Workshop on Implementing monetary policy post-crisis: What have we learned? What do we need to know? Organized by Columbia University SIPA and the Federal Reserve Bank of New York May 4, 2016 How should central banks steer money market interest rates? Francesco Papadia* *This presentation represents work in progress. The section on derivative control of interest rate is joint work with Juliusz Jablecki Prepared with the assistance of Madalina Norocea and Piero Esposito 1
The past • Pre-August 2007 2
The ECB corridor before the crisis • O/N rate in the middle of the corridor 3
Excess of liquidity and spreads before the crisis • Excess liquidity and spread O/N MRO rate around 4 zero
Interest rates within a corridor system Where is the market interest rate on day t is the interest rate at the end of the maintenance period is the expectation operator based on information available on day t is the rate applying when banks are long on liquidity and depositing it with the ECB is the probability of banks being long on liquidity at the end of the maintenance period is the rate when banks are short of liquidity and borrowing from the ECB is the probability of banks being short on liquidity at the end of the maintenance period. 5
Monetary policy implementation in the United States* Interest rate Penalty rate Demand for reserves Target rate Required reserves 0 Target supply Reserve balances 6 *Todd Keister, Antoine Martin, and James McAndrews
Central banks balance sheets broad vs. narrow frameworks 7
Precision in interest rate control I 8
Precision in interest rate control II • US and € -area with comparable precision, Japan 9 more precise, UK less.
The Present • After August 2007 10
Central bank balance sheets 500 450 400 Index (Jan 2007=100) 350 300 250 200 150 100 50 0 Jan-07 May-08 Sep-09 Feb-11 Jun-12 Nov-13 Eurosystem Federal Reserve Bank of England Bank of Japan 11 Source: Central banks statements
The ECB corridor after the crisis First volatility of O/N, then compression onto the floor of the 12 corridor
Excess of liquidity after the crisis • Huge amount of liquidity pushing O/N to the bottom of the corridor 13
Fundamental equation: special case 14
Maintenance period 8 August – 11 September 2007 Daily reserve surplus/deficit (left-hand scale) Average daily reserve surplus (left-hand scale) EONIA (right-hand scale) MRO with supplementary FTO of benchmark LTRO FTO of 94.8 bn MRO with 61.1 bn FTO of 42.2 bn +14.5 bn of 40.0 bn benchmark +5.0 bn 170.0 5.00 MRO with FTO of 150.0 benchmar -60.0 bn 130.0 4.75 regular LTRO k +73.5 bn 110.0 of 50.0 bn MRO with 90.0 4.50 benchmark 70.0 +1.0 bn 50.0 4.25 EUR billions 30.0 10.0 4.00 % -10.0 -30.0 FTO of 7.7 bn 3.75 -50.0 FTO of -70.0 47.7 bn MRO with 3.50 -90.0 benchmark -110.0 +46.0 bn 3.25 -130.0 -150.0 -170.0 3.00 08 Aug 07 09 Aug 07 10 Aug 07 11 Aug 07 12 Aug 07 13 Aug 07 14 Aug 07 15 Aug 07 16 Aug 07 17 Aug 07 18 Aug 07 19 Aug 07 20 Aug 07 21 Aug 07 22 Aug 07 23 Aug 07 24 Aug 07 25 Aug 07 26 Aug 07 27 Aug 07 28 Aug 07 29 Aug 07 30 Aug 07 31 Aug 07 01 Sep 07 02 Sep 07 03 Sep 07 04 Sep 07 05 Sep 07 06 Sep 07 07 Sep 07 08 Sep 07 09 Sep 07 10 Sep 07 11 Sep 07 15 Source : ECB
EONIA-MRO spread 0.4 1 4 6 2 8 9 10 5 11 3 7 0.2 0 bps -0.2 -0.4 -0.6 -0.8 Jan-03 Aug-03 Mar-04 Sep-04 Apr-05 Oct-05 May-06 Nov-06 Jun-07 Jan-08 Jul-08 Feb-09 Aug-09 Mar-10 Sep-10 Apr-11 Nov-11 May-12 Dec-12 Jun-13 Jan-14 Jul-14 Notes : (1) Lehman Brothers Collapse; Injection of liquidity via fine tuning operations (2) Narrowing of the corridor & Full allotment at fixed rate (3) 1st 1 year LTRO (4) Start of SMP (5) & (6)The 3 year LTROs (7) Deposit rate cut to 0 (8) Start of 3 yr LTROs early repayment (9) MRO rate cut (10) MRO rate cut to 0.25 16 (11) Negative deposit rate Source : ECB
Spread between peripheral and German 10y bonds 17
The new FED corridor approach • Corridor between two absorbing facilities 18
And what about the future? • Just continue like now • Get back to old symmetric corridor • Derivative-based interest rate control 19
Just continue like now Long term balance sheet extrapolations ECB (lhs); FED (rhs) 6000 5000 Current accounts 4500 Current account 5000 Banknotes 4000 Banknotes Assets 3500 Assets 4000 3000 EUR bn USD bn 2500 3000 2000 2000 1500 1000 1000 500 0 0 2016 2017 2018 2019 2020 2021 2022 2023 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 20
Get back to old symmetric corridor Liquidity control through OMOs No ex-ante excess liquidity Stabilizing required reserves Narrow or broad framework? In the US? In the € -area? 21
Derivative-based interest rate control I prepared with Juliusz Jablecki • Symmetric corridor • Rigid demand for liquidity • Stabilizing device needed • Daily OMOs • Draw from reserves required on average during maintenance period • Draw from target rate facility (Taralac) • Compensate P/L effect through a straddle 22
Derivative-based interest rate control II • In a Wicksellian approach the central bank wants to control the interest rates, with quantities only a tool. Why not concentrating on the variable of interest rather than on the tool? • Liquidity: turnover in contracts on € interest rates is twice as high as that in cash market (both secured and unsecured); • Price origination : anecdotal evidence suggests pricing increasingly originates in the derivative market (e.g bond futures); • Lower transactions costs : a 3M € unsecured deposit trades at ca. 15bp bid-ask spread vs. only 2-5bp on 3M OIS; • Lower credit risk : collateralization and netting arrangements would allow limiting credit exposure. 23
Derivative-based interest rate control III • CB offers protection against O/N volatility with a straddle , a combination of a payer and receiver option with a strike equal to the CB target rate • The writing of straddle contracts complements normal liquidity provision based on a given forecast of autonomous factors • The payout of the straddle is 0 if the O/N rate stabilizes exactly at the CB target rate and increases linearly with deviations from the strike Banks are hedged against deviations of O/N rates Straddle payout from CB target Average O/N rate 24 CB target rate
Derivative-based interest rate control IV A straddle because: • Banks have symmetric exposure to O/N rate deviations from target if OMO covers expected shocks • A swap would only give one sided protection • Straddles are traded e.g. on 3M EURIBOR futures EURIBOR future straddles are liquid and trade at narrow bid-ask spread 25
Derivative-based interest rate control V • CB balances liquidity conditions with OMO & offers banks a straddle with strike equal to target rate • Trading sessions take place and liquidity shocks materialize • If the banking system has a net liquidity shortfall/surplus, recourse will be taken to the borrowing/deposit standing facility • All or part of the cost of taking recourse to either of the standing facilities can be recovered. 1st liquidity shock 2nd liquidity shock 3rd liquidity shock Mid-day Morning Afternoon COB OMO session session session 26
Derivative-based interest rate control VI • With a free of charge and limitless straddle, interest rates would be pegged at target. • A capped straddle will not eliminate interest rate volatility fully and will leave some space for interbank market functioning • A cap calibrated to 200% of cumulative variance of daily liquidity shocks reduces O/N volatility by a factor of 4.5 O/N rate volatility 0,2 0,18 0,16 0,14 0,12 0,1 0,08 0,06 0,04 0,02 0 27 0 100 200 300 400 500 600 700 Straddle cap (% of cumulative AF volatility)
Derivative-based interest rate control VII • Isolate from effects of LCR as interest rate control is separate from liquidity supply/demand? • Derivatives-based monetary policy implementation vs. TARALAC facility • How to apportion the straddle to individual banks? • Should the straddle be offered free of charge? • How would a straddle-based approach influence money market activity? • What about using fixed-floating swaps? 28
Thank you! …and some publicity My Blog: Money matters? Perspectives on Monetary Policy My Tweet: @FrancescoPapad1 29
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