Title: Exploring the Impact of Financial Market Evolution on Monetary Policy Implementation
In January 2024, the Federal Reserve Board in Washington, D.C. released a paper titled “A Field Guide to Monetary Policy Implementation Issues in a New World with CBDC, Stablecoin, and Narrow Banks” in FEDS. This article aims to discuss the transmission effects of monetary policy implementation in the context of structural changes in financial markets, new policy tools, technological advancements, and regulatory developments.
Building upon previous research on the banking industry from scholars such as Tobin (1969) and Gurley and Shaw (1960), the author establishes a quantitative framework to analyze the relationship between regulatory developments in the banking and non-banking sectors and monetary policy implementation. This framework describes a set of interconnected supply and demand curves for all financial instruments in a financial market competition model, while considering the portfolio allocation costs and balance sheet costs of financial intermediaries. Additionally, the article specifically examines the impact of central bank digital currencies (CBDC), stablecoins, and narrow banks on deposits provided by these institutions, including retail and wholesale deposits. It also explores how these structural changes may affect interest rates and the size and structure of balance sheets. The study concludes that the introduction of new fixed-rate assets by the Federal Reserve or other financial intermediaries can have significant implications for equilibrium rates and the financial intermediation model, and may also affect the effectiveness of monetary policy tools, especially when these new financial assets are close substitutes for existing ones.
The baseline model used in this study, based on Chen et al. (2014), incorporates multiple sectors, including households, banks, non-banks, businesses, government, and foreign sectors. The author integrates insights from monetary theory and monetary policy perspectives on the banking industry, following Tobin’s (1969) approach, and derives the demand for financial assets by each sector using a simple portfolio optimization framework. The key element of this framework is portfolio habit, which defines the benchmark asset and liability allocations for households and financial intermediaries. While households and financial intermediaries can deviate from these habit allocations, doing so incurs portfolio costs. In addition to portfolio composition costs, financial intermediaries also face costs associated with expanding their balance sheets.
The equilibrium interest rates described in this article can be simplified into two aspects: one that describes the combination of loan rates and treasury rates consistent with the loan market equilibrium, and another that describes the combination of loan rates and treasury rates consistent with the treasury market equilibrium.
Furthermore, the equilibrium interest rates for deposits and non-bank debts can be represented in the baseline model assumptions by the orange line on the right side of Figure 1. The spread between deposit rates and non-bank debt rates reflects the difference between reserve management rates and other Federal Reserve liability management rates, as well as the relative demand for deposits and non-bank debts by households. The funding market equilibrium relationship, depicted by the green line in the figure, describes the balance between households’ desire to invest in deposits and non-bank debts and the supply of deposits and non-bank debts provided by banks and non-banks. The position of this curve is strongly influenced by the weighted average asset return rates of banks and non-banks and the asset rates competing with deposits and non-bank debts in households’ investment portfolios.
In addition, since households have relatively strong habits regarding their desired holdings of financial assets, their preferences largely determine the relative size of financial intermediaries. Specifically, the relative size of bank, non-bank, and Federal Reserve balance sheets is primarily driven by households’ relative demand for deposits, non-bank debts, and physical currency. The asset composition of banks and non-banks largely reflects the habits of these sectors.
The article considers three variants of the baseline model, taking into account central bank digital currencies (CBDC), stablecoins, and narrow banks. The first variant considers the inclusion of retail and wholesale CBDC. In this model, only households can invest in retail CBDC, while banks and non-bank financial institutions can invest in wholesale CBDC.
The second variant introduces stablecoins issued by narrow non-bank institutions, which are held only by households.
The third variant considers the role of narrow banks, which issue deposits and hold assets only in the form of reserves.
For example, Figure 3 illustrates the substitution effect of introducing a new interest-bearing asset on household deposit demand. The left part shows the initial household deposit curve, which is upward sloping, with the deposit rate plotted on the vertical axis. When the deposit rate equals the reference rate for the investment portfolio, the demand for deposits by households matches the habitual level of deposits. The right part shows the assumed impact of introducing a new interest-bearing asset on this deposit curve. If the new financial asset attracts habitual demand levels at the expense of deposits, the habitual deposit level will decrease, as shown by the movement from the black line to the green line. If the new financial asset offers interest, the reference rate for the investment portfolio also changes. The figure shows the impact when the reference rate increases from the green line to the red line. Finally, based on the assumption of habit deviation costs, if the habitual deposit level decreases, the slope of the deposit line becomes steeper, as shown by the rotation from the red line to the blue line. All these types of substitution effects play a significant role in the model.
In particular, the article suggests that central bank digital currencies (CBDC) are a new financial asset and studies the first variant of the baseline model, considering retail and wholesale CBDC denoted as R_CBDC and W_CBDC, respectively. R_CBDC is held only by households and serves as a new financial asset and investment tool, with corresponding new liabilities for the Federal Reserve. The study assumes that households have a “habit” for R_CBDC, similar to their habits for other financial assets. The introduction of R_CBDC in the model also requires a new Federal Reserve liability management rate, ???_???????, assumed to be zero to match the assumed rate for physical currency. Additionally, the study assumes that the rate for W_CBDC is set at a level equivalent to the reserves held by financial intermediaries or other liabilities of the Federal Reserve.
The study’s findings indicate that changes in all managed rates by the Federal Reserve – the nominal rate for physical currency, retail CBDC, reserves, other Federal Reserve liabilities, and wholesale CBDC – as well as the equilibrium loan rate, result in a one-to-one transmission of all market rates. In this case, all spreads remain unaffected, and therefore, equilibrium quantities are also unaffected. The equilibrium in the extended model largely depends on assumptions about the habit changes of households and financial intermediaries. Generally, if the portfolio habit for retail or wholesale CBDC is at the expense of the habit for another liability of the Federal Reserve or treasury, the equilibrium in the model remains largely unchanged compared to the baseline model.
Specifically, the increase in the retail CBDC rate exerts upward pressure on interest rates. As shown in Figure 4, the rise in the R_CBDC rate causes the loan market equilibrium curve to move upward, resulting in an increase in loan rates and a decrease in treasury rates. This change also moves the funding market equilibrium line outward, leading to an increase in deposit rates and non-bank debt rates. The increase in the R_CBDC rate causes households to shift from other assets to R_CBDC. This reduction in available funds in the deposit and non-bank debt markets results in a contraction of asset sizes for both banks and non-banks, with all asset categories experiencing this decline to some extent. There is a slight negative impact on the total loan volume. On the Federal Reserve’s balance sheet, reserves, wholesale CBDC, other liabilities, and currency decrease, while retail CBDC increases. Overall, the size of the Federal Reserve’s balance sheet expands.
For wholesale CBDC, as it is held by both banks and non-bank institutions, an increase in the W_CBDC rate directly affects their asset allocation. The impact of the W_CBDC rate on interest rates is shown in Figure 5, similar to the case of the reserve rate and other Federal Reserve liability rates in the baseline model. As shown in the left graph, the increase in the W_CBDC rate causes the loan market equilibrium curve to move upward and to the left, while also lifting the treasury market equilibrium curve. The latter effect is due to the assumption that the W_CBDC rate becomes part of the “benchmark” rate on the demand curve for foreign sector treasury. The net effect is an increase in both treasury rates and loan rates. These increases result in an increased demand for funds by banks and non-banks, as indicated by the outward movement of the funding market equilibrium line in the right graph, leading to an increase in deposit rates and non-bank debt rates.
In conclusion, this analysis highlights several ways in which technological, regulatory, and financial structural changes may interact with the implementation and transmission of monetary policy. In recent years, the Federal Reserve has introduced fixed-rate assets in the form of interest-bearing reserves and fixed-rate overnight reverse repurchase agreements, creating powerful new tools for policy implementation, especially in an environment of ample reserve conditions. Therefore, when the Federal Reserve (in the form of retail and wholesale CBDC) or specialized financial intermediaries (in the form of stablecoins or narrow banks’ deposits) introduce additional fixed-rate financial assets, they interact with existing markets and institutions, impacting important aspects of policy implementation and transmission. These effects are most pronounced when the new fixed-rate tools become approximate substitutes for existing financial instruments.
Note: The article contains specific diagrams and figures, which have not been included in this rewritten version.
