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April 12, 2010

Tarullo Soft Shoes Monetary Policy

Posted by David Zaring

One of the Obama administration officials I find particularly interesting is Dan Tarullo. He is

not a banker,
a former law professor, and
somewhat critically inclined regarding conventional monetary policy and banking regulation.

Nonetheless, he has found himself on the board of the Federal Reserve, recently justifying its decision to keep the federal funds rate low to a bunch of bankers. Perhaps it isn't how he imagined he'd be doing things at the central bank. Anyway, one treads into monetary policy cautiously as a lawyer, but usually, the Fed sets monetary policy through the aforementioned federal funds rate offered to its member banks. Te Fed is trying to reassure the markets that there won't be galloping inflation because it will be using unconventional tools, all rooted in the massive amount of stabilization it has already done for the banks, instead of the federal funds rate, to prevent it. Hence Tarullo:

The most important instrument is likely to be increasing the interest rate paid to banks on the reserves they hold with the Fed. Raising this rate should itself tend to raise the federal funds rate, because banks have little incentive to lend into the federal funds market at rates below what they can earn risk-free at the Fed. The efficacy of this instrument can be increased by draining reserves through the use of a number of instruments, including reverse repurchase agreements (reverse repos), term deposits for reserve balances, and, if necessary, sales of assets on our balance sheet.

In other words, the claim is that monetary policy can be set in a different way. That strike sme as interesting, and a direct result, of course, of all the intervening the Fed did during the crisis. Fr those interested, after the jump I'll give you Tarullo's plain English description of what, exactly, the Fed did then. It's pretty easy to follow.

First, the Federal Reserve created a number of liquidity programs, which provided well-secured, mostly short-term credit to various parts of the financial system that were under increasingly severe strains. Among these were the Term Auction Facility (TAF), which auctioned short-term funds to banks; the Primary Dealer Credit Facility, which served as a backstop liquidity provider for securities firms; the Term Asset-Backed Securities Loan Facility (TALF), which was designed to help revive the market for asset-backed securities, and others.

Second, and separately, the Federal Open Market Committee (FOMC) undertook large-scale purchases of Treasury securities, agency mortgage-backed securities, and agency debt. This unconventional monetary policy action was taken because the FOMC, after having reduced short-term interest rates nearly to zero, determined that the severity of the economic downturn made additional stimulus necessary. In addition to improving conditions in mortgage markets, these asset purchases helped lower yields on long-term debt; they also substantially increased the level of reserve balances that depository institutions held with Federal Reserve Banks.

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