Economic Policy #05 Monetary Policy Monetary Policy •  Introduc6on •  Instruments •  Objec6ves •  Ins6tu6ons •  Transmission channels EP#05: Monetary policy 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 disinfla6on as an overriding policy objec6ve •  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 unconven6onal MP ac6ons EP#05: Monetary policy 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 EP#05: Monetary policy Liquidity provision Liquidity is provided through: •  open market opera0ons (purchases of financial assets by the CB from commercial banks) => federal funds rate (U.S.) •  repurchase agreements or repos (CB holds the corresponding assets for a fixed period) => refinancing rate In so doing central banks set price of liquidity and control the quan6ty of base money. CB can also influence the banks’ lending behaviour through reserve requirements. EP#05: Monetary policy C.S. Instruments of European Central Bank (ECB) •  Minimum reserves (1 % of the demand deposits and of 6me deposits shorter than two years) •  Two overnight standing facili0es: –  Marginal lending facility (ceiling rate) –  Marginal deposit facility (floor rate) •  Weekly refinancing opera0ons (compe66ve bids through which ECB provides liquidity against collateral => refinancing rate (the main rate of Eurosystem) These three rates are some6mes called leading interest rates. Interbank rate fluctuates between floor and ceiling rate and in normal 6me close to refinancing rate. EP#05: Monetary policy Refinancing rates and market rate in euro area Refinancing rates and market rates in the Eurozone Source: ECB. Bénassy-Quéré, Economic Policy, 2012-13 EP#05: Monetary policy Refinancing rates in the US, the euro area and Japan 10.11.17 19:54ECB Cuts Benchmark Interest Rate to 0.5 Percent - Hamodia Jewish and Israel News Printed from Hamodia.com BUSINESS ECB Cuts Benchmark Interest Rate to 0.5 Percent EP#05: Monetary policy The objec6ves of monetary policy The objec6ves of MP have varied significantly over 6me: •  in 70s CB had broad mandates involving difficult trade- offs between alterna6ve targets •  aeer infla6on period during 70s price stability emerged as dominant goal •  some CBs pursue other objec6ves simultaneously •  aeer financial crisis 2007-09 discussion about gearing MP more towards financial stability EP#05: Monetary policy The objec6ves of MP: price stability #1 •  Infla6on should be neither too high: –  Shoeleather costs, menu costs, redistribu6on effects, uncertainty weigh6ng on individual decisions, risk of generalized indexa6on and ul6mately of hyperinfla6on,.. –  Ex: Germany in the 1930s, Argen6na in the 80s, Zimbabwe in the 2000s,.. EP#05: Monetary policy The objec6ves of MP: price stability #2 •  … nor too low –  Upward bias in measured CPI –  Risk of defla6on and liquidity trap –  Downward rigidity of nominal wages points toward 1-4 % infla6on band => Most central banks have objec6ves between 1-3 % EP#05: Monetary policy The objec6ves of MP: exchange rate stability •  Un6l 90s transi6on countries relied on a fixed exchange rates as a means of controlling infla6on •  MP of many European countries was geared toward maintaining the external value of the currrency vis-à-vis some larger country •  The amrac6on of fixed exchange rates has faded away in recent years EP#05: Monetary policy The objec6ves of MP: output stabiliza6on •  MP can be used to stabilize aggregate demand, i.e. support demand through an expansionary MP in recession and a restric0ve MP when demand is ballooning. •  The ra6onale for counter-cyclical MP goes back to the Great Depression in 1930s. •  But desirability and effec6veness of counter-cyclical MP are debated because of variable 6me lags involved in the transmission mechanism which can transform MP into a procyclical policy. EP#05: Monetary policy The objec6ves of MP: financial stability •  Usually not a formal objec6ve, but in the ’gene6c code’ of CB •  Responsibility of the CB as a lender of last-resort to banks is inevitable, but should be exerted with great cau6on because of: –  Moral hazard problem –  Possible incompa6bility with price stability •  Asset-price targe6ng as part of the central bank mandate? EP#05: Monetary policy 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 stabiliza0on –  Yes, on an equal foo6ng with price stability •  Financial stability –  Yes EP#05: Monetary policy 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 opera6ons •  Output stabiliza0on –  No, but may intervene on exchange markets •  Financial stability –  Not explicitly EP#05: Monetary policy The mandates of four central banks (Bank of England) •  Legal vehicle –  Bank of England Act, 1998 •  Price stability –  Yes, defini6on of price stability belongs to government •  Exchange-rate stability –  No •  Output stabiliza0on –  Yes, secondary to price stability •  Financial stability –  Yes EP#05: Monetary policy 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 stabiliza0on –  No, only as a consequence of price stability •  Financial stability –  Yes EP#05: Monetary policy Mandates of CB: key differences •  US Fed has dual mandate of full employment and price stability, while ECB has not •  ECB decides on objec6ves, while BoE and RBNZ do not •  Crisis has prompted fresh discussion on the central bank role in financial stability •  Example: crea6on in 2011 of European Systemic Risk Board chaired by ECB President. EP#05: Monetary policy Central bank credibility CB credibility is very important for effec6ve MP. If the CB exploits expecta6on 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 infla6onary because only structural policies can lower structural unemployment. The other result is a lack of credibility. EP#05: Monetary policy Central bank credibility (cont.) How can CB enhance its credibility? •  By adequate ins0tu0onal design (independence, transparency and accountability) •  By tying its hands: exchange rate peg, monetary policy rules •  By selec6ng conserva0ve central bankers, i.e. more adverse to infla6on than the average of society (K. Rogoff) •  By incen0ve contracts EP#05: Monetary policy Importance of CB independence Why is CB independence so important? •  independent central bank is insulated from the poli6cal pressures •  fiscal policy tends to follow a poli6cal business cycle, if central banks were subject to poli6cal approval, monetary policy would also follow this vola6le pamern •  elected poli6cians do not have the technical savvy to conduct monetary policy •  If the CB was beholden to poli6cal interests, the government could amass large budget deficits then turn to the CB to pay off its debts EP#05: Monetary policy CB independence •  Increasing number of countries granted full independence to their CB during 1990s and 2000s. communication st everywhere) by Treaties: structions from the ept in some cases on mandates o the legislative ins’ testimony at European Parliament on differs quite a lot e (ECB) and BoE MPC meetings al votes d interest rate path by ank of Norway, RBNZ , 36 Bénassy-Quéré, Economic Policy, 2012-13 EP#05: Monetary policy CB independence and infla6on •  This ins6tu6onal move to independence resulted from the bemer ability of independent CB to cope with the infla6onary pressures of previous decades. File:Alisna and Summers Central Bank Independence vs Inflation.gif From Wikimedia Commons, the free media repository No higher resolution available. Alisna_and_Summers_Central_Bank_Independence_vs_Inflation.gif ​(405 × 282 pixels, file size MIME type: image/gif) The level of central bank independence compared to inflation. This is from data published by Alisna and Summers publication entitled, "Central Bank Independence and Macroeconomic Performance: Some Comparative Ev http://ideas.repec.org/a/mcb/jmoncb/v25y1993i2p151-62.html I, the copyright holder of this work, release this work into the public domain. This app worldwide. Wikimedia Commons je dostupné v češtině Open in Media Viewer EP#05: Monetary policy 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 •  poli0cal independence: the central bank is able to conduct monetary policy without legisla6ve influence EP#05: Monetary policy Central bank accountability •  CB accountability reflects its exposure to external scru6ny and its answerability vis-à-vis its principal. •  in most countries CB are accountable to the legisla6ve branch –  US ‘Humphrey Hawkins’ tes6mony –  ‘Monetary dialogue’ at European Parliament –  BoE governor lemer EP#05: Monetary policy Communica6on •  Central banks can reduce uncertainty by communica6ng relevant informa6on about macroeconomic fundamentals, the condi6on of financial ins6tu6ons and the financial sector more generally, and the conduct of policy. •  Their communica6on differs quite a lot –  ECB Press conference (ECB) –  Disclosure of FOMC and BoE MPC mee6ngs minutes and individual votes –  Disclosure of expected interest rate path by Swedish Riskbank, Bank of Norway, RBNZ, Fed EP#05: Monetary policy What monetary strategy? •  Monetary rules useful to enhance credibility •  Intermediate targe0ng (e.g. of monetary aggregates) out of fashion •  Infla3on targe3ng (IT) has become increasingly popular in the 2000s: – Target = CB infla6on forecast, condi6onal on market expecta6on and policy rate – IT requires transparency on models, procedures and forecasts – Most central banks implement flexible infla6on targe6ng, with some weight on the output gap EP#05: Monetary policy C.S. Infla6on targe6ng in the Czech Republic EP#05: Monetary policy In the initial period of inflation targeting, the Czech National Bank used "net" inflation as its m communicative indicator of inflation. The CNB's medium-term inflation target for end–2000 w time as the switch to inflation targeting, i.e. in December 1997. The central bank committed its monetary policy instruments so as to achieve annual net inflation within the 3.5%–5.5% range better anchor inflation expectations, the CNB also announced a target range for net inflation of end–1998. In November 1998, a short-term net inflation target range of 4%–5% was set for en Monetary Strategy document published in April 1999 formulated a long-term objective of pric Inflation targeting in the Czech Republic - Czech National Bank https://www.cnb.cz/en/monet Transmission channels of MP Transmission channels: the way monetary policy decisions affect output and infla6on EP#05: Monetary policy The interest rate channel Tradi6onal Keynesian channel: •  Monetary expansion in the presence of nominal rigidi6es leads to a fall in the interest rate, hence to a revival of investment and durable-goods consump6on and via mul6plier 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. EP#05: Monetary policy The asset-price channel •  Lower interest rate raises asset prices held by households, who in turn par6ally consume this extra wealth, which then s6mulates 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 ra6o. EP#05: Monetary policy The credit channel Lower policy rates s6mulate commercial banks to relax credit constraints and hence to s6mulate 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). EP#05: Monetary policy The foreign-exchange channel •  lower policy rates s6mulate net exports through an exchange-rate deprecia6on (Mundell- Fleming) •  important in small, open economies –  interests rates alone cannot be sufficient indicator of the stance of monetary policy –  monetary condi0on index (MCI) EP#05: Monetary policy ECB transmission mechanism Interest rates also affect aggregate demand and supply, which can have an effect on wages and prices in general. Low interest rates generally increase borrowing because of the increase in asset prices that are used as collateral, instilling greater confidence in the borrowers and the lenders, and because lenders are willing to take more risks to earn a higher yield. The result of keeping interest rates low for too long is what partly caused the 2008 credit crisis. A flowchart depicting the monetary policy transmission mechanism from target interest rates to changes in market prices. Economic shocks that affect prices, but which the central bank cannot control, include large changes in the global economy, bank capital, fiscal policy, and commodity prices. Monetary Policy Operations The ECB rarely buys securities outright. Reserves are provided to the European banking system primarily through what EP#05: Monetary policy Reference textbook Bénassy-Quéré, A. et al. Economic Policy : Theory and prac0se. Oxford University Press, 2010. Chap. 4 EP#04: Fiscal Policy