## Conventional Monetary Policy

Conventional Monetary Policy refers to actions taken by the Federal Reserve that are typical in a historical sense. We view three policy tools as being conventional, and we summarize each of them here. Each of these policies has in some sense been pushed to their limits, forcing the Federal Reserve to resort to unconventional monetary policy.

# What is the federal funds rate?

Conventional monetary policy consists principally of the Federal Reserve purchasing and selling government securities in the open market in order to alter the supply of money in the economy --- increasing the money supply to stabilize the economy in downturns and, when necessary, decreasing the money supply to keep inflationary pressures at bay. Since the early 1980s, the Federal Reserve has implemented monetary policy by setting a federal funds rate target and undertaking open market operations to hit that target (Thornton 2008). As such, the stance of monetary policy can be largely summarized by the prevailing federal funds rate at any given time.

The federal funds rate is the interest rate on unsecured overnight loans between financial institutions. These overnight loans are typically used to meet reserve requirements or loan demand at other financial institutions. Movements in this interest rate pass through to other short-term interest rates, such as libor rates, and has some effect on longer-term interest rates on loans made directly to households (e.g. mortgage) and to firms (e.g. commercial and industrial loan rates).

# What is the Policy Response to the Coronavirus Crisis?

March 15, 2020, the federal funds rate was lowered to 0-1/2, hitting the zero lower bound. The zero lower bound implies that nominal interest rates cannot go below zero. This is due to the existence of cash. Banks who face negative interest rates (that is, must pay other banks to hold their money), could simply not lend in the federal funds market. Similarly, savers that might face negative interest rates could hold cash instead, which has exactly zero nominal interest returns.

The Federal Reserve has also issued forward guidance to financial markets over the expected path of the federal funds rate. Not only have they set the federal funds rate to zero today, but they plan on keeping the federal funds rate at zero until they are confident that "the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals." Such a statement of how the federal funds rate will evolve in the future can be stimulatory, especially for investment decisions that planning horizons.

# What is the Historical Precedent?

The federal funds rate has been used by the Federal Reserve to set policy since the 1980s. Changes in the federal funds rate have happened frequently since then, with the Federal Reserve typically meeting to adjust interest rates eight times per year.

This is not the first time that nominal interest rates have reached zero in the United States. During the Great Recession, nominal interest rates fell to zero for the first time. Many of the unconventional policies used during the Coronavirus epidemic (and summarized on this website) were used during the Great Recession as well.

A long-standing issue with respect to the federal funds rate is how effective monetary policy can be at the zero lower bound. When the nominal policy rate hits zero, it is difficult for central banks to ease further by pushing the federal funds rate into negative territory. The reason has to do with alternative sources of savings. If nominal interest rates were negative, it would mean that savers would be paying to put their money away. An alternative to such negative-return saving is to simply withdraw money in the form of cash. Cash is essentially a zero-interest savings vehicle that is always accessible.

# What Is the Academic Evidence?

A classic question in macroeconomics is the extent to which monetary policy has real effects, --- that is, whether changes to the money supply or to nominal interest rates have actual effects on output and employment.

The classic study of Friedman and Schwartz (1956) argues that during the Great Depression, missteps by the Federal Reserve in restricting the growth of the money supply caused the downturn to be larger and worse than it needed to be. Romer and Romer (2004) use contemporary macroeconomic data and internal Fed forecasts of the economy to show that monetary policy shocks (i.e., changes in the federal funds rate uncorrelated with expectations of future economic growth) have large and persistent positive effects on output and negative effects on inflation.

This finding of large effects of monetary policy shocks on output and inflation contrasts somewhat with the findings of smaller effects presented in Christiano, Eichenbaum, and Evans (1999). This separate strand of the literature relies upon timing assumptions for how various fundamental shocks in the economy interact with one another. Coibion (2012) synthesizes the approaches in the previous two papers to argue that the effects of monetary policy shocks lie somewhere between, with one percentage point reduction in the federal funds rate increasing industrial production by 2-3 percentage points.

Ramey (2016) provides a helpful overview of the empirical literature on the effects of monetary policy shocks. In so doing, Ramey (2016) also observes that, as often occurs with empirical work, the estimated effects of monetary policy shocks are not stable, depending upon sample period and assumptions one makes about the underlying statistical model. Addressing this concern, Miranda-Agrippino and Ricco (2017) develop statistical techniques to address the types of concerns raised in Ramey (2016). Miranda-Agrippino and Ricco (2017) argue for the unequivocal conclusion that lowering interest rates stimulates the economy.

# What is the Discount Window?

The Discount Window allows eligible banking institutions to borrow directly from the Federal Reserve. By posting eligible collateral, eligible institutions are able to borrow, at a penalty rate, to meet short-term funding needs.

There are two discount windows depending on the soundness of the financial institutions. High-quality depository institutions can access the primary discount window, which has a lower borrowing rate, longer-term maturity (up to ninety days), and does not require additional processing. Low-quality depository institutions instead must use the secondary discount window. The secondary discount window offers a higher lending rate (50bp higher than the primary rate), much shorter maturities (typically overnight), and requires providing additional information to the Fed to confirm the reasons for borrowing.

What makes an institution "high-quality" or "low-quality"? Banking authorities typically use a CAMELS rating, which stands for "Capital Adequacy, Asset Quality, Management, Earnings, Liquidity, and Sensitivity." Banking authorities assign financial institutions a score for each of these six categories, and then aggregate the scores to one number. Depository institutions with a CAMELS rating of 1, 2, or 3 can use the primary discount window. Depository institutions with a CAMELS rating of 4 or 5 cannot use the primary discount window, and instead must use the secondary discount window.

# What is the Policy Response to the Coronavirus Crisis?

#### Prime Discount Window Borrowing Rate

The Fed lowered the primary and secondary credit rates by 150 basis points to 0.25 percent as of March 16, 2020. Because banks are typically reluctant to use the discount window due to, on March 15, 2020, the Federal Reserve officially encouraged banks to access the Discount Window. Such official encouragement is new.

# What Has Been the Effect?

Discount window lending rose in the week following the lending rate decline (March 19, 2020) by close to $7 billion, rising to$40 billion in the subsequent week. While the Federal Reserve issued a statement of their satisfaction with this increase in borrowing, this amount is dwarfed by what was borrowed during the Great Recession.

# What is the Historical Precedent?

Historically, the discount window was the primary tool of the Fed in its early days. Over time, the federal funds market became its preferred market of choice. During the Great Recession, discount window lending rose substantially. Total discount window lending outstanding reached a peak of approximately \$112 billion on the week of October 29, 2008.

# What Is the Academic Evidence?

Most academic studies on discount window lending focus on early Fed history, when the discount window was its main policy tool and there was greater scope for regional variation in how it was used. For example, Richardson and Troost (2009) find that in Mississippi during the Great Depression, lower discount window lending is associated with fewer bank failures and a smaller decline in real output (as measured by wholesale transactions and credit).

# What Market is Under Stress?

The Federal Reserve has the power to mandate holdings of reserves by depository institutions. Historically, holding reserves meant maintaining stability in the system by forcing depository institutions to hold liquid assets in the case of unexpected withdrawals. Following the creation of the Federal Reserve System, required reserves help the orderly execution of open market operations by providing a market for federal funds.

Holding reserves can be costly for banks. When the return to lending is higher than the interest that is paid on reserves, banks are essentially being taxed. Interest is currently paid on reserves, and has been since October 1, 2008. There is technically a separate interest rate for excess reserves and required reserves, however the levels have been identical since November 2008.

Prior to the Great Recession, the Federal Reserve operated on a "scarce reserves" approach. The Federal Reserve did not pay interest on reserves, which meant banks did not want to hold more reserves than they were required to. Excess reserves were essentially zero. Since the Great Recession, the Federal Reserve has started paying interest on reserves and has moved to an "ample reserves" framework. By adjusting interest rates on excess reserves, they can simultaneously influence the amount of reserves held by financial institutions and market interest rates.

This shift to an ample reserves framework has also changed how monetary policy "works." Previously, by changing the amount of reserves (i.e., the money supply) in the system, the Federal Reserve would affect the federal funds rate, as it would be the interest rate that clears the reserve market. Now, by paying interest on reserves, the Fed controls the "backup plan" of financial institutions. The federal funds rate must be at least as high as interest on excess reserves.

# What is the Policy Response to the Coronavirus Crisis?

Reserve requirements were reduced to zero effective March 26, 2020 (the beginning of the following reserve maintenance period). The interest rate paid on required and excess reserve balances was also lowered to 10bp.

# What is the Historical Precedent?

Reserve requirement adjustments have rarely been used as an expansionary policy tool. The reserve requirements were used in 1937-1938 to prevent a potential expansion of credit and ensuing inflationary pressure; some, including Friedman and Schwartz (1963), blamed this policy on the resulting short recession. The Federal Reserve used reserve requirements often in the 1960s and 1970s in response to the creation of new financial instruments. For example, the Federal Reserve changed reserve requirements specifically on CD's to affect their cost of issuance.

# What Is the Academic Evidence?

Academic evidence on the effectiveness of this kind of policy is extremely limited. This is for two reasons. First, with some exceptions, the central bank has not used reserve management very often as a stimulative policy. Second, since the Great Recession, the Federal Reserve's views towards excess reserves has changed due to the ample reserves framework, discussed above.

Nonetheless, there is at least one interesting topic of note. A variety of papers have studied the increase in reserve requirements prior to and during the 1937-38 recession. There were a large amount of excess reserves (i.e., a large latent supply of cash) in 1936 that the Fed at that time was worried about. The Fed raised reserve requirements to ensure that this large pool of money wouldn't cause inflation. Park and Van Horn (2015) find that this had no effect on bank lending. Similarly, Calomiris, Mason, and Wheelock (2011) argue that, contrary to arguments made by Friedman and Schwartz (1963), this doubling of reserve requirements did not cause the 1937-1938 recession in the U.S.

• Federal Reserve Economic Data (FRED) (Codes in Italics)
• Effective federal funds rate (EFFR)
• Primary Credit (WPC)
• Primary Lending Rate (DPCREDIT)
• Required Reserves (RESBALREQW)
• Excess Reserves (EXCSRESNW)