Section I: market oriented, interest-based systems

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1 Interest based versus non-interest monetary policy instruments Second Draft S. Ahmad R. Jalali-Naini, IMPS, MBRA, Tehran, Iran January 2011 Section I: market oriented, interest-based systems Monetary Policy Goals: inflation, resource utilization, & lately financial stability. Issue: a successful monetary policy requires a nominal anchor, a variable that a central bank utilizes to discipline its decisions & to convince the public of its credibility. To maintain the nominal anchor (exchange rate, money supply growth rate, inflation rate, price level, ) close to the targeted value, the policy maker must have instruments (tools) at its disposal to achieve the task at hand. ١

2 Classic Question: money or interest rate as the monetary policy instrument Poole (1970): assuming the CB can control interest rate & money supply instruments, if the aim is to minimize deviation of output from targeted value, the optimal instrument choice depends on the coefficients of a stochastic IS-LM model, variance of the error terms in these two functions & their covariances. No definitive conclusion. Friedman (1975), McCallum & Hoehn (1983), Benavie & Froyen (1983): if the variance of real expenditure disturbance is lower than that for the financial sector, interest rate is superior to a money aggregate instrument. Cover & VanHoose (2000): pervasive adoption of interestrate instruments is due to credibility gains by a conservative central bank. Criteria of choice between money growth rates, interest rates, or exchange rates Choice depends on several instrument characteristics. Assuming controllability, it depends on transparency, tightness & on whether authorities can commit to future monetary policies (Atkeson, Kehoe, & Chari 2007). Tightness is a desirable feature of a MP instrument. A more transparent instrument is more revealing of the actions of the policy maker to the public. Transparency is desirable particularly when the policymaker cannot commit to future policies. ٢

3 Criteria for instrument choice AKC (2007) suggests that in economies with developed financial markets, interest rates are the best monetary policy (MP) instrument & exchange rates is the next-best. Instruments transparency: Prices are in general much more transparent than quantities as policy instruments. Calvo & Vegh (1999), think more transparent instruments have a natural advantage relative to less transparent instruments. Because the exchange rate (ER) is a price (not a quantity), ER provides a much more transparent signal to the public of the central bank s intentions & actual actions than a money quantity target. Inflation Targeting (IT) & instrument choice Mainly due to instability of demand for money & unsuccessful experience with use of ER as the nominal anchor, money supply & ER control has been out of favor after the mid-1980s, instead use of interest rate instruments has since become widespread particularly in economies with deep financial markets. Under IT short term interest rates are the main policy instrument. The operating target is the policy rate & its intermediate target is the inflation forecast. Advocates: IT makes Monetary policy (MP) more transparent, reduces uncertainty & improves the coordination between MP & other macroeconomic policies. However, IT requires an independent CB to implement policy effectively. Others: non-targeters also did not have an inferior economic performance (Ball & Sheridan 2005). ٣

4 Under Flexible IT (FIT) the objective is to stabilize inflation around the target rate & output around the potential Under FIT, MP is reduced to forecast targeting & the instrument is a choice of policy-rate path such that the corresponding forecasts of inflation & output best stabilize inflation around the desired rate & output around the potential rate. Under IT & FIT, CB have instrument independence not necessarily goal independence. IT as a framework for MP has been widely practiced since the early 1990s. US does not follow IT but incorporates some features of IT. Instrument rules & Targeting rules A distinction should be made between instrument rules, i.e. the formula for setting controllable instrument variables in response to current economic conditions, & targeting rules. Svensson (2003) makes a case for the use of targeting rules as compared to targeting instruments e.g. Taylor rule. There is no single approach to policy rule analysis which is uniquely legitimate. Targeting rules are appropriate & convenient for some problems/conditions while instrument rules are for others. (McCallum & Nelson 2005). ۴

5 IT & Financial Crisis (FC) of Before the FC dominant view favored maintaining lowinflation as the best role for a CB, considering the alternatives. While fairly effective in controlling inflation, IT cannot deliver financial stability. Neither price stability nor interest-rate policy is sufficient to achieve financial stability. Svensson (2011). The recent FC has changed the above view. Maintaining inflation & financial stability is a means to the ultimate goal of sustainable economic growth and social welfare. Given the ramifications of unstable financial markets on the ultimate goal of CBs, maintaining orderly financial markets is currently a consideration CB cannot be oblivious to. 2 alternatives for linking IT with macro-prudential policies: treat credit growth & asset prices as targets and enter them into an (explicit or implicit) loss functions along with resource utilization (output gap management) & inflation or continue with flexible IT but impose bank level prudential regulation as part of Financial Stability Policy (FSB). Financial Crisis & policy rate instrument efficacy Financial systems based on debt & leverage are prone to speculation & bubbles, however, the policy instrument under an IT regime is not very effective for ensuring financial stability. Setting policy rates at sufficiently high levels to check credit expansion, increased leverage, the rise of asset (house) prices, & speculation will have a strong adverse influence on inflation & output gap. Too much reliance on interest rates to prevent credit expansion, rising leverage, & unsustainable asset price increases can be socially costly in terms of output & employment. ۵

6 Distinguishing between MP & FS policies & instruments A sensible strategy is to formulate a financial stability (package with a suitable set of instrument. MP & financial-stability policy (FSP) should be distinguished because they have different objectives & require different suitable instruments. MP should be aimed at price stability & countercyclical management. FSP should be directed at monitoring, supervision, & regulation of financial intermediaries for prudential conduct & guard against excessive credit creation. Monetary & Financial Stability Policy Distinction of MP & FS, however, does not & should not imply the absence of interaction between them. MP, via low interest rates influences asset prices, which given supporting conditions, can set off price bubbles. In the absence of FSP, leveraging can over-expand balance sheets. FSP directly affects financial conditions at the micro & macro levels, thereby influencing the transmission mechanism of monetary policy. Currently most of central banks have responsibility for both kinds of policies. What is the best institutional arrangement? ۶

7 Section II: interest based systems with thin & incomplete financial markets (Emerging Economies) Instrument choice when financial markets are thin & incomplete In the developing economies with shallow & inadequately functioning financial markets, interest rates are not an effective instrument option. In such a case the choice of instrument is between monetary aggregate (growth) & exchange rate. According to AKC (2007), the latter is the superior choice, because of transparency. ٧

8 Continue Exchange rate targeting has at times been adopted by open developing economies. A credible fixed exchange rate policy can benefit from the credibility of the economies against which the currency is pegged in order to reduce inflation to a comparable level to those pertaining in there. A CB cannot have a truly independent MP when ER is the nominal anchor. Under a pegged or managed ER the CB will have to buy or sell foreign currency, which effects the monetary base analogous to OMO. Problems with the exchange rate as an instrument Without disciplined fiscal & monetary policies ER targeting is not sustainable, particularly if ER is fixed but domestic inflation rate is not low & productivity growth in tradables is not adequate. In oil exporting economies: conflicting signals, revenue considerations vs. price stability. Real exchange targeting (RERT) may keep tradables competitive, however, a consequence of RERT is that both the money supply & ER become endogenous. Moreover, RERT can create a feedback from domestic inflation to the nominal ER. Hence a country that commits to RERT rule gives up the money supply & nominal ER as nominal anchors. ٨

9 Choice of nominal anchor in high inflation countries: the politics of anchor selection As investigated by Aisen (2007), stabilization policies implemented by different countries facing high & chronic inflation differ in design but such differences may well be due to political rather than economic motives. ER & money-based stabilization are the two policy alternatives that result in two different consumption paths even if they lead to the same end result in terms of welfare. ER based programs generate an initial consumption boom & a subsequent recession while money-based stabilizations create early consumption decline followed by a recovery. While a benevolent dictator may be indifferent to the choice, but elected officials prefer ER policies prior to elections. IT is not an option to anchor inflation expectations in high inflation countries Studies presented in Bernanke & others (1999) indicate that IT frameworks often been introduced during periods when inflation was falling or already. Sims (2005) argues that IT is least useful in those countries that have had high inflation. The implication is that the basic communication policy, which gives an IT program credibility, does not tend to be very effective in lowering double & triple-digit inflation rates to low single digit levels. Stabilization programs are announced as policy packages with a diverse range of policies (fiscal, monetary, income). ٩

10 Section III: non-interest based systems General Monetary Policy Goals: Inflation, resource utilization, & Stability. Issue: MP regime & choice of instruments. Use of conventional tools of monetary policy in a non-interest rate environment Traditional tools of monetary policy: legal reserve requirements, credit ceilings & controls, lending by CB, moral suasion can be used in the context of a non-interest rate (NIR) banking/financial system to control growth of the money supply. Monetary policy via & money supply (intermediate target) control with base-money as the operating target, is both compatible & possible within a NIR set up provided that basic infrastructure & instruments are in place or being developed. In principle, OMO operations can be conducted for liquidity management & money- supply control in an NIR environment. ١٠

11 Conducting OMOs The need for liquidity is recognized by Shari a but requires suitable vehicles. OMOs can be conducted through shari a compliant securities, e.g. musharaka, ijarah, salam, & istina Sukuk, as has been the case in some countries. Experience will show to what extent these instruments can be used for signaling short-term money market rates, rather than capital market rates. Conducting significant volumes of OMO requires a more developed & deeper NIR (Sukuk) market than currently exists & for both the central bank & commercial banks to have more of such assets in their portfolios. Securitization for conducting OMOs & MP Islamic law allows for securitization but it must be done in shari a compatible way. The primary requirement is that underlying asset mix should not include interest based assets e.g. in a fixed return setting, Ijara-based securitization involves securitization of physical assets & not financial claims. For effective MP a cost of fund (capital) link is vital. By selling & purchasing securities CB affects asset prices, hence rates, as the main link in MP transmission mechanism channel. In principle, various NIR instruments (Sukuk) could be used as a tool to conduct OMO & MP. Through OMO they can be used to control liquidity & also influence the cost of capital (cost of funds). Via the latter, & if the NIR market is well developed, OMOs can influence economy through prices/rates of return or monetary quantities. ١١

12 Conducting Monetary Policy with NIR instruments Hurdles: the lack of depth & liquidity in NIR security market; dependence of MP on fiscal policy; inadequate governance structures; insufficient transparency are major impediments to effective monetary policy in general & IT in particular. If institutional hurdles are phased out, effective MP can be implemented with NIR; also IT with an assortment of NIR & IR instruments. Pure NIR? Can policy rates be passed-through (PT) markets? Malaysian data indicates that the PT from policy rates to the Islamic money market is fast & sizeable & consistent with those of conventional estimates. Also, profit rates follow IR based money market rates closely, reflecting the evidence of arbitraging between the two markets. Continue When there is institutional arbitrage between the NIR & IR markets, the transmission of monetary policy will be equally effective through the NIR & IR sectors. But what about a strict NIR system? There has been much progress in engineering NIR securities. McCauley (2009) argues that there are synergies between the CB objectives of monetary stability & financial development. This is due to the degrees of freedom in the asset & liability composition of the CB balance sheet. Given that CB operations will tend to impart liquidity to the chosen instruments, the CB can make its choices with an eye to developing financial markets. Some countries are moving rapidly in the direction of innovating NIR financial securities & adopting it for MP operations. ١٢

13 Financial Stability in non-interest systems When financing is based on the principles of profit/loss sharing, the average rate of return is determined by the marginal efficiency of capital & time preference (D for investment & S of savings) which is positive in a growing economy. Assuming that NIR financing is closely linked to the real economy/tangible assets, the implication is that economic growth maintains positive profits for the financial/banking sector. Since banking sector profitability is pro-cyclical, there is a business cycle risk (systematic risk) that an NIR is exposed to. No empirical assessment of the effectiveness of NIR based instruments for counter-cyclical MP is available. Continue To the extent that the NIR banking systems rely on deposits rather than wholesale funding, limit their exposure to opaque/complex assets & do not allow high leverage, they are potentially more stable than interestbased systems which allow & have incentives to engage in high leverage especially when interest rates are low. Askari et al (2010) support the stability argument on a conceptual basis. The foregoing, however, does not mean that NIR systems can avoid the normal banking (systematic) risks, moral hazard & adverse selection. An empirical study on bank stability, conducted prior to the recent FC, indicates the small Islamic banks are stronger than the conventional commercial banks but the larger ones are not (IMF 2008), indicating that as the banking operation grows, problems relating to adverse selection and moral hazard becomes more prominent. ١٣

14 Choice of monetary instrument in a noninterest setting when NIR markets are thin Assuming credible commitment & assuming money growth & exchange rates instruments are available & exogenous: in line with Poole (1970), the tighter instrument is preferred. However, the issue of instrument availability is still outstanding when NIR markets are thin forcing policy-makers into undertaking administrative measures for monetary control. Empirical data for Iran shows a strong positive relationship between money supply & inflation, a relatively limited short-term effect of money on output. Tightness for inflation considerable. But money supply is dominated by fiscal considerations & there is need for instruments. Exchange Rate-Based Inflation Targeting (ERBIT) ER can be used (in place of interest rate) as the proxy target & the operating instrument for MP. Those economies that practice ERBIT (ER becomes the operating target) are highly open and ER is important in the monetary policy transmission mechanism. ١۴

15 Thank You ١۵