ArticlePDF Available

Monetary policy under a corridor operating framework

Authors:

Abstract and Figures

The Federal Reserve aggressively eased monetary policy during the 2008-09 global financial crisis. The Federal Open Market Committee (FOMC) cut the federal funds rate target to near zero, and the Board of Governors introduced a number of novel liquidity facilities. In addition, the FOMC purchased long-term Treasuries and agency mortgage-backed securities on a large scale. These actions caused the Fed’s balance sheet to balloon. ; As the balance sheet grew to unprecedented size, the Open Market Desk at the New York Fed found it increasingly difficult to achieve FOMC’s target funds rate. In response, in October 2008, as authorized under the Financial Services Regulatory Act of 2006 and the Emergency Economic Stabilization Act of 2008, the Federal Reserve began paying interest on excess reserves. This interest rate expected to establish a floor under the federal funds rate. The discount rate—which since January 2003 has been set as a penalty rate the funds rate target—was expected to limit upward pressure on the funds rate ; With these moves, the Federal Reserve’s operating framework now incorporates the essential elements of a “channel” or “corridor” system. In such a system, the target for the federal funds rate would typically be set within the corridor established by the discount rate at the ceiling and interest rate on excess reserves at the floor. Although the Federal Reserve has not formally adopted a channel system, establishing a under the federal funds rate target will be especially important as the Federal Reserve begins to exit its highly accommodative policy stance. ; Kahn examines how a corridor system works in theory and practice. While such a framework may offer a number of advantages as an operating system, it may also create new challenges. The key advantages are that it could help the Federal Reserve achieve its target for the federal funds rate while allowing the balance sheet to act as an independent tool of policy. A key question is whether the discount rate will be an effective ceiling and the interest rate on excess reserves an effective floor. In addition, how changes in the funds rate target, the discount rate and the rate on excess reserves will be sequenced is unclear. In particular, the roles of the FOMC, Board of Governors, and Reserve Bank Boards of Directors in such a system may need to be clarified.
Content may be subject to copyright.
A preview of the PDF is not available
... 25-26). See also Kahn (2010) for a similar explanation why banks held excess reserves pre-GFC in the United States. ...
Article
Full-text available
This paper discusses commercial banks' demand for central bank reserves under two alternative monetary policy framework configurations, namely: (i) an interest rate corridor system with scarce liquidity, and (ii) a floor system with ample liquidity. It outlines the interaction between the monetary implementation framework used to steer short-term market interest rates and banks' demand for reserves. We find that by implementing a floor system, the Eurosystem has eliminated the opportunity costs of holding reserves and enabled banks to hold relatively large buffers of reserves compared with the corridor system. Additionally, the demand for reserves may have increased endogenously, as the environment of ample liquidity conditions has incentivised many banks to adapt their business models. In parallel, the demand for reserves has also increased for more exogenous reasons such as post-global financial crisis liquidity regulation and increased liquidity concentration. Our estimates indicate an increase, over recent years, in the level of excess liquidity required in the euro area to avoid a rise in short-term market rates. Moreover, the dependency on the adopted monetary policy instruments and the external environment highlights the increased uncertainty in estimating future levels of required reserves.
... On the other hand, the deposit rate, which is the interest rate that banks receive on their holdings of reserves from the Central Bank after interbank transactions have been resolved, is typically set below the policy rate. This provides an incentive for banks to offload excess reserves into the interbank market (Kahn 2010). Under the corridor system of interest rates, the policy rate typically lies in the middle of the "channel" defined by the lending and deposit rates. ...
Article
Modern Monetary Theory advocates make the distinction between voluntary and involuntary constraints with respect to operation of key institutions, such as the Central Bank and Treasury, in their conduct of macroeconomic policy. In this article we explore several episodes of UK policymaking, in order to demonstrate consistency regarding the policy coordination between HM Treasury and the Bank of England, and, in addition, highlight numerous voluntary constraints which by their very nature can be finessed when circumstances demand. In particular, we show that the use of the Ways and Means account on a number of notable occasions has meant that Government spending was not constrained by prospective tax receipts and sales of Government securities. Also, the introduction of non-convertible banknotes and other strategies, including the financing of the First War Loan, meant that the prevailing voluntary constraints were sidestepped.
... Since IOER gives the ability to set interest rates higher than zero-lower bound, it is particularly suitable if the aggregate quantity of reserves is large and interbank rates are not responsive to open market operations. Kahn (2010) illustrates these mechanics. ...
Preprint
Full-text available
In this paper, we document a link between interest-on-excess-reserves (IOER) and global banks' internal capital markets. We find that foreign bank affiliates in the U.S. receive less funding from their parent banks when their home Central Bank increases the rate paid on excess reserves. We find a negative and statistically significant effect of IOER on the affiliate bank lending: a 100 basis points increase in the home Central Bank's rate on excess reserves is linked to a 2.3 percentage points decline in the U.S. credit provided by foreign bank affiliates. We exploit different organizational forms and IOER eligibility for identification. We also control for demand-side factors in a loan-level data in which borrowers have multiple lending relationships. We find that within a banking organization, the credit supply response is stronger in the affiliates that are smaller, have ex ante less profitable loans, and rely on parent bank funding. Taken together, these results are consistent with a novel channel of unconventional monetary policy where IOER crowds out global credit supply. We argue that the type of monetary policy framework matters.
... Since IOER gives the ability to set interest rates higher than zero-lower bound, it is particularly suitable if the aggregate quantity of reserves is large and interbank rates are not responsive to open market operations. Kahn (2010) illustrates these mechanics. ...
Chapter
Is the interest rate corridor an effective instrument to dampen the accumulation of excess reserves and inter-bank rate volatility? Yes, it is. We find that the interbank rates volatility is dependent on excess reserves regimes. The overnight forex rate volatility increases more compared to the South African overnight rate (Sabor) in response to positive shocks to banks’ excess reserves. Positive shocks to banks’ excess reserves explain a larger variation in the overnight forex rate volatility compared to the Sabor rate volatility. In addition, the estimated threshold for the excess reserves of R100 billion has a statistical and economic significance in the response of the inter-bank rates and their volatility. The Sabor and overnight forex rate volatilities decline in the low excess reserves regime compared to the high excess reserves regime. Thus, there is a direct relationship between the level of excess reserves and the inter-bank rate volatility. Lowering the level of excess reserves below the R100 billion threshold will assist in lowering the volatility in the Sabor and overnight forex rates. Furthermore, the results of the transition function imply that the interest rate corridor floor allows the South African Reserve Bank to separate the interest rate policy (monetary policy stance) from the liquidity policy. This means that policymakers can gradually phase in the autonomous use of the deposit rate to manage bank liquidity or excess reserves. This gradual phasing in of the autonomous use of the deposit rate to manage bank liquidity or excess reserves can take the approach of tiering excess reserves and use the estimated threshold as a guideline.
Chapter
This chapter presents a preliminary review of the central bank balance sheet tools that can be deployed to assist in the achievement of price, financial and macro-economic stability in South Africa. The chapter discusses the key channels through which large-scale asset purchases (quantitative easing) are transmitted and whether the size, duration and composition of central bank asset purchases matter. We provide vast literature review of (i) when are the right conditions for the central bank to pursue large-scale asset purchases and (ii) whether quantitative easing (QE) is only effective at the zero-lower bound. This chapter discusses the motivation as to why the South African Reserve Bank (SARB) must conduct QE beyond the COVID-19 pandemic period, increase the pace at which it accumulates foreign currency reserves, lengthen the repurchase agreements maturities, adopt the excess reserves tiering approach and an interest rate corridor floor that allows the central bank to separate the monetary policy stance from the liquidity management policy. In addition, the analysis in the book assesses whether the Public Investment Corporation balance sheet can be used alongside the SARB balance sheet to achieve the national objectives of price, financial and macro-economic stability.
Article
This paper econometrically tests for effects on bank lending of the Federal Reserve’s policy of paying interest on excess reserves (IOER). Following the 2008 financial crisis, US banks decreased their loan allocations and increased holdings of excess reserves. A model of bank asset allocation shows that when the rate of IOER is higher than other short-term rates, banks will switch from zero excess reserves to a regime with higher excess reserves and lower lending. Using a sample of panel data on US banks from 2000 through 2018, we find evidence of a switch to a positive excess reserve regime in the post-crisis period. Controlling for market interest rates, loan demand, and economic activity, we find that IOER accounts for the majority of the decline in bank lending after the financial crisis.
Chapter
Full-text available
This chapter evaluates the macroeconomic impact of the interest rate corridor policy implemented by the central bank in Turkey. In this context, firstly the general framework, types and application of interest rate corridor policy are explained. Then, the interest rate corridor policy implemented by the CBRT after the global crisis was examined in detail. In addition, domestic and foreign literature examining the macroeconomic effects of the interest rate corridor policy has been included. This chapter examines the macroeconomic impact of the interest rate corridor policy implemented in Turkey using data from the 2011-2018 period. In the study, Engle-Granger Cointegration Analysis and Toda-Yamamoto Causality Analysis were used as models. As a result of the study, it was concluded that interest rate corridor had an effect on economic growth, foreign direct investment, and exchange rate variables.
Article
A core responsibility of the Federal Reserve is to ensure financial stability by acting as the “lender of last resort” through its discount window (DW). Historically, however, the DW has not been effective because its usage is stigmatized. In this paper, we develop a coordination game with adverse selection, and we test in the lab policies that have been proposed to mitigate DW stigma. We find that lowering the DW cost and making DW borrowing difficult to detect are ineffective, but regular random DW borrowing can overcome DW stigma. Implications for other forms of stigma in finance are discussed.
Article
Full-text available
Paper for a conference sponsored by the Federal Reserve Bank of New York entitled Financial Innovation and Monetary Transmission
Article
This paper reviews the experience of eight major foreign central banks with policy interest rates comparable to the interest rate on excess reserves paid by the Federal Reserve. We pursue two main lines of inquiry: 1) To what extent have these policy interest rates been lower bounds for short-term market rates, and 2) to what extent has tightening that included increasing these policy rates been achieved without reliance on reductions in reserves or other deposits held at the central bank? The foreign experience suggests that policy rate floors can be effective lower bounds for market rates, although incomplete access to central bank accounts and interest on them weakens this result. In addition, the foreign experience suggests that tightening by increasing the interest rate paid on central bank balances can help reduce or eliminate the need to drain balances. These results are consistent with theoretical results that show that tightening without draining is possible, irrespective of whether excess reserves are large or small.
Article
An increasing number of central banks implement monetary policy via two standing facilities: a lending facility and a deposit facility. In this paper we show that it is socially optimal to implement a non-zero interest rate spread. We prove this result in a dynamic general equilibrium model where market participants have heterogeneous liquidity needs and where the central bank requires government bonds as collateral. We also calibrate the model and discuss the behavior of the money market rate and the volumes traded at the ECB’s deposit and lending facilities in response to the recent financial crisis.
Article
This paper evaluates reserves regimes versus interest rate corridors, which have become competing frameworks for monetary policy implementation. Rate corridors, relying on lending and deposit facilities to create ceilings and floors for overnight interest rates, evince mixed results on controlling volatility. Reserve requirements allow period-average smoothing of interest rates but, even if remunerated, are subject to reserve avoidance activities. A system of voluntary, period-average reserve commitments could offer equivalent rate-smoothing advantages. If central banks created symmetric opportunity costs of meeting or falling short of period-average reserve requirements (or commitments), they could achieve flat reserve demand on settlement day.
Article
Channel systems for conducting monetary policy are becoming increasingly popular. Despite its popularity, the consequences of implementing policy with a channel system are not well understood. We develop a general equilibrium framework of a channel system and study the optimal policy. A novel aspect of the channel system is that a central bank can “tighten” or “loosen” its policy without changing its policy rate. This policy instrument has so far been overlooked by a large body of the literature on the optimal design of interest-rate rules.
Article
There is considerable anecdotal and empirical evidence suggesting that banks are reluctant to borrow from the Fed's discount window. This behavior is commonly explained as the result of stigma attached to this source of funding, though stigma is hard to establish conclusively. New theoretical research provides a formal framework to analyze stigma, including the recent policies introduced to deal with it.
Article
To combat the financial crisis that intensified in the fall of 2008, the Federal Reserve injected a substantial amount of liquidity into the banking system. The resulting increase in reserve balances exerted downward price pressure in the federal funds market, and the effective federal funds rate began to deviate from the target rate set by the Federal Open Market Committee. In response, the Federal Reserve revised its operational framework for implementing monetary policy and began to pay interest on reserve balances in an attempt to provide a floor for the federal funds rate. Nevertheless, following the policy change, the effective federal funds rate remained below not only the target but also the rate paid on reserve balances. We develop a model to explain this phenomenon and use data from the federal funds market to evaluate it empirically. In turn, we show how successful the Federal Reserve may be in raising the federal funds rate even in an environment with substantial reserve balances.
Article
Many central banks implement monetary policy in a way that maintains a tight link between the stock of money and the short-term interest rate. In particular, their implementation procedures require that the supply of reserve balances be set precisely in order to implement the target interest rate. Because bank reserves play other key roles in the economy, this link can create tensions with other important objectives, especially in times of acute market stress. This article considers an alternative approach to monetary policy implementation -- known as a "floor system" -- that can reduce or even eliminate these tensions. The authors explain how this approach, in which the central bank pays interest on reserves at the target interest rate, "divorces" the supply of money from the conduct of monetary policy. The quantity of bank reserves can then be set according to the payment or liquidity needs of financial markets. By removing the opportunity cost of holding reserves, the floor system also encourages the efficient allocation of resources in the economy.