Column Central banking, done differently

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: The past year has provided researchers, academics and practitioners of finance an extraordinary stage for expanding their understanding of changed dynamics of financial markets born of the emergence of a largely unregulated “shadow” banking system (the SIVs, CDO-squareds, monolines and such other arcane jargon). Fascinating as the above subject is, the most debated issue has been the conduct of monetary policy, in particular the role of the Federal Reserve Board. The slew of responses that the Fed has “innovated” have highlighted an important issue: the best means for a central bank to address multiple objectives during times of acute stress in financial markets. Forget about the received wisdom of moral hazard and market discipline. It is now clear that, in times of acute financial stress, central banks willy-nilly have to provide “liquidity support” to their wards, given their systemic importance. This, however, interferes with management of systemic liquidity, which is crucial for maintaining the target policy rate, the basis of monetary policy. This is even more so than in normal times, when there are conflicts with other central bank objectives, one of which is facilitating payments. During the financial turmoil that began last year, for instance, the Federal Reserve could have eased the liquidity shortage by supplying the most liquid assets in the economy—bank reserves—but this would have driven market interest rates below the target rate and interfered with monetary policy objectives. The Fed had to develop new, indirect methods of supplying liquid assets such as the Term Securities Lending Facility, which swapped Treasury securities for less liquid collateral. To address this basic tension between money supply and monetary policy, an alternative approach to monetary policy implementation has attracted attention. In this context, a recent research paper from the Federal Reserve Board of New York (Keister, T., A. Martin and J. McAndrews, 2008, “Divorcing money from monetary policy) has highlighted a method of conducting monetary policy more efficiently that will strike a chord in India. The basic insight of this approach is to remove the opportunity cost to commercial banks of holding reserve balances by paying interest on these balances at the prevailing target rate. My apologies, then, if the following looks a trifle technical; you will see that the basic insight is very simple.