Over most of the post-war period the Federal Reserve conducted monetary policy by manipulating the Federal Funds rate in order to affect market interest rates. It avoided lending directly in private credit markets, other than to supply discount window loans to commercial banks. Even then, it limited discount window activity to loans secured by government Treasury Bills.
After the onset of the subprime crisis in August 2007, the situation changed dramatically. To address the deterioration in both financial and real activity, the Fed directly injected credit into private markets. It began in the fall of 2007 by expanding the range of eligible collateral for discount window loans to include agency debt and high grade private debt. It did so in conjunction with extending the maturity of these types of loans and with extending eligibility to investment banks. Since that time, the Fed has set up a myriad of lending facilities.
The most dramatic interventions came following the collapse of Lehman Brothers, when the Fed began directly lending in high grade credit markets. It provided backstop funding to help revive the commercial paper market. It also intervened heavily in mortgage markets by directly purchasing agency debt and mortgage-backed securities. There is some evidence to suggest that these policies have been effective in reducing credit costs. Commercial paper rates relative to similar maturity Treasury Bills fell dramatically after the introduction of backstop facilities in this market. Credit spreads for agency debt and mortgage-backed securities also fell in conjunction with the introduction of the direct lending facilities.
The Fed’s balance sheet provides the most concrete measure of its credit market intervention: Since August 2007 the quantity of assets it has held has increased from about eight hundred billion to over two trillion, with most of the increase coming after the Lehman collapse. It financed the balance sheet expansion largely with interest bearing reserves, which are in effect overnight government debt. Thus, over this period the Fed has attempted to offset the disruption of a considerable fraction of private financial intermediation by expanding central bank intermediation. To do so, it has exploited its ability to raise funds quickly and cheaply by issuing (in effect) riskless government debt. Overall, the Fed’s unconventional balance sheet operations appeared to provide a way for it to stimulate the economy even after the Federal Funds reached the zero lower bound.
At the same time, operational models of monetary policy have not kept pace with the dramatic changes in actual practice. There is of a course a lengthy contemporary literature on quantitative modeling of conventional monetary policy, beginning with Christiano, Eichenbaum and Evans (2005) and Smets and Wouters (2007). The baseline versions of these models, how ever, assume frictionless financial markets. They are thus unable to capture financial market disruptions that could motivate the kind of central bank interventions in loan markets that are currently in play. Similarly, models which do incorporate financial market frictions, such as Bernanke, Gertler and Gilchrist (1999) or Christiano, Motto and Rostagno (2005) have not yet explicitly considered direct central bank intermediation as a tool of monetary policy. Work that has tried to capture this phenomenon has been mainly qualitative as opposed to quantitative (e.g., Kiyotaki and Moore (2008), Adrian and Shin (2008)). Accordingly, the objective of this paper is to try to fill in this gap in the literature: the specific goal is develop a quantitative macroeconomic model where it is possible to analyze the effects of unconventional monetary policy in the same general manner that existing frameworks are able to study conventional monetary policy.
To be clear, we do not attempt to explicitly model the sub-prime crisis. However, we do try to capture the key elements relevant to analyzing the Fed’s credit market interventions. In particular, the current crisis has featured a sharp deterioration in the balance sheets of many key financial intermediaries. As many observers argue, the deterioration in the financial positions of these institutions has had the effect of disrupting the flow of funds between lenders and borrowers. Symptomatic of this disruption has been a sharp rise in various key credit spreads as well as a significant tightening of lending standards This tightening of credit, in turn, has raised the cost of borrowing and thus enhanced the downturn. The story does not end here: The contraction of the real economy has reduced asset values through out, further weakening intermediary balance sheets, and so on. It is in this kind of climate, that the central bank has embarked on its direct lending programs.
To capture this kind of scenario, accordingly we incorporate financial intermediaries within an otherwise standard macroeconomic framework. To motivate why the condition of intermediary balance sheets influences the overall flow of credit, we introduce a simple agency problem between intermediaries and their respective depositors. The agency problem introduces endogenous constraints on intermediary leverage ratios, which have the effect of tieing overall credit flows to the equity capital in the intermediary sector. As in the current crisis, a deterioration of intermediary capital will disrupt lending and borrowing in a way that raises credit costs.
Download
PDF Ebook A Model of Unconventional Monetary Policy
