23/10/18 1 Economic Policy #05 Monetary Policy Monetary Policy •  Introduc;on •  Instruments •  Objec;ves •  Ins;tu;ons •  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 disinfla;on as an overriding policy objec;ve •  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 unconven;onal MP ac;ons EP#05: Monetary policy 23/10/18 2 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 quan;ty 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 ;me deposits shorter than two years) •  Two overnight standing facili0es: –  Marginal lending facility (ceiling rate) –  Marginal deposit facility (floor rate) •  Weekly refinancing opera0ons (compe;;ve bids through which ECB provides liquidity against collateral => refinancing rate (the main rate of Eurosystem) These three rates are some;mes called leading interest rates. Interbank rate fluctuates between floor and ceiling rate and in normal ;me close to refinancing rate. EP#05: Monetary policy 23/10/18 3 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 Stránka 1 z 2http://hamodia.com/2013/05/03/ecb-cuts-benchmark-interest-rate-to-0-5-percent/ Printed from Hamodia.com FRANKFURT, Germany (AP) - BUSINESS ECB Cuts Benchmark Interest Rate to 0.5 Percent Friday, May 3, 2013 at 10:35 am | ‫תשע"ג‬ ‫אייר‬ ‫כ"ג‬ The European Central Bank cut its key interest rate to a record-low 0.50 percent Thursday, and announced other measures to spur lending and help lift the euro area out of a stubborn recession. ECB President Mario Draghi said the bank was prepared to flex its muscles further in the face of high and rising unemployment and growing evidence that Europe’s economy is getting weaker. He said the ECB stood “ready to act if needed,” but he also implored European governments – which responded to the region’s debt crisis by slashing spending – to do more to stimulate economic growth. On Wednesday, the U.S. Federal Reserve signaled it wouldn’t rule out taking more action to boost growth, and Fed Chairman Ben Bernanke warned America’s political leaders that their policies were holding back the economy. EP#05: Monetary policy The objec;ves of monetary policy The objec;ves of MP have varied significantly over ;me: •  in 70s CB had broad mandates involving difficult trade- offs between alterna;ve targets •  ager infla;on period during 70s price stability emerged as dominant goal •  some CBs pursue other objec;ves simultaneously •  ager financial crisis 2007-09 discussion about gearing MP more towards financial stability EP#05: Monetary policy 23/10/18 4 The objec;ves of MP: price stability #1 •  Infla;on should be neither too high: –  Shoeleather costs, menu costs, redistribu;on effects, uncertainty weigh;ng on individual decisions, risk of generalized indexa;on and ul;mately of hyperinfla;on,.. –  Ex: Germany in the 1930s, Argen;na in the 80s, Zimbabwe in the 2000s,.. EP#05: Monetary policy The objec;ves of MP: price stability #2 •  … nor too low –  Upward bias in measured CPI –  Risk of defla;on and liquidity trap –  Downward rigidity of nominal wages points toward 1-4 % infla;on band => Most central banks have objec;ves between 1-3 % EP#05: Monetary policy The objec;ves of MP: exchange rate stability •  Un;l 90s transi;on countries relied on a fixed exchange rates as a means of controlling infla;on •  MP of many European countries was geared toward maintaining the external value of the currrency vis-à-vis some larger country •  The anrac;on of fixed exchange rates has faded away in recent years EP#05: Monetary policy 23/10/18 5 The objec;ves of MP: output stabiliza;on •  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 ra;onale for counter-cyclical MP goes back to the Great Depression in 1930s. •  But desirability and effec;veness of counter-cyclical MP are debated because of variable ;me lags involved in the transmission mechanism which can transform MP into a procyclical policy. EP#05: Monetary policy The objec;ves of MP: financial stability •  Usually not a formal objec;ve, but in the ’gene;c code’ of CB •  Responsibility of the CB as a lender of last-resort to banks is inevitable, but should be exerted with great cau;on because of: –  Moral hazard problem –  Possible incompa;bility with price stability •  Asset-price targe;ng 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 foo;ng with price stability •  Financial stability –  Yes EP#05: Monetary policy 23/10/18 6 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 opera;ons •  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, defini;on 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 23/10/18 7 Mandates of CB: key differences •  US Fed has dual mandate of full employment and price stability, while ECB has not •  ECB decides on objec;ves, while BoE and RBNZ do not •  Crisis has prompted fresh discussion on the central bank role in financial stability •  Example: crea;on in 2011 of European Systemic Risk Board chaired by ECB President. EP#05: Monetary policy Central bank credibility CB credibility is very important for effec;ve MP. If the CB exploits expecta;on 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 infla;onary 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 selec;ng conserva0ve central bankers, i.e. more adverse to infla;on than the average of society (K. Rogoff) •  By incen0ve contracts EP#05: Monetary policy 23/10/18 8 Importance of CB independence Why is CB independence so important? •  independent central bank is insulated from the poli;cal pressures •  fiscal policy tends to follow a poli;cal business cycle, if central banks were subject to poli;cal approval, monetary policy would also follow this vola;le panern •  elected poli;cians do not have the technical savvy to conduct monetary policy •  If the CB was beholden to poli;cal 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. Independence, accountability and communication tral banks are (almost everywhere) pendent by law or by Treaties: They do not accept instructions from the executive branch (except in some cases on exchange-rate policy) Governors have long mandates y are accountable to the legislative ch US ‘Humphrey Hawkins’ testimony ‘Monetary dialogue’ at European Parliament BoE governor letter 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. 36 Bénassy-Quéré, Economic Policy, 2012-13 EP#05: Monetary policy CB independence and infla;on •  This ins;tu;onal move to independence resulted from the bener ability of independent CB to cope with the infla;onary pressures of previous decades. 10.11.17 19:13File:Alisna and Summers Central Bank Independence vs Inflation.gif - Wikimedia Commons Stránka 1 z 3https://commons.wikimedia.org/wiki/File:Alisna_and_Summers_Central_Bank_Independence_vs_Inflation.gif 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: 16 KB, MIME type: image/gif) The level of central bank independence compared to inflation. This is from data published by Alisna and Summers (1993) in the publication entitled, "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence". See: 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 applies worldwide. In some countries this may not be legally possible; if so: I grant anyone the right to use this work for any purpose, without any conditions, unless such conditions are required by law. The categories of this image should be checked. Check them now! (https://commons.wikimedia.org/w/index.php?ti tle=File:Alisna_and_Summers_Central_Bank_Independenc e_vs_Inflation.gif&action=edit&withJS=MediaWiki:Catchec k.js) Remove redundant categories and try to put this image in the most specific category/categories Remove this template by clicking here (https://commons.wikimedia.org/w/ index.php?title=File:Alisna_and_Summers_Central_Bank_Independence _vs_Inflation.gif&action=edit&withJS=MediaWiki:Catcheck.js) (or on the first line) Wikimedia Commons je dostupné v češtině [x] Open in Media Viewer EP#05: Monetary policy 23/10/18 9 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 legisla;ve influence EP#05: Monetary policy Central bank accountability •  CB accountability reflects its exposure to external scru;ny and its answerability vis-à-vis its principal. •  in most countries CB are accountable to the legisla;ve branch –  US ‘Humphrey Hawkins’ tes;mony –  ‘Monetary dialogue’ at European Parliament –  BoE governor lener EP#05: Monetary policy Communica;on •  Central banks can reduce uncertainty by communica;ng relevant informa;on about macroeconomic fundamentals, the condi;on of financial ins;tu;ons and the financial sector more generally, and the conduct of policy. •  Their communica;on differs quite a lot –  ECB Press conference (ECB) –  Disclosure of FOMC and BoE MPC mee;ngs minutes and individual votes –  Disclosure of expected interest rate path by Swedish Riskbank, Bank of Norway, RBNZ, Fed EP#05: Monetary policy 23/10/18 10 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 infla;on forecast, condi;onal on market expecta;on and policy rate – IT requires transparency on models, procedures and forecasts – Most central banks implement flexible infla;on targe;ng, with some weight on the output gap EP#05: Monetary policy C.S. Infla;on targe;ng in the Czech Republic EP#05: Monetary policy In the initial period of inflation targeting, the Czech National Bank used "net" inflation as its main analytical and communicative indicator of inflation. The CNB's medium-term inflation target for end–2000 was announced at the same time as the switch to inflation targeting, i.e. in December 1997. The central bank committed itself to employing its monetary policy instruments so as to achieve annual net inflation within the 3.5%–5.5% range at the end of 2000. To better anchor inflation expectations, the CNB also announced a target range for net inflation of 5.5%–6.5% for end–1998. In November 1998, a short-term net inflation target range of 4%–5% was set for end–1999.The CNB Monetary Strategy document published in April 1999 formulated a long-term objective of price stability in terms of net inflation within the 1%–3% range for end–2005. In April 2000, a target was set for end–2001 (see the accompanying document: The Setting of the Inflation Target for 2001 (pdf, 114 kB)). In April 2001, a decision was made to switch to targeting headline inflation (i.e. growth in the total consumer price index) and to expressing the target trajectory for headline inflation by means of a continuous band. A band was announced starting in January 2002 at 3%–5% and ending in December 2005 at 2%–4% (see the accompanying document: The Setting of the Inflation Target for 2002–2005 (pdf, 36 kB)). An inflation target of 3% with a tolerance band of one percentage point in either direction was announced for the period from January 2006 (see the accompanying document: The CNB's inflation target from January 2006 (pdf, 76 kB)). In March 2007, a new inflation target of 2% was announced with effect from January 2010. As before, the CNB will strive to ensure that actual inflation does not differ from the target by more than one percentage point on either side (see the accompanying document: The CNB's new inflation target and changes in monetary policy communication). The CNB bases its assessment of the inflation trend on the statistical data published by the Czech Statistical Office. The inflation outturns – which, within the inflation targeting regime, form the basis for both the conduct and retrospective assessment of monetary policy – are thus published by an institution independent of the CNB. This arrangement enhances the credibility of inflation targeting. Exceptions from achieving the inflation target (caveats/escape clauses) In the inflation targeting regime, the need for escape clauses derives from the occurrence of large shock changes in exogenous factors (particularly supply-side shocks) that are completely or largely outside the purview of central bank monetary policy. Attempts to keep inflation on target in these circumstances might cause undesirable volatility of output and employment. If such a shock deflects projected inflation from the target, the CNB does not respond to the primary impacts of the shock. It will apply an exemption (escape clause) from the obligation to hit the inflation target and accept the temporary deviation of the inflation forecast and consequently also future inflation from the target caused in this way. There is a whole range of shocks which can create room for applying such escape clauses. Changes to indirect taxes are one such shock. Click here for the latest inflation figures.   Copyright © Czech National Bank, 2003-2018 | All rights reserved Inflation targeting in the Czech Republic - Czech National Bank https://www.cnb.cz/en/monetary_policy/inflation_targeting.html 2 of 2 23/10/18, 07:09 Transmission channels of MP Transmission channels: the way monetary policy decisions affect output and infla;on EP#05: Monetary policy 23/10/18 11 The interest rate channel Tradi;onal Keynesian channel: •  Monetary expansion in the presence of nominal rigidi;es leads to a fall in the interest rate, hence to a revival of investment and durable-goods consump;on and via mul;plier 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 par;ally consume this extra wealth, which then s;mulates 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 ra;o. EP#05: Monetary policy The credit channel Lower policy rates s;mulate commercial banks to relax credit constraints and hence to s;mulate 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 23/10/18 12 The foreign-exchange channel •  lower policy rates s;mulate net exports through an exchange-rate deprecia;on (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 10.11.17 20:09European Central Bank Monetary Policy Stránka 2 z 3http://thismatter.com/money/banking/european-central-bank-monetary-policy.htm changing the refinancing rate to directly affect money market interest rates; setting expectations of future interest rates and inflation, which directly affects medium and long-term interest rates; changing saving and investment decisions of both households and firms, with higher rates increasing savings and investments while decreasing borrowing for consumption. Higher interest rates also increase the risk that borrowers will not be able to pay back their loans, thereby causing lenders to decrease the amount of available credit. Interest rates can also affect asset prices, since many assets are bought with borrowed money. Real estate is a prime example of an asset whose value varies with interest rates. 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 are called refinancing operations, which are weekly auctions of 2-week repurchase agreements in which the ECB, through the national central banks, provides reserves to banks in exchange for securities and then reverses the transactions 2 weeks later. The ECB's Governing Council, which sets monetary policy for the ECB, establishes a main minimum interest rate in the refinancing options, called the minimum bid rate, which is equivalent to the target federal funds rate. Unlike in the United States, where monetary policy is conducted by the Federal Reserve Bank of New York, refinancing operations take place at the National Central Banks < http://www.ecb.int/home/html/links.en.html > (NCBs). Any European financial institution that is subject to the ECB's reserve requirements may participate in the ECB's weekly auctions in contrast to the 20 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