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Monetary policy under a corridor operating framework

  • George A. Kahn

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.

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Article provided by Federal Reserve Bank of Kansas City in its journal Economic Review.

Volume (Year): (2010)
Issue (Month): Q IV ()
Pages: 5-34

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Handle: RePEc:fip:fedker:y:2010:i:qiv:p:5-34:n:v.95no.4
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  1. Morten L. Bech & Elizabeth Klee, 2009. "The mechanics of a graceful exit: interest on reserves and segmentation in the federal funds market," Staff Reports 416, Federal Reserve Bank of New York.
  2. David Bowman & Etienne Gagnon & Mike Leahy, 2010. "Interest on excess reserves as a monetary policy instrument: the experience of foreign central banks," International Finance Discussion Papers 996, Board of Governors of the Federal Reserve System (U.S.).
  3. Berentsen, Aleksander & Monnet, Cyril, 2008. "Monetary policy in a channel system," Journal of Monetary Economics, Elsevier, vol. 55(6), pages 1067-1080, September.
  4. Todd Keister & Antoine Martin & James McAndrews, 2008. "Divorcing money from monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue Sep, pages 41-56.
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