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

2

The past

•Pre-August 2007

The ECB corridor before the crisis

• O/N rate in the middle of the corridor 3

4

Excess of liquidity and spreads before the crisis

• Excess liquidity and spread O/N MRO rate around

zero

5

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.

6

Penalty rate

Target rate

Required reserves

Demand for

reserves

Reserve balances

Interest rate

Target supply

0

Monetary policy implementation in the United States*

*Todd Keister, Antoine Martin, and James McAndrews

7

Central banks balance sheets broad vs. narrow

frameworks

8

Precision in interest rate control I

9

Precision in interest rate control II

• US and €-area with comparable precision, Japan

more precise, UK less.

10

The Present

•After August 2007

Central bank balance sheets

Source: Central banks statements

11

0

50

100

150

200

250

300

350

400

450

500Ja

n-0

7

May

-08

Sep

-09

Feb

-11

Jun-1

2

No

v-1

3

Ind

ex (

Ja

n 2

00

7=

10

0)

Eurosystem Federal Reserve Bank of England Bank of Japan

12

The ECB corridor after the crisis

First volatility of O/N, then compression onto the floor of the

corridor

13

Excess of liquidity after the crisis

• Huge amount of liquidity pushing O/N to the bottom

of the corridor

Fundamental equation: special case

14

Maintenance period

8 August – 11 September 2007

-170.0

-150.0

-130.0

-110.0

-90.0

-70.0

-50.0

-30.0

-10.0

10.0

30.0

50.0

70.0

90.0

110.0

130.0

150.0

170.0

08

Aug 0

7

09

Aug 0

710

Aug 0

7

11

Aug 0

7

12

Aug 0

713

Aug 0

7

14

Aug 0

715

Aug 0

7

16

Aug 0

717

Aug 0

7

18

Aug 0

7

19

Aug 0

720

Aug 0

7

21

Aug 0

722

Aug 0

7

23

Aug 0

724

Aug 0

7

25

Aug 0

7

26

Aug 0

727

Aug 0

7

28

Aug 0

729

Aug 0

7

30

Aug 0

731

Aug 0

7

01

Sep 0

7

02

Sep 0

703

Sep 0

7

04

Sep 0

705

Sep 0

7

06

Sep 0

707

Sep 0

7

08

Sep 0

7

09

Sep 0

710

Sep 0

7

11

Sep 0

7

EU

R b

illi

on

s

3.00

3.25

3.50

3.75

4.00

4.25

4.50

4.75

5.00

%

Daily reserve surplus/deficit (left-hand scale) Average daily reserve surplus (left-hand scale) EONIA (right-hand scale)

FTO of 94.8 bnFTO of

61.1 bn

FTO of

47.7 bn

FTO of

-60.0 bn

FTO of 42.2 bnMRO with

benchmark +5.0 bn

FTO of 7.7 bn

MRO with

benchmar

k +73.5 bn

MRO with

benchmark

+46.0 bn

MRO with

benchmark

+14.5 bn

supplementary

LTRO

of 40.0 bn

regular LTRO

of 50.0 bnMRO with

benchmark

+1.0 bn

Source: ECB

15

EONIA-MRO spread

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

(11) Negative deposit rate

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4Ja

n-0

3

Au

g-0

3

Mar

-04

Sep

-04

Ap

r-05

Oct

-05

May

-06

No

v-0

6

Jun-0

7

Jan

-08

Jul-

08

Feb

-09

Au

g-0

9

Mar

-10

Sep

-10

Ap

r-11

No

v-1

1

May

-12

Dec

-12

Jun-1

3

Jan

-14

Jul-

14

bp

s

2 1 7 6 5 3 4 8 9 10 11

Source: ECB

16

17

Spread between peripheral and German 10y bonds

18

The new FED corridor approach

• Corridor between two absorbing facilities

19

And what about the future?

• Just continue like now

• Get back to old symmetric corridor

• Derivative-based interest rate control

20

Just continue like now

Long term balance sheet extrapolations ECB (lhs); FED (rhs)

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

2016 2017 2018 2019 2020 2021 2022 2023

US

D b

n

Current accounts

Banknotes

Assets

0

1000

2000

3000

4000

5000

6000

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028

EU

R b

n

Current account

Banknotes

Assets

21

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?

22

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

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

Stra

dd

le p

ayo

ut

Average O/N rateCB target rate

Banks are hedged against

deviations of O/N rates

from CB target

24

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.

Morning

session

Mid-day

session

Afternoon

session

1st liquidity shock 2nd liquidity shock 3rd liquidity shock

COB OMO

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

0

0,02

0,04

0,06

0,08

0,1

0,12

0,14

0,16

0,18

0,2

0 100 200 300 400 500 600 700

Straddle cap (% of cumulative AF volatility)

O/N rate volatility

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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?

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My Blog: Money matters? Perspectives on Monetary Policy

My Tweet: @FrancescoPapad1

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Thank you! …and some publicity