These purchases were funded primarily by increasing the stock of reserve balances in the banking system, which compelled changes in the operating framework the Fed uses to achieve interest rate control.4 With an abundant supply of reserve balances, variations in their supply— the mechanism through which the Fed implemented monetary policy before the crisis—would no longer cause meaningful changes in federal funds rates or other money market rates. Implementation of monetary policy therefore required a new operational approach. The Fed’s current policy implementation framework uses a system of rates that it directly administers to influence the level of short-term interest rates, without needing to actively adjust the supply of reserves. Specifically, the Fed uses the rate of interest paid on excess reserves (IOER) held by depository institutions as its primary tool for keeping the federal funds rate in its target range. It supplements this tool by offering overnight reverse repos (ON RRPs) at a specified offering rate to a broad set of counterparties, including eligible money market funds, government-sponsored enterprises, primary dealers, and banks.5 Together, IOER and ON RRPs set a floor on rates, beneath which bank and nonbank financial institutions with access to these facilities should be unwilling to lend funds.6 This framework has been working very well. Since December 16, 2015, when the FOMC began the process of normalizing the stance of monetary policy, it has raised its federal funds target range four times to a current range of 1 to 1¼ percent.
Stress testing is an example of a top-down tool we could consider: does the capital position suggested by the detailed, bottom-up modelling deliver resilience at both firm- and sector level to common, real world shocks that we can reasonably expect them to withstand? Stress testing may not be the only additional tool. The government has an objective of facilitating productive investment to aid recovery and adaptation – not just to the structural changes wrought by the experience of the pandemic, but also to the equally severe, long term threat of climate change. Insurers are embracing the part that they can play in financing the transition to a net zero carbon economy with their long term investment. But many of the projects that take us to net zero will be innovative and lacking an historical track record: there is a legitimate concern that the riskiness of such projects will be overstated by capital modelling that relies heavily on historical data for its inputs and for validation. At the same time the prudential regime has to reflect the economic risks involved. We are interested in the possibility for equally innovative risk measurement tools that have the flexibility to cope with any such bias in existing modelling methods, and deliver a balanced risk assessment: I welcome your thoughts on this directly or in responses to the Solvency II call for evidence. Conclusion In finance, the ‘Greeks’ have become synonymous with the inner workings of models for pricing derivatives – a fox-like activity if ever there was one.