A lesson in central bank policy

This is a reply to a query at the History of Economics website by Tom Humphrey on the form and aims of central bank policy as undertaken by the Fed in 2009:

You asked if the Fed, early in the crisis, wasn’t engaged in credit, not monetary, policy when it bought and/or loaned against questionable commercial bank assets while simultaneously paying interest on excess reserves.

The answer, of course, is that you are right. The Fed indeed was engaged in credit, not monetary, policy. It sought to help banks by changing the composition not the size of their balance sheets. To this end it did two things.

First, it bought and/or discounted at the discount window non-liquid, potentially questionable assets from the banks, paying for those assets by crediting banks’ reserve accounts. At the same time, the Fed paid positive interest to the banks if they would hold those new (excess) reserves idle. In so doing the Fed enhanced the liquidity and safety of bank balance sheets while inducing the banks to hold their reserves idle rather than using those reserves to expand loans and deposits.

Here was credit policy par excellence. The swap of reserves in exchange for questionable non-monetary assets altered the composition of bank balance sheets. But because banks had a powerful incentive not to expand their loans and deposits, the size of bank balance sheets remained unchanged.

In sum, monetary policy aims at altering the size of bank balance sheets. It does so by inducing banks to raise or lower their volume of loans and deposit. By contrast, credit policy aims at improving bank safety and liquidity. It does so by changing the composition, not the size, of bank balance sheets. Early in the financial crisis the Fed primarily was pursuing credit policy rather than monetary policy.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.