The Complementarity of Interest Rate and Balance Sheet Policies

Interest rates and balance sheets: a unified framework for central banking

In this paper Andrey Alexandrov and Markus K. Brunnermeier ask: when a central bank has access to both conventional tools such as rates on required and excess reserves and unconventional tools such as QE/QT, how should it deploy them jointly to maximize social welfare?

The authors build a continuous-time macro-finance model with two agent types: households (bearing idiosyncratic capital risk) and financial intermediaries (who can partially diversify that risk)  who switch roles stochastically over time. Prices are sticky, generating a New Keynesian Phillips Curve. The central bank sets two separate interest rates on required and excess reserves, and manages the balance sheet by trading long-term bonds in real time, while the Treasury can only adjust taxes and bond issuance gradually.
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The analytical strategy proceeds in three steps: (i) characterize a constrained efficient allocation using a social planner endowed with richer fiscal instruments as a welfare benchmark; (ii) show where the laissez-faire competitive equilibrium falls short of that benchmark; and (iii) derive the optimal interest rate and balance sheet policy mix that implements the constrained efficient allocation in the decentralized economy.
Findings

• Dual inefficiencies, dual instruments. The model exhibits two distinct sources of welfare loss: (i) sticky prices causing aggregate output and consumption gaps; (ii) pecuniary externalities causing inefficient distribution of consumption and risk across agents. Interest rate policy is the natural remedy for the first; balance sheet policy is required for the second.​
• Interest rate policy suffices near the steady state but not far from it. With a fixed balance sheet, interest rate policy alone can close the output gap and achieve near-efficient distribution of consumption in a small vicinity around the stochastic steady state. However, as aggregate shocks push the economy away from the steady state, distributional efficiency requires active balance sheet management. ​
• Balance sheet policy plays a “preparatory” role. The central bank’s QE/QT operations work in advance of shocks since by positioning the private sector’s duration exposure efficiently, they ensure that subsequent interest rate moves redistribute risk and wealth in the optimal direction. After a balance sheet expansion, duration risk migrates off private agents’ balance sheets, requiring a more aggressive interest rate response to subsequent shocks.​
• Significant substitutability, but not full substitutability. When the two instruments address the two inefficiencies separately, they exhibit substitutability: generous QE requires aggressive rate moves later. However, when both inefficiencies must be addressed simultaneously, both instruments are uniquely pinned down as neither can substitute for the other.
• Two reserve rates are essential. The ability to set the excess reserves rate and the required reserves rate independently is critical. The excess reserves rate controls the immediate impact responses of the output gap and net worth distribution to a shock. The required reserves rate manages the transition path of the output gap following the shock.
• Intermediate bond market segmentation is optimal. Perfect market segmentation prevents the central bank from shifting bond holdings across agent types while a perfectly elastic distribution allows agents to fully hedge and precludes efficient risk allocation. Optimal policy implementation requires an intermediate degree of segmentation, so that QE can influence the distribution of duration risk without agents fully undoing the effect.

Optimal (Un)Conventional Monetary Policy
Authors: Andrey Alexandrov, Markus K. Brunnermeier
From: Tor Vergata University of Rome, Princeton University
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Beyond the rate: why central banks need their balance sheets

In this paper, Joseph Abadi asks: how do conventional interest rate policy and unconventional central bank asset purchases transmit to the real economy through financial markets, and how should they be jointly optimized?

The author develops a continuous-time New Keynesian model with capital built around two frictions absent from standard frameworks. First, financial intermediaries face investment mandates  making their asset demand downward sloping so that quantities affect prices. Second, households face transaction costs when reallocating savings across intermediaries, making portfolio adjustment sluggish. This creates a two-speed financial market: intermediaries price assets in the short run, households in the long run. Finally, the central bank controls two instruments: the short-term nominal interest rate and direct capital purchases financed by issuing bonds.

Findings

• The inelastic markets channel amplifies conventional monetary policy. An interest rate hike lowers asset prices, redistributing wealth away from leveraged intermediaries and increasing the risk premium amplifying the initial drop in investment and output beyond what a standard New Keynesian model would predict.
• Asset purchase unwinding can cause undershooting. When the central bank holds assets for an extended period, households gradually withdraw savings from the market in response to compressed risk premia. When the central bank eventually sells those assets, the intermediaries’ risk-bearing capacity is already depleted and prices undershoot their steady-state level, potentially triggering a recession.
• Interest rate cuts and asset purchases are complements. Under the optimal Ramsey policy, whenever the central bank purchases assets, it also cuts interest rates to boost the intermediaries’ wealth share and indirectly reinforce the effect of purchases. The two instruments work in the same direction during downturns.
• Optimal policy requires a “late-exit” strategy. The central bank commits to maintaining its balance sheet even after financial markets recover. This commitment makes asset prices more sensitive to a given balance sheet expansion. Markets price in the anticipated persistence of purchases, lowering yields more than if an immediate unwind was expected.

Monetary Policy with Inelastic Asset Markets
Author: Joseph Abadi
From: Federal Reserve Bank of Philadelphia