EC3115 :: L.5 : Monetary policy tools and targets Almaty, KZ :: 2 October 2015 EC3115 Monetary Economics Lecture 5: Monetary policy tools and targets Anuar D. Ushbayev International School of Economics Kazakh-British Technical University https://anuarushbayev.wordpress.com/teaching/ec3115-2015/ Tengri Partners Merchant Banking & Private Equity a.ushbayev@tengripartners.com www.tengripartners.com Almaty, Kazakhstan, 2 October 2015
EC3115 :: L.5 : Monetary policy tools and targets - 2 / 32 - Relevant reading Book treatment F. Mishkin. (2013). The Economics of Money, Banking and Financial Markets, 10 th edition, Pearson Education, Chapters 16, 17. D. Cobham. (2002). The Making of Monetary Policy in the UK, 1975-2000, London: Wiley. Must-read articles A. Grimes. (2014). Four Lectures on Central Banking, Motu Working Paper 14-02, Motu Economic and Public Policy Research, Wellington.
EC3115 :: L.5 : Monetary policy tools and targets - 3 / 32 - The toolkit basics Section 1 The toolkit basics
EC3115 :: L.5 : Monetary policy tools and targets - 4 / 32 - The toolkit basics Main tools of monetary policy Open Market Operations (OMOs) directly affects the quantity of reserves and (hence) the monetary base Standing facilities directly set lower and upper bounds for money market interest rates Reserve requirements directly affect the demand for reserves Foreign exchange interventions 1 directly affect the quantity of reserves, the monetary base and the nominal exchange rate 1 We shall ignore the FX dimension for now, but we will return to it in the second part of this course.
EC3115 :: L.5 : Monetary policy tools and targets - 5 / 32 - The toolkit basics Virtually all central banks follow: a macroeconomic mandate of price stability a microeconomic mandate of stability of national payment systems The macroeconomic mandate usually gets formulated as a goal to continuously achieve a certain nominal target, or anchor, by varying the stance of monetary policy. To achieve their goals successfully, central banks have to have a credible combination of instruments and their systematic use directed at achieving such goals, which most often necessitates the use of an operating target. Now, virtually all central banks have their own intermediate operating interest rate target (usually a short term one, such as the overnight or weekly rate), which they use as the main indicator of the stance of monetary policy and which they will manipulate in order to achieve their medium- to long-term goals 2. 2 Exceptions are central banks that operate in the regimes of currency board or rigidly pegged exchange rates to be discussed later in this course.
EC3115 :: L.5 : Monetary policy tools and targets - 6 / 32 - The toolkit basics The market for reserve balances (demanded primarily for payment settlement and reserve requirement compliance) is where the overnight interest rate is determined. In many countries the infrastructure of the pure market for reserves is augmented by an interest rate corridor regime, arising from the central bank s use of standing facilities for the provision and withdrawal of liquidity. Market equilibrium occurs where the total quantity of reserves demanded equals the total quantity of reserves supplied, thus dynamically determining the overnight rate. TR d }{{} total reserves demanded = RR }{{} required reserves + ER }{{} excess reserves where RR are held to meet reserve requirements and ER are held for precautionary motives, such as deposit outflows. TR s }{{} total reserves supplied = N BR }{{} non-borrowed reserves + BR }{{} borrowed reserves where NBR are a result of central bank open market operations, and BR are borrowed by banks.
EC3115 :: L.5 : Monetary policy tools and targets - 7 / 32 - The toolkit basics How does an inter-bank loan affect balance sheets? Bank A + Loan to Bank B $100 No change - Reserve balances $100 Bank B + Reserve balances $100 + Borrowing from Bank A $100 No change Central bank - Reserve balances at Bank A s account + Reserve balances at Bank B s account $100 $100 An inter-bank loan has no effect on the central bank balance sheet, where the reserves stay all the while, except for changing the distribution of reserves liabilities between banks.
EC3115 :: L.5 : Monetary policy tools and targets - 8 / 32 - The toolkit basics Classical analysis 3 assumes the following shapes of demand and supply curves for reserve balances: Demand curve downward sloping, with an infinitely elastic region, by the following reasoning: Excess reserves are insurance against deposit outflows, and the cost of holding these excess reserves is their opportunity cost the interest rate that could have been earned on lending these reserves out, minus the interest rate that is offered by the central bank on its deposit facility (i d ). Thus, when the overnight rate is above the interest rate paid on the deposit facility (or interest paid on excess reserves), a decrease in the overnight rate will lead to a decrease in the opportunity cost of holding excess reserves. Ceteris paribus, the total quantity of reserves demanded rises. If, however, the overnight rate begins to approach the deposit rate from above, banks would not lend in the money market at an interest rate lower, than lending to the central bank. Instead, they would just keep on adding to their holdings of deposits indefinitely, which will result in the demand curve for reserves becoming flat (infinitely elastic), at i d. 3 We shall study alternative views on this in the next lecture.
EC3115 :: L.5 : Monetary policy tools and targets - 9 / 32 - The toolkit basics Supply curve upward sloping, with an infinitely inelastic and an infinitely elastic region, by the following reasoning: Borrowing reserves from other banks is a substitute for borrowing from the central bank, and the cost of the latter is the interest rate the central bank charges on these loans at its lending facility (i l ), which is usually set strictly higher than the official target rate. Thus, if the overnight rate is below the the interest rate charged at the lending facility, banks will not borrow from the central bank and borrowed reserves will be zero because borrowing in the inter-bank market is cheaper. Therefore, as long as the overnight rate remains below the lending rate, the supply of reserves will just equal the amount of non-borrowed reserves supplied by the central bank and the supply curve will be vertical (infinitely inelastic). If, however, the overnight rate begins to approach the lending rate from below, banks will not be willing to borrow from each other at a rate higher than the lending rate of the central bank (standing to provide liquidity at this rate at all times and in any amount), which will result in the supply curve for reserves becoming flat (infinitely elastic), at i l.
EC3115 :: L.5 : Monetary policy tools and targets - 10 / 32 - The toolkit basics Equilibrium in the market for reserves Equilibrium occurs at the intersection of the supply curve R s and the demand curve R d at point 1 and an interest rate of i.
EC3115 :: L.5 : Monetary policy tools and targets - 11 / 32 - The toolkit basics Response to an open market operation An open market purchase increases non-borrowed reserves and hence the reserves supplied, and shifts the supply curve from R s 1 to Rs 2. In panel (a), the equilibrium moves from point 1 to point 2, lowering the overnight rate from i 1 to i 2. In panel (b), the equilibrium moves from point 1 to point 2, but the overnight rate remains unchanged, i 1 = i 2 = i d.
EC3115 :: L.5 : Monetary policy tools and targets - 12 / 32 - The toolkit basics Types of open market operations OMOs are the most important and precise conventional monetary policy tool, the primary determinant of changes in interest rates and the monetary base. They fall in two categories: 1. Outright (or dynamic) open market operations: to actively change the level of reserves and the monetary base. 1.1 outright sale of securities to increase the overnight rate and contract the monetary base. 1.2 outright purchase of securities to decrease the overnight rate and expand the monetary base. 2. Temporary (or defensive) open market operations: to offset movements in other factors that affect reserves and the monetary base e.g. govt deposits at the central bank, exchange rate fluctuations, changes to demand for physical cash, etc. 2.1 repurchase agreements (repos) temporary purchase to effect a downward pressure on interest rates and increase reserves. 2.2 reverse repurchase agreements (reverse repos) temporary sale to effect an upward pressure on interest rates and decrease reserves.
EC3115 :: L.5 : Monetary policy tools and targets - 13 / 32 - The toolkit basics If the overnight rate trades higher than the target rate, the central bank may enter into repo transactions, buying securities at a price, such that the yield of the transaction works out to the target rate. Such repos will relieve undesired upward pressure on the overnight rate. Central bank + Securities (on repo) $100 + Reserve balances $100 Primary dealer + Reserve balances $100 + Repo $100 Repo balance sheet mechanics
EC3115 :: L.5 : Monetary policy tools and targets - 14 / 32 - The toolkit basics If the overnight rate trades lower than the target rate, the central bank may enter into reverse repo transactions, selling securities at a price, such that the yield of the transaction works out to the target rate. Such repos will relieve undesired downward pressure on the overnight rate. Central bank - Reserve balances $100 + Reverse repo $100 Primary dealer + Securities (on reverse $100 repo) - Reserve balances $100 Reverse repo balance sheet mechanics
EC3115 :: L.5 : Monetary policy tools and targets - 15 / 32 - The toolkit basics Response to a change in the lending (discount) rate In panel (a) when the lending rate is lowered by the central bank from i 1 to i 2, the horizontal section of l l the supply curve falls, as in R s 2, and the equilibrium overnight rate remains unchanged at i1. In panel (b) when the lending rate is lowered by the central bank from i 1 to i 2, the horizontal section of the supply l l curve R s 2 falls, and the equilibrium overnight rate falls from i1 to i 2 as borrowed reserves increase.
EC3115 :: L.5 : Monetary policy tools and targets - 16 / 32 - The toolkit basics In addition to its use as a tool to control the overnight market rate, the most important advantage of the discount lending facility is that the central bank can use it to perform its role of lender of last resort to prevent and offset financial crises and bank panics. The Bank of England in the 19 th century became responsible for the stability of the financial system by acting as the lender of last resort during several banking crises of that time. The Federal Reserve System was created specifically with the most important role of serving as the lender of last resort, to prevent bank failures from spinning out of control. Discounting, therefore, is a particularly effective way of supporting the banking system with liquidity in times of crisis 4. 4 We shall discuss this in more detail later in a special lecture.
EC3115 :: L.5 : Monetary policy tools and targets - 17 / 32 - The toolkit basics Response to a change in the deposit rate In panel (a) when the deposit rate is lowered by the central bank from i 1 d to i2, the horizontal section of d the demand curve falls, as in R d 2, but the equilibrium overnight rate remains unchanged at i1. In panel (b) when the deposit rate is lowered by the central bank from i 1 d to i2, the horizontal section of the demand d curve R d 2 falls, and the equilibrium overnight rate falls from i1 to i 2.
EC3115 :: L.5 : Monetary policy tools and targets - 18 / 32 - The toolkit basics Response to a change in the interest rate on reserves In panel (a) when the equilibrium overnight rate is above the interest rate paid on reserves, a rise in the interest rate on reserves from i 1 or to i2 or raises the horizontal section of the demand curve, as in Rd 2, but the equilibrium overnight rate remains unchanged at i 1. In panel (b) when the equilibrium overnight rate is at or below the interest rate paid on reserves, a rise in the interest rate on reserves from i 1 or to i2 or raises the horizontal section of the demand curve, the equilibrium overnight rate rises i 1 to i 2.
EC3115 :: L.5 : Monetary policy tools and targets - 19 / 32 - The toolkit basics Response to a change in required reserves When the central bank raises reserve requirements 5, required reserves increase, which increases the demand for reserves. The demand curve shifts from R d 1 to Rd 2, the equilibrium moves from point 1 to point 2, and the overnight rate rises from i 1 to i 2. 5 Several central banks (e.g. the BoE), do not set reserve requirements at all, since they can cause liquidity problems, increases uncertainty and complicate liquidity management.
EC3115 :: L.5 : Monetary policy tools and targets - 20 / 32 - The toolkit basics How the standing facilities limit fluctuations in the overnight rate Since the standing facilities mean that an interest rate-setting central bank will stand ready to absorb any amount of reserves at i d and provide any amount of reserves at i l, these limits are binding for the overnight rate. A rightward shift in the demand curve for reserves to R d will raise the equilibrium federal funds rate to a maximum of i = i l while a leftward shift of the demand curve to R d will lower the overnight rate to a minimum of i = i d.
EC3115 :: L.5 : Monetary policy tools and targets - 21 / 32 - The toolkit basics What is the result of all this? Key ECB policy interest rates and the EONIA (euro overnight index average), Jan 1999 Mar 2012.
EC3115 :: L.5 : Monetary policy tools and targets - 22 / 32 - The toolkit basics What about Kazakhstan? (TONIA Tenge OverNight Index Average)
EC3115 :: L.5 : Monetary policy tools and targets - 23 / 32 - Nominal targets for monetary policy Section 2 Nominal targets for monetary policy
EC3115 :: L.5 : Monetary policy tools and targets - 24 / 32 - Nominal targets for monetary policy Goals of monetary policy 1. Price stability primary macroeconomic goal together with the microeconomic goal of stability of national payment systems. 2. High employment and output stability. 3. Economic growth. 4. Stability of financial markets. 5. Interest-rate stability. 6. Stability in foreign exchange markets.
EC3115 :: L.5 : Monetary policy tools and targets - 25 / 32 - Nominal targets for monetary policy Criteria for a monetary policy target To facilitate the success of a central bank s strategy to fulfill it s ultimate objective of price stability, the target of monetary policy has to satisfy the following criteria: Effectiveness the strategy using this target should be effective in the pursuit of the final objective. Verifiability the target should be able to formulated quantitatively and announced so that the central bank can be held accountable later. Transparency the setting of the target should be clear. Medium-term orientation use of target should make it possible to achieve (with short-term deviations) the final objective over the medium term, thereby providing an anchor to inflation expectations.
EC3115 :: L.5 : Monetary policy tools and targets - 26 / 32 - Nominal targets for monetary policy Choice of nominal target Monetary target absolute level or % growth of a monetary aggregate (reserves, monetary base, M1, M2, etc.) Nominal income target absolute level or % growth of Nominal GDP Inflation target absolute level or % growth of a chosen price level index (CPI, PCE, etc.) Nominal exchange rate target 5 usually absolute level of a chosen bilateral exchange rate or a currency basket, with a margin of permissible fluctuation on either side 5 To be explored later in this course.
EC3115 :: L.5 : Monetary policy tools and targets - 27 / 32 - Nominal targets for monetary policy Monetary targeting Central bank announces that it will achieve a certain value (the target) of the annual growth rate of a monetary aggregate, such as a 5% growth rate of M1 or a 6% growth rate of M2. The central bank then is accountable for hitting the target. Practiced by central banks in the 1970s: Fed: M1, NBR and other aggregates growth (1975-1982) very poor performance, target ranges missed all the time. BoE: M3 growth (1973-1985) very poor performance. BoC: M1 supply growth (1975-1982) very poor performance. We did not abandon M1, M1 abandoned us. Gerald Bouey 6, (1983), Minutes of Proceedings and Evidence, No. 134, House of Commons Standing Committee on Finance, Trade and Economic Affairs, Parliament of Canada. 6 Governor of the Bank of Canada (1973-1987).
EC3115 :: L.5 : Monetary policy tools and targets - 28 / 32 - Nominal targets for monetary policy Let me illustrate the sort of problem that might be faced by citing some numbers representing successive weekly forecasts of annual rates of money supply growth for a recent month-admittedly not a good month for our projectors. The projections cited begin with the one made in the last week of the preceding month and end with the projection made in the last week of the then current month. The numbers are: -0.5 percent, +4 percent, +9 percent, +14 percent, +7 percent and +4.5 percent. I might also note that, in the middle of that thencurrent month, the projections for the following month were for a 14 percent rate of growth. By the end of the month, the projection was -2.5 percent. Assuming that the Desk had been assigned a target of a 5 percent growth rate for money supply, it seems quite obvious that, at mid-month, when the forecast was for a 14 percent growth rate for both the current and the following month, we would have been required to act vigorously to absorb reserves. Two weeks later, on the other hand, if the estimates had held up, we would have been required to reverse direction rather violently. Alan Holmes, (1969), Operational Constraints on the Stabilization of Money Supply Growth (with discussion by J. Tobin), Controlling Monetary Aggregates, Conference Series 1, Federal Reserve Bank of Boston.
EC3115 :: L.5 : Monetary policy tools and targets - 29 / 32 - Nominal targets for monetary policy Nominal GDP targeting Central bank announces a target level (or growth level) in nominal GDP. Theoretically stabilizing characteristics, however in practice: GDP stats are released considerably later than e.g. CPI and so the CB would inevitably have to rely on out-dated readings for the variable that it would be targeting. Often GDP data are revised materially and with long lags, considerably complicating the policy setting process. NGDP growth can be volatile, and move in different directions with real GDP, thus making policy impractical. Society does not directly care NGDP growth (or its level) per se. Real GDP and inflation, separately, are important to agents. E.g. in case of negative shock to RGDP, the CB would have to loosen monetary policy to keep NGDP on track, thus accommodating both a RGDP decrease and higher inflation. Flexible inflation targeting takes such shocks into account.
EC3115 :: L.5 : Monetary policy tools and targets - 30 / 32 - Nominal targets for monetary policy Inflation targeting CB announces an inflation target to be achieved as an average over the medium term and demonstrates an institutional commitment to achieve price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal. High transparency of the strategy through communication with the public and the markets about the plans and objectives. Allows considerable flexibility for policy in the short run, and elements of tactics based on nominal GDP targeting could be built into an inflation-targeting regime. Has almost all the benefits of NGDP targeting, but without the problems of imprecision and revision of data used for monetary policy decision-making. New Zealand was the first country to formally adopt inflation targeting in 1990, followed by Canada in 1991, the United Kingdom in 1992, Sweden and Finland in 1993, and Australia and Spain in 1994.
EC3115 :: L.5 : Monetary policy tools and targets - 31 / 32 - Nominal targets for monetary policy International experience of inflation targeting
EC3115 :: L.5 : Monetary policy tools and targets - 32 / 32 - Nominal targets for monetary policy Summary of qualities of various targets The table is taken from D. Cobham, (2002), The Making of Monetary Policy in the UK, 1975-2000, London: Wiley.