fed's portfolio. For example, we are purchasing up to $100 billion in the debt of government-sponsored enterprises (GSEs) and up to $500 billion in mortgage-backed securities guaranteed by federal agencies by midyear."
How long will the second set of policy tools Chairman Bernanke describes be employed? No set timetable exists, but one would presume that as long as the bricks of market dysfunction are lying around, the tools will be necessary. Eventually, of course, markets will heal, the bricks will crumble, and the stage will be set to a return to business as usual in monetary policy and the economy. The sooner the better, but in the meantime it's helpful to have the tools in hand to start cracking the bricks.
David Altig is senior vice president and director of research at the Atlanta Fed.