Dynamic concept Monetary policy

Forward guidance could be enhanced while QE phasing out

Since the financial crisis in 2008, the FED has adopted two main policy tools – policy interest rate and large scale asset purchases (QE).

The policy interest rate tool is to set the target for the federal fund rate, so to influence the money market rates. The policy interest rate is a conventional tool central banks have used to control economic growth. As the economy weakened since the financial crisis, the Fed repeatedly cut its target for the federal fund rate and in December 2008, the target was reduced to the lowest possible – a range of zero and 1/4 percent.

In terms of control theory, the policy interest rate tool became saturated and not effective any more especially if the economy weakens further and more monetary easing is required. In that condition, the Fed introduced an unconventional monetary policy tool – large scale asset purchase, so called QE. The program is to buy from open market of treasury bond and mortgage backed bond in order to push down the long term interest rate.

Accompanying with the two monetary tools, the Fed introduced forward guidance of these policies and thus added a time dimension to the policy tools. More freedom means more goals can be archived. The idea of forward guidance is to manage public’s forward expectations of how policy will evolve over long term. The forward guidance proved to be effective to flatten the yield curve and keep long term interest low. The U. S. 10 year treasury yield had been lower than 2%.

The Fed sent a test signal of tapering this June, the market responded sharply. As the Fed preparing to phase out the QE program, the forward guidance on the policy rate is likely to be enhanced to mitigate shock to the financial market and the economy.

Leave a Reply

Your email address will not be published. Required fields are marked *