Tools of monetary policy

I just finished a new paper on current U.S. monetary policy operating procedures. Here’s the abstract:

The Federal Reserve characterizes its current policy decisions in terms of targets for the fed funds rate and the size of its balance sheet. The fed funds rate today is essentially an administered rate that is heavily influenced by regulatory arbitrage and divorced from its traditional role as a signal of liquidity in the banking system. The size of the Fed’s balance sheet is at best a very blunt instrument for influencing interest rates. In this paper I compare the current operating system with the historical U.S. system and the procedures of other central banks. I then examine strategies for transitioning from the current system to one that would give the Federal Reserve better tools with which to achieve its strategic objective of influencing inflation and output.

Here’s a link to a video of my presentation of the paper at a conference at Stanford last week.

29 thoughts on “Tools of monetary policy

  1. joseph

    “Here’s a link to a video of my presentation of the paper at a conference at Stanford last week.”

    More accurately, a presentation for the Hoover Institution, a political think tank, not an academic venue.

    1. pgl

      “Live from the Hoover Institution at Stanford University”.

      Stanford does host the Hoover Institute (for better or worse).

    2. James_Hamilton Post author

      You speak out of ignorance, Joseph. There were nearly 200 people there, including many of the nation’s best-known academics and 7 current and former members of the FOMC.

      1. Moses Herzog

        If it was specifically for the Hoover institute, I think there is some validity to the comment. That’s not saying that it didn’t have educational value or that all those involved didn’t have good intentions—but I think with the right perspective the point bears being made.

        EXAMPLE: Phil Gramm getting the job as Vice-Chairman at UBS Bank and giving lectures. Who on God’s green Earth thinks Phil Gramm knows anything about investment banking other than ripping down regulations that bank executives don’t like and demolishing finance regulations that Hedge Funds that can dump TBTF bank stock before reckoning day comes don’t like?? Now I wanna make it clear I have high regard for Professor Hamilton, and if it was for Stanford rather than Hoover (yes, I know there is a “connection”), then it makes Joseph’s comment a little more “unfair”. I stronglybelieve Professor Hamilton’s personal and professional ethics are high and his own goals at the conference were for the right reasons. However, when academics/professors associate themselves with outfits like Hoover, AEI, and Heritage, they might think a little bit how their association with such outfits lends credence to certain policies, which are not good for this nation—-and we are seeing that now in the last 30+ years of propaganda, which has gotten us the man we have in the White House right now. There is a price to be paid for doing that—and it’s time some professors acknowledged that fact including but not limited to the farce at George Mason and Mercatus.

        1. Barkley Rosser

          Oh dear, what an unfortunate sideshow. I guess I have to step in to defend Jim being at the Hoover Institution for this conference, which was indeed attended by a largely politically centrist group of highly eminent economists, with four of the presenters being Federal Reserve district bank presidents and one the current Vice Chair of the board, Richard Clarida. Jim was in seriously respected company, even if one does not like the Hoover Institution.

          So, what about it. It certainly does tilt right politically and has done so openly since it was founded a century ago in 1919 by, yes, Herbert Hoover himself, an already wealthy Stanford alumnus,, but a decade before he became president. However, it is no AEI or Heritage Foundation, being far more scholarly and less immediately tied to policy making as well as having far more prestigious people associated with it, including some (a minority granted) who are not politically conservative.

          It was originally a library and that was what it was called until after WW II, in particular originally a library for materials about WW I, and it soon came to have the largest amount of such materials of any place in the world. After WW II it would expand to become a research institute, but it was and remains a serious library and archive, preserving many important papers, including those of the revolutionary socialist and Marxist political economist, Rosa Luxemburg (who was killed in the Spartacist revolt in Germany in the immediate aftermath of WW I).

          It is true that it has housed and still does quite a few former high officials, almost all from GOP administrations, including former SecStates Kissinger, George Schultz (also an economist), and Condoleeza Rice), with its latest such addition being recently resigned SecDef, Mattis. However, it also has had many distinguished intellectuals not from the government, including 5 Nobel Prize winning economists. Neither AEI nor Heritage has even one of those. It also has some who are fairly liberal in their politics, including John Shoven, Michael Spence (Nobelist and former Harvard dean), and the quirky and controversial Ken Judd, along with columnist Jim Hoagland.

          In short, while definitely dominated by political conservatives, it is a highly intellectually respectable place that maintains at least a veneer of not being hardline partisan. I really think that sniping at Jim for participating in what was clearly a conference involving highly distinguished people and not dominated by any particular political orientation is not called for.

  2. Barkley Rosser


    Many are now saying that the interest rate the Fed is paying on reserves deposited with it by banks is now a crucial policy tool. Is that not acknowledged by Fed policymakers, and did you discuss this at all?

    1. Barkley Rosser

      Just listened to first 20 minutes of your talk. You indeed deal with the matter, showing that until recently the ffr was in the corridor between the floor of the reverse repo rate and the ceiling of the rate I mentioned above, the IOER. But you note that while the reverse repo rate is a hard floor, the IOER is not a hard ceiling, and indeed is now being breached, with a likely factor being the increased budget deficit leading to increased borrowing by the Treasury. Sounds reasonable, but I have to cut out now.

      1. Barkley Rosser


        The discussion of the past role of the discount rate, which has been a completely secondary sideshow for some time, is interesting. For those not watching the talk, Jim noted that when the discount rate was more important several decades ago and served as a floor below the fed funds rate with a gap between them mostly. He explained that due to perceived non-pecuniary costs borne by banks borrowing from the discount window at their friendly regional Fed bank. The cost was that doing so sent a signal that a bank was having problems, so it was bad for the reputation of the bank.

        As it is, I have heard from personal connections at at a discount window that there are some exceptions to this. Curiously these exceptions reflect the deep and long history of the Fed. Basically these tend to be small banks that are especially involved in agricultural lending, which has a well-known seasonal aspect, with lots of financing needs in the fall, with this in the distant past claimed to be a factor why financial crises often happened in the fall. In any case, that was one of the original motives for establishing the Fed, precisely to help ease the financing crunch in the fall for these kinds of banks, much ore important a century ago than now.

        But, as it is, those kinds of banks got into using this source and few bothered to think about it. This is why they can get away as it did not create damage for their reputations, given the long history of them using the discount window for their seasonal borrowing. So, they are an odd exception to the usual story, lurking in a corner, a remnant of the origins of the Fed. Anyway, that is how I see it.

  3. joseph

    “Stanford does host the Hoover Institute.”

    The Hoover Institute at Stanford is much the same as Stephen Kopits at Princeton. They are co-located but the relationship is strained. The Hoover Institute tries to claim credibility by attaching the Stanford name to their organization at every opportunity.

    There has been a long running battle between the Stanford faulty and the Hoover Institute as an embarrassment to the University. They have agreed to a draw in which the University has no input to the Institute and its selection of fellows and the Hoover Institute has no formal relationship with the University. Hoover Institute fellows are not on the faculty of the University and do not teach there. (Well, there are a couple of exceptions like John Taylor, but the teaching precedes the fellowing.)

    The Institute is not a real research institute. It is a welfare spa for right wingers who put out political propaganda tracts. You know the type — Richard Allen, Niall Ferguson, Victor Davis Hanson, Henry Kissinger, General “Mad Dog” Mattis, Ed Meese, Casey Mulligan, George Osborne, Condi Rice, George Shultz, Thomas Sowell, Pete Wilson, and John (testicle crusher) Yoo.

    1. Barkley Rosser


      I have written a comment on this already, but I would say this is a biased presentation. Yes, the people you mention are there, but so are many others not former officials from GOP administrations, but serious scholars, including some who are political liberals.

      I also think you are overstating the degree of tension between the Institution and Stanford University. It has always been part of Stanford University for the past century, although with clear formal independence from oversight by the university administration. While most of the rest of the university is more liberal than it, its scholarly reputation enhanced by the presence of several Nobel Prize winners does keep the rest of the university not all that upset about having it on campus.

      1. Barkley Rosser

        Just to add to this, I note that in the beginningin 1919 when iit was just a library, in fact the library was just a subsection of the main Stanford University library. It was in 1926 that it first got its own separate facility because it had obtained so much material on WW I, it main original focus. There really has not been much conflict between the two; I do not know where yo ugot that from.

        The full title of the pace is the Hoover Institution and Library on War, Revolution, and Peace.

  4. Not Trampis

    compulsive reading/viewing/listening?? Whatever always educative. Many thanks from down under

  5. thomas michl

    Fig 10 should probably chart the Tri-Party Repo rate rather than the GCF repo rate. GCF is a blind-brokered interdealer market. Primary dealers borrow in the TPR from money market funds mostly and then lend to non-primary dealers in GCF, with a spread reflecting positive carry. So the Fed’s o/n reverse repo facility is really not the floor to GCF. It has been the floor for TPR (although since TPR is not brokered, reputational factors can cause money market funds to lend below o/n RRP temporarily). In 2018, it seems that T-Bills replaced TPR as the effective floor, however. You might want to correct this in the text, since money funds don’t trade in GCF as far as I know.

    The same applies to your proposal for an o/n RP facility. It needs to include broker-dealers to cap GCF repo.

    Your explanation of what constrains FHLB trading omits to mention that they have strict liquidity controls that require early return of cash, so the o/n RRP facility, TPR, and GC repo are not options for their “liquidity book.” This puts a limit on how much arbitrage FHLBs can engage in.

    My overall comment is: the Fed’s operating procedures will need to address the shadow banking system that we have now, now the Jimmy Stewart banking system that we’ve left behind.

  6. Steven Kopits

    A really good presentation, Jim. Clear, easy to understand.

    My thoughts:

    1. As has been explored before, the QE’s appear to have proved ineffective, and indeed, some were more linked to rising interest rates than lower ones. Your exposition made that very clear.

    2. You mention, in an offhand comment, that unwinding QE will probably not affect rates much either. I am not so convinced, because I think that balance sheet increases came in a period of non-binding constraints, whereas the roll-off is occurring in a period of binding constraints. So it’s an asymmetrical proposition, I think — but do not know.

    3. You had earlier claimed no material difference between a recession and a depression. I disagree. During a depression (and only during a depression), you’ll see short term rates at zero for many years, with the implication that, for at least some material part of this time, real rates were well below zero. At the ZLB, interest rates are ineffective — just the story the QE’s tell us, all of which occurred at the ZLB if memory serves. Thus, unlike a recession, the interest rate has no transmission mechanism during a depression.

    During a depression, we see two other phenomena that we don’t see during ordinary recessions: housing prices fall for an extended period of time, and materially, -17% from peak to trough during the Great Recession. Second, and very much related, consumer credit contracts for an extended period of time, in this case, until Q2 2013. Thus, unlike a recession, we see a compromise of consumers’ key asset class — housing — and a related unwind of consumer credit. These are balance sheet, not income statement, items, and interest rates act through the income statement (they reduce borrowing costs) rather than directly on the balance sheet, ie, reducing principal amounts. This would lead us to expect interest rate initiatives would be comparatively unsuccessful — just as you have suggested, or at least intimated.

    The focus of policy during a depression should therefore be on principal balances, not interest rates. That is, the government should have indeed helped Main Street, not Wall Street, with unsterilized cash injections, under the assumption that causality flows from households to the banks in a depression (high marginal propensity to pay down debt or raise consumption in a slack economy, with neither causing an increase in inflation during the depressed period), rather than the other way around in a recession. This then is a call for MMT, but only during a depressionary period., which in the US would have extended to at least Q2 2013, and by some other metrics, conceivably to 2016, when the FFR lifted off from zero (ie, signs nominal rates are above zero), if I recall correctly.

    Put another way, the monetary toolkit splits two ways, depending on whether short term rates are above zero or not. If above zero, the ordinary interest rate interventions should prove effective. Below zero, MMT is required, because the problem is collateral impairment, not excessive interest costs.

    I would also encourage you to ask Cynthia Wu to run her recent model with impairment of housing values and falling consumer credit. She writes: “In an application meant to mimic the experience of the US in the Great Recession, we show that their endogenous QE rule significantly mitigates the output decline from a series of adverse demand shocks. By increasing the central bank’s balance sheet in an amount similar to what the Fed did over QE1-QE3, endogenous QE provides stimulus to the economy roughly the equivalent of pushing short term rates two percentage points below zero. This is close to the estimated decline in the “shadow rate” series from Wu and Xia (2016).” (What is their transmission mechanism, if interest rates rose during QE?).

    This would seem that QE had an enormously robust effect, which does not seem to square with actual experience. I would be interested to see if those results hold up if housing values are falling during the period, loan-to-value ratios are falling (ie, down payments percentages are rising) and consumer credit is falling. I will guess such a model modification will show QE to be ineffective, just as your presentation suggests.

    1. Barkley Rosser

      How things change but sort of look like what was before.

      So, prior to 2008 the usual tool of NY Fed open market ops was to intervene in the repo market to control the fed funds rate, although occasionally other policy tools would be used.

      Now the controlling policy tool to determine the fed funds rate according to Jim’s talk is the reverse repo rate, which now sets the hard floor for the ffr. I do not think Jim’s talk explains why that shift has happened, and I do not have an explanation. But this looks like a bottom line.

      1. thomas michl

        Barkley, I think the o/n RRP facility was designed to put a floor under fed funds by giving the FHLBs more bargaining power against the banks that arbitrage (or at least did) between fed funds and interest-on-reserves. It probably does that but since the FHLBs need their cash back early in the day they don’t use it much–mostly its a backstop for money market funds when they can’t lend in tri party repo. The Fed claimed it will be temporary but it looks like it will be needed to put a floor under the whole money market (including repo). Since early 2018 the RRP facility has not seen much action as repo rates have all risen, partly because of the rise in T-bill rates it seems.

      2. Barkley Rosser

        I see I did not make my question above clear.

        It is my understanding that when the NY Fed intervened in the repo market prior to 2008, it did so to control the repo rate itself, which then controlled the fed funds rate.

        Now it seems they are focusing on the reverse repo rate, and this is what I am curious about, why the change? Or was it always the reverse repo rate they focused on and I simply did not realize that?

        1. James_Hamilton Post author

          Barkley Rosser: The Fed has always used both repos and reverse repos, long before the current arrangement. Historically they would use a repo to inject reserves temporarily into the system and a reverse repo to take reserves temporarily out of the system. Historically it was all about fine-tuning the supply of nonborrowed reserves available to the banking system and had nothing to do with trying to control the repo rate. Historical operations might be on the order of a billion dollars, nothing like the current positions that can be in the hundreds of billions.

          1. Barkley Rosser

            Thanks, Jim.

            Of course once Judy Shelton gets in there, they won’t need to have those hundreds of billions of positions as they will simply go back to the gold standard and all will be great at the Fed again, :-).

          2. Moses Herzog

            Let me use a more extreme example to illustrate my point. I am not putting this comment up to buttress or reinforce my comments on Hoover, which I believe stand on their own without having to add 5 extra comments. But I am adding this out of my respect for Professor Hamilton, who I regard as near as a human can get as being unquestionable in his personal ethics.

            If Albert Einstein had walked onto George Mason University campus or Mercatus to give a speech on the dangers of the atomic age, would I still respect Albert Einstein?? Undoubtably so, I would still respect him. However, I might have pulled him aside and asked him why the hell he couldn’t have chosen a better venue. Now, I genuinely leave it to Prof Hamilton to do what he will with this comment, the comment can go off to the murk of nothingness having only been seen by 4 eyeballs. Just wanted to make that portion of my comment clear.

          3. Barkley Rosser


            This was not just a matter of Jim “walking onto the Stanford campus and giving a talk at the Hoover Institution.” He was part of a major conference that took place there with many of the speakers top leaders or former leaders of the Fed about Fed policies, a very important conference that it was an honor for Jim to be invited to give one of the major talks in.

            So, to go to your silly example, the Mercatus Center would have had to have hosted a major conference on the dangers of the atomic age (something it has never done and never will do) that included a large number of the other top experts on this topic along with Einstein. As Menzie has noted, the Hoover Institution and Mercatus are not identical, with Hoover being both less clearly hard line ideological, although it does have a tilt, as well as being much more presitigious and respected as a center of serious scholarship.

            So, under those circumstances, a major conference with many leading figures participating, would you “pull Einstein aside” to remonstrate with him about giving a talk their under such circumstances? I do not think so.

            As for Jim, he has already given his answer when joseph popped up inaccurately characterizing the Hoover Institution as “a political think tank.” Jim focused on the conference and the sorts of people in attendance at it. So if you are going to make stretched and annoying such comparisons, at least try to get things a bit more similar, please.

        2. Barkley Rosser

          Oh, and Moses, since it is Mother’s Day, and you brought up Einstein, I shall note that my late mother once played string quartets with Einstein. The big joke was that while he was able wait for four bars not playing, he came in at the wrong time when he had to wait for 18 bars, leading him to wisecrack that “Well, that just goes to show that while Einstein can count to four, he cannot count to 18.”

          Happy Mother’s Day, you all, :-).

  7. JBH

    Strategies for Monetary Policy: A Parody. Hoover Institute. May 3, 2019.

    The Priesthood Speaks. Listen up ye priests and acolytes.

    The treadle on our spinning wheel out of which we spin straw into fiat money had come unhinged and gone slightly wobbly after our last misadventure. The place is also stuffed to the gills with a mountain of excess straw which we are unable to sell back to our suppliers around the countryside without collapsing the local economy. Be aware therefore that we are going to hold back on straw sales for a time. We have already begun work on a new straw barn to hold double the amount we last stored. Taking extra precaution against spontaneous combustion should any leakages occur in the roof and wet the straw. And we have already come up with a new channeled improvement for the treadle.

    Moresoever, ye can when ye go back about the countryside let slip to the multitude of debt serfs that soon, very soon – the entrails foretell around the time of the next great crisis that the accretion of our multi-decade actions and misactions will bring upon the land – that fiat will no longer consist of in part paper, but rather will become all and wholly electronic and digital. Make them aware that the great improved channel treadle requires this or otherwise we may not be able to quench in time the next great catastrophe that will befall the financial pastures to which we the priesthood hold all the keys.

    Do not under any circumstance let slip the real and true secretive reason for all this. If asked, speak ye instead in learned tones that we must take away all their paper because of the criminals amongst them who truck and barter their dastardly deeds with only that leafy thin archaic relic. And that this must be perforce stomped out.

    1. Barkley Rosser

      So, JBH, does this mean that Jim Hamilton and other presenters at this conference at the erstwhile right wing Hoover Institution are all on the secret list Q has of sealed indictments who will be arrested at night and shipped off to Gitmo when the indictments are unsealed any minute now?

  8. don

    This comment comes very late, but I have a question about the effectiveness of quantitative easing. It seems to me from causal observation that the measure does depress the dollar in foreign exchange markets and thereby perhaps importing some aggregate demand from abroad. Has this effect been systematically examined?
    Secondly, it seems to me that a massive lake of excess reserves might influence expectations of future inflation. Might this not cause long term nominal rates to rise when accumulations of excess reserves are ratcheted up?


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