Economic Policy #05_06
Monetary Policy


Monetary Policy
•Objectives
•Institutions
•Instruments
•Transmission channels
•Rules in monetary policy
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Overview
•Money is old device but the concept of monetary policy (MP) emerged during interwar period
•During 50s and 60s MP was eclipsed by fiscal policy and primarily concentrated on minimizing the
cost of public borrowing
•In the 70s the role of MP was reassessed with disinflation as an overriding policy objective
•By the late 90s MP geared toward achieving price stability
•Financial crisis in 2008 highlighted  the role of CB as guarantors of financial stability, CB
engaged in unconventional MP actions
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What do central banks do?
•Central banks:
•
•issue banknotes
•provide banks with liquidity
•impose compulsory reserves on commercial banks
•act as ’lender of last resort’ to banks
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What is liquidity?
•Market liquidity: the ease with which a position in an asset can be liquidated without appreciably
altering its price. This concept is asset-specific. •Funding liquidity: the ease with which a
solvent institution can service its liabilities as they fall due. This concept is
institution-specific.
•
•The 2007-2008 crisis started as market-liquidity crisis (first on mortgage-backed securities, then
on all fixed-income markets) and morphed into a funding-liquidity crisis.
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Liquidity provision
•Liquidity is provided through:
•open market operations (purchases of financial assets by the CB from commercial banks)
•repurchase agreements or repos (CB holds the corresponding assets for a fixed period)
•
•In so doing central banks set price of liquidity and control the quantity of base money.
•
•CB can also influence the banks’ lending behaviour through reserve requirements.
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The objectives of monetary policy
•The objectives of MP varied significantly over time:
•
•in 70s CB had broad mandates involving difficult trade-offs between alternative targets
•after inflation period during 70s price stability emerged as dominant goal
•some CBs pursue other objectives simultaneously
•after financial crisis 2007-09 discussion about gearing MP more towards financial stability
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The objectives of MP: price stability #1
•Inflation should be neither too high:
–Shoeleather costs, menu costs, redistribution effects, uncertainty weighting on individual
decisions, risk of generalized indexation and ultimately of hyperinflation,..
–Ex: Germany in the 1930s, Argentina in the 80s, Zimbabwe in the 2000s,..
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The objectives of MP: price stability #2
•… nor too low
–Upward bias in measured CPI
–Risk of deflation and liquidity trap
–Downward rigidity of nominal wages points toward 1-4 % inflation band
–
–
•=> Most central banks have objectives between 1-3 %
•
•
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The pros and cons of stabilizing asset prices
Central banks have traditionally been reluctant to target asset prices, but:
• there are other instruments than the policy rate to promote financial stability (counter-
cyclical capital buffers, taxes)
• the debate has been revived by the crisis
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The objectives of MP: exchange rate stability
•Until 90s transition countries relied on a fixed exchange rates as a means of controlling
inflation •MP of many European countries was geared toward maintaining the external value of the
currrency vis-à-vis some larger country •The attraction of fixed exchange rates has faded away in
recent years
•
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The objectives of MP: output stabilization
•MP can be used to stabilize aggregate demand, i.e. support demand through an expansionary MP in
recession and a restrictive MP when demand is ballooning. •The rationale for counter-cyclical MP
goes back to the Great Depression in 1930s. •But desirability and effectiveness of counter-cyclical
MP are debated because of variable time lags involved in the transmission mechanism which can
transform MP into a procyclical policy.
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The objectives of MP: financial stability
•Usually not a formal objective, but in the ’genetic code’ of CB
•Responsibility of the CB as a lender of last-resort to banks is inevitable, but should be exerted
with great caution by:
–Limiting moral hazard
–Being closely connected with banking supervisors
–Coordinating with fiscal authority (because losses should be ultimately borne by taxpayers)
•Asset-price targeting as part of the central bank mandate?
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The mandates of four central banks (US Fed)
•Legal vehicle
–Full Employment and Balanced Growth Act (“Humphrey Hawkins Act”)
•Price stability
–Yes
•Exchange-rate stability
–No, but may intervene on exchange markets, at the request of the US Treasury
•Output stabilization
–Yes, on an equal footing with price stability
•Financial stability
–Yes
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The mandates of four central banks (ECB)
•Legal vehicle
–EU Treaty (since Maastricht Treaty of 1992)
•Price stability
–Yes
•Exchange-rate stability
–No, but exchange rates are part of the second pillar of the monetary-policy strategy, and the ECB
has the sole right to conduct foreign-exchange operations
•Output stabilization
–No, but may intervene on exchange markets
•Financial stability
–Not explicitly
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The mandates of four central banks (Bank of England)
•Legal vehicle
–Bank of England Act, 1998
•Price stability
–Yes, definition of price stability belongs to government
•Exchange-rate stability
–No
•Output stabilization
–Yes, secondary to price stability
•Financial stability
–Yes
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The mandates of four central banks (Bank of Japan)
•Legal vehicle
–Bank of Japan Law, 1997
•Price stability
–Yes
•Exchange-rate stability
–No, but may be instructed to intervene to exchange markets
•Output stabilization
–No, only as a consequence of price stability
•Financial stability
–Yes
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Mandates of CB: key differences
•US Fed has dual mandate of full employment and price stability, while ECB has not
•ECB decides on objectives, while BoE and RBNZ do not
•Crisis has prompted fresh discussion on the central bank role in financial stability •Example:
creation in 2011 of European Systemic Risk Board chaired by ECB President.
•
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Central bank credibility
•CB credibility is very important  for effective MP.
•
•If the CB exploits expectation errors of economic agents and targets a higher level of output
(i.e. output above its natural level) in order  to reduce unemployment, the outcome is bound to be
inflationary because only structural policies can lower structural unemployment. The other result
is a lack of credibility.
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Central bank credibility (cont.)
•How can CB enhance its credibility?
•By adequate institutional design (independence, transparency and accountibility)
•By tying its hands: exchange rate peg, monetary policy rules
•By selecting conservative central bankers, i.e. more adverse to inflation than the average of
society (K. Rogoff)
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Central bank transparency
•Ejffinger and Geraats (2006): the extent to which central banks disclose information that is
related to the policymaking process
–political transparency (information on policy objectives)
–procedural transparency (the way monetary decisions are taken)
–policy transparency (explanation of policy decisions)
–operational transparency (information on errors and unexpected events).
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Central bank transparency index (2002)
Aus
Can
Euro
Jap
NZ
Swe
Swi
UK
US
Political
3
3
3
1.5
3
3
2.5
3
1
Economic
2
2.5
2.5
1.5
3
2
1.5
3
2.5
Procedural
1
1
1
2
3
3
1
3
2
Policy
1.5
2
2
1.5
3
3
2
1.5
3
Operational
1.5
2
2
1.5
2
3
0.5
2.5
1.5
Total
9
10.5
10.5
8
14
14
7.5
13
10
Source: Eijffinger&Geraats (2006)
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Central bank independence
•Consider three measures of CB independence:
•instrument independence: the central bank is free to set any monetary policy instrument/variable
•goal independence: the central bank is free to set its own goals for monetary policy
•political independence: the central bank is able to conduct monetary policy without legislative
influence
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Importance of CB independence
•Why is CB independence so important?
•independent central bank is insulated from the political pressures
•fiscal policy tends to follow a political business cycle, if central banks were subject to
political approval, monetary policy would also follow this volatile pattern
•elected politicians do not have the technical savvy to conduct monetary policy
•If the CB was beholden to political interests, the federal government could amass large budget
deficits then turn to the Fed to pay off its debts
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CB independence
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•Increasing number of countries granted full independence to their CB during 1990s and 2000s.
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CB independence and inflation
•
•
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•
•
•
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•This institutional move to  independence resulted from the better ability of independent CB to
cope with the inflationary pressures of previous decades.
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What relation between FP and MP?
•FP and MP are interdependent in the long run because unsustainable FP deteriorates monetary
stability (e.g. 2002 crisis in Argentina).
•In the short run, there is no consensus about desirable policy-mix:
•FP and MP should be coordinated, because governments and CBs are jointly responsible for
macroeconomic management and noncooperative equilibrium could emerge (result: MP is too tight and
FP too relaxed)
•Opponents: coordination by nature threatens CB independence; full independence solves
game-theoretical problem => monetary dominance regime
•Infrequent in peacetime is fiscal policy regime, where MP ensures solvency of government.
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Central bank accountability
•CB accountability reflects its exposure to external scrutiny and its answerability vis-à-vis its
principal.
•in most countries CB are accountable to the legislative branch
–US ‘Humphrey Hawkins’ testimony
–‘Monetary dialogue’ at European Parliament
–BoE governor letter
•
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Accountability in New Zealand
•Before appointing the Governor, the Minister is required to fix policy targets during that
person's term of office
•The Bank delivers to the Minister and publishes at least every six months a monetary policy
statement reviewing and assessing recent monetary policy and articulating the policies and means by
which the Bank intends to achieve the policy targets
•The Minister may seek the removal of the Governor if inter alia:
–the Bank does not adequately carry out its functions (the primary function being monetary policy);
or
–the performance of the Governor in ensuring the Bank achieves the policy targets has been
inadequate; or
–a monetary policy statement is inconsistent in a material respect with the Bank's primary
function, or with any policy target fixed in the Policy Targets Agreement.
•
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Communication
•Central banks can reduce uncertainty by communicating relevant information about macroeconomic
fundamentals, the condition of financial institutions and the financial sector more generally, and
the conduct of policy.
•Their communication differs quite a lot
–ECB Press conference (ECB)
–Disclosure of FOMC and BoE MPC meetings minutes and individual votes
–Disclosure of expected interest rate path by Swedish Riskbank, Bank of Norway, RBNZ, Fed
•
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Instruments of European Central Bank (ECB)
•Minimum reserves (1 % of the demand deposits and of time deposits shorter than two years)
•Two overnight standing facilities:
–Marginal lending facility (ceiling rate)
–Marginal deposit facility (floor rate)
•Weekly refinancing operations (competitive bids through which ECB provides liquidity against
collateral => refinancing rate (the main rate of Eurosystem)
•
•These three rates are sometimes called leading interest rates. Interbank rate fluctuates between
floor and ceiling rate and in normal time close to refinancing rate.
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Conventional and non-conventional reactions to the crisis
•Lower official rates
•Massive liquidity provision
–Extension of refinancing maturity (up to 3 years)
–Fixed rate, full allotment tenders (ECB)
–New instruments such as TALF (Fed), covered bonds purchase program (ECB)
–Broader collateral basket
–Quantitative easenning (Fed, ECB, BoE, BoJ)
•International liquidity arrangements
–Currency swap lines
–Short-term IMF financing
•Repairing transmission mechanisms
–ECB’s temporary ’Securities Market Program’ and ’Outright Monetary Transactions’
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Refinancing rates and market rate in euro area
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Refinancing rates in the US, the euro area and Japan
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Transmission channels of MP
Transmission channels: the way monetary policy
 decisions affect output and inflation
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The interest rate channel
•Traditional Keynesian channel:
•Monetary expansion in the presence of nominal rigidities leads to a fall in the interest rate,
hence to a revival of investment and durable-goods consumption and via multiplier affect to rise of
aggregate demand (AD)
•Uncertainty: CB can directly affect overnight nominal interest rate, while AD rather depends on
expected real long-term interest rates.
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The asset-price channel
•Lower interest rate raises asset prices held by households, who in turn partially consume this
extra wealth, which then stimulates AD.
•E.g. Japan in the early 1990s, U.S. in 2001.
•The importance of this channel has increased as a consequence of the general rise in the
wealth-to-income ratio.
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The credit channel
•Lower policy rates stimulate commercial banks to relax credit constraints and hence to stimulate
credit supply.
•
•The banks’ financial health is crucial for the transmission of MP. When the banks’ balance sheets
are burdened with nonperforming loans (loans with high probability of default) or with impaired
assets (assets not traded any more or whose market value is much lower than they were purchased),
banks are less willing to grant new loans => credit crunch (e.g. Japan at the end 90s and beginning
of the 2000s).
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The risk taking channel
•Short-term interest rates play a key role in determining future bank profitability, the
risk-taking capacity of financial intermediaries and real activity.
•Relatively small changes in short-term interest rates can have a large impact on risk taking.
•A cut in the short rate induces lowly capitalized banks i) to expand credit to riskier firms, ii)
to end credit to riskier firms less often, iii) to more likely grant loans to applicants with a
worse credit history, and iv) to grant them larger loans or loans with a longer maturity than
highly capitalised firms.
–
•
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The foreign-exchange channel
•lower policy rates stimulate net exports through an exchange-rate depreciation (Mundell- Fleming)
•important in small, open economies
–interests rates alone cannot be sufficient indicator of the stance of monetary policy
–monetary condition index (MCI)
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ECB transmission mechanism
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Monetary-policy rules
•Rules useful to enhance credibility
•Intermediate targeting (e.g. of monetary aggregates) out of fashion
–however ECB’s monetary pillar has proved useful to monitor credit growth
•Inflation targeting (IT) has become increasingly popular in the 2000s:
–Target = CB inflation forecast, conditional on market expectation and policy rate
–IT requires transparency on models, procedures and forecasts
–Most central banks implement flexible inflation targeting, with some weight on the output gap
•
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Inflation targeting in 2012
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