From Micro to Macro
1.
2.
3.
4.
Goals/Economic Outcomes
Intermediate Targets: Nominal Anchor
Operating Targets
Tools
6 Aspects of Monetary Policy Strategy:
Economic Goals
1. Expansionary Monetary policy cannot
increase economic growth in the long-run.
2. As inflationary policy becomes expected,
wage inflation rises in tandem eliminating
impact on inflation on output or
unemployment.
3. High inflation has large negative impacts on
economic welfare & financial stability
4. Nominal Anchor Needed to avoid inflation.
6 Aspects cont.
(Mishkin, Monetary Policy Strategy, Forthcoming)
5. Nominal Targets are subject to “time
consistency” issues – In the short-run,
the government may be tempted to dilute
the currency making it difficult to build
credibility for a nominal target.
6. Independent central banks have better
credibility and bring better outcomes.
Credibility
A nominal anchor w/o credibility
• leads to high inflationary expectations
and high interest rates.
• leads to increasing wage demands and
potentially a wage-price spiral.
Nominal Anchors
1. Monetary Aggregates: M1, M2
2. Exchange Rates
3. Price Stability
•
Inflation Targeting
Money Supply The stock of the medium of
exchange supplied by the central bank.
Types of Financial Assets
M1
Currency in Circulation [C] + Demand Deposits [D]
M2
M1 + Savings Deposits + “Small” Time Deposits +
[Liquid Money Market Instruments inc/ “Small” NCD’s]
M3
M2 + LTD [“Large” Time Deposits and NCD’s]
Anchoring the Money Supply
Popular in 1970s and 80s,
Used by ECB till 2003
Monetary
Base
*
Money
Multiplier
Banknotes & Reserve Accounts under
the control of central bank
=
Money
Supply
Fractional reserve
banking
14
13
12
11
10
9
8
Jan-04
Jan-99
Jan-94
Jan-89
Jan-84
Jan-79
Jan-74
Jan-69
7
Jan-64
•The history of
volatility of the M2
multiplier has
convinced the Fed
that it is impossible to
control the money
supply through their
control of the
monetary base.
M2 Multiplier
Jan-59
US M2
Money
Multiplier
Link between Money Supply and
Economy
Money
Supply
*
Velocity
Speed of circulation
of money supply
=
Nominal
Spending
Power
Velocity Hard to Predict
2.2
2.1
2.0
1.9
1.8
1.7
1.6
1.5
60
65
70
75
80
85
90
US M2 Velocity
95
00
05
Price Stability: Long Term
• Big central banks focus on price and/or
output stability.
– ECB: “The primary objective of the ECB’s
monetary policy is to maintain price stability.
The ECB aims at inflation rates of below, but
close to, 2% over the medium term.”
– BoJ: “currency and monetary control shall be
aimed at, through the pursuit of price stability,
contributing to the sound development of the
national economy."
– FED: “to promote effectively the goals of
maximum employment, stable prices and
moderate long-term interest rates”
Five Pillars of of Inflation Targeting
1.
2.
3.
4.
5.
Institutional commitment to price stability.
No other nominal anchors.
Absence of Fiscal Dominance
Policy Instrument Independence
Transparency and Accountability
A medium term communication strategy
• Clear statement of numerical target for
inflation over the medium (1-2 year) term.
• Communication with public about current
forecasts of inflation and policy actions
used to achieve target.
• Central Bankers accountable for achieving
goals.
Adoption of Inflation Target
Regimes
•
•
•
•
•
New Zealand, 1989
Canada, 1991
UK and Israel, 1992
Australia, Sweden and Finland, 1993
Regionally: Thailand, Philippines, and S.
Korea all have adopted inflation targeting
in recent years.
Ja
n0
Ap 2
r- 0
2
Ju
l-0
O 2
ct
-0
2
Ja
n0
Ap 3
r- 0
3
Ju
l-0
O 3
ct
-0
3
Ja
n04
Ap
r- 0
4
Ju
l-0
O 4
ct
-0
4
Ja
n0
Ap 5
r- 0
5
Ju
l-0
O 5
ct
-0
5
Ja
n06
Ap
r- 0
6
Ju
l-0
6
How seriously does ECB take
inflation target?
EU Harmonized Inflation
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
Will USA shift to explicit inflation
targeting?
• To date, US has used a cult of personality
approach to build credibility for price
stability of target.
• New guard at central bank may prefer a
more explicit approach.
Bernanke et al
Big Current Questions
• Can monetary policy that stabilize goods
price inflation allow to much volatility in
asset price inflation?
• Should monetary policy take into account
asset prices which adjust more quickly
than goods prices?
• Will efforts to keep stock prices from falling
lead to monetary expansion and inflation?
Fed cut effective funds rate in
August before announcing decline
in target in September.
Effective Fed Funds Rate
5.50
5.40
5.30
5.20
5.10
7/
6/
20
07
7/
13
/2
00
7
7/
20
/2
00
7
7/
27
/2
00
7
8/
3/
20
07
8/
10
/2
00
7
8/
17
/2
00
7
8/
24
/2
00
7
8/
31
/2
00
7
9/
7/
20
07
9/
14
/2
00
7
5.00
4.90
4.80
4.70
4.60
EFF
Exchange Rate Targets
• Outside the G7, a number of economies
focus monetary policy on maintaining a
stable exchange rate.
– No independent currency, currency board,
conventional exchange rate peg.
• Some economies will target money and
other domestic nominal anchors or target
the exchange rate as the occasion calls for
– Intermediate regimes called managed
floating, crawling peg, exchange rate bands.
IMF Exchange Rate Classification
60
50
40
30
20
10
0
No Currency
Currency
Board
Fixed
Exchange
Rate
Band
Crawling
Peg
Managed
Float
Source http://www.imf.org/external/np/mfd/er/2005/eng/1205.htm
Free Float
Bipolar Hypothesis
•
•
Fixed exchange rates are subject to
speculative attacks.
One theory is that central banks should:
1. Make the fixed exchange rate impervious to
attack through currency board or
dollarization
or
2. Adoption floating exchange rate
Controversy remains about this theory
Operating Targets
•
•
A target for monetary policy that can be
achieved on a day to day basis.
Characteristics of an operating target
1. Observable
2. Controllable
3. Linked to Goals & Nominal Anchors
Consensus on Operating Targets
Cecchetti p. 475
a) The reserve requirement can be used to
control demand for reserves but is not
useful for controlling money multiplier.
b) Central bank lending is necessary to
insure financial stability but not for day to
day monetary policy control.
c) Short-term interest rates is the main tool
for controlling inflation
Operating Target
• Examples of an operating target
1.Inter-bank Interest Rate
2.Level of Bank Reserves
3.Exchange Rate
Operating Targets: Target Interest
Rates
• Most big country CB’s target interbank interest
rates, the rate at which banks lend reserves to
one another (in HK, this is called what?)
Fed
BoJ
ECB
BoK
UK
Federal Funds Rate
Uncollateralized Call Money Rate
Main Refinancing Rate
Overnight Call Rate
Official Bank Rate
Interbank Market
iIBR
iTGT
S
D
Reserve Accounts
Targeting the Inter-bank Rate
• Inter-bank rate set by supply and demand
in inter-bank market.
– Central bank sets supply of reserves.
• Banks would like to have a certain amount
of funds in their reserve accounts.
– The higher the inter-bank rate, the fewer
reserves they would like to hold themselves
and the more they would like to lend to others.
• Central bank must set supply of reserves
equal to demand at the target rate.
Linked to Goals: 2 Directions
Monetary
Policy
Committee
Nominal
Anchor
Operating Target
Monetary
Transmission
Mechanism
Nominal
Anchor
Taylor Rule
•
Economist named John Taylor argues
that US target interest rate is well
represented by a function of
1. current inflation
2. Inflation GAP: current inflation vs. target
inflation
3. Output Gap: % deviation of GDP from long
run path
•
Function: Inflation Target π* = .02
itTGT  .025   t  12  ( t   * )  12  Output Gapt
Setting the Interbank Interest Rate
• Raise interest rate target when inflation
threatens to rise above the target level.
• Reduce interest rate target when inflation
threatens to fall below the target level.
Tends to stabilize output in the face of
demand shocks
Supply shocks may require
adjustment of the inflation target.
Target Rates Affect Money Market
Rates
Money Market Rates USA
7
6
5
4
3
2
1
C.P. Rate
CEIC Database
Fed Funds
T-Bill 3 Mo
Mar-06
Sep-05
Mar-05
Sep-04
Mar-04
Sep-03
Mar-03
Sep-02
Mar-02
Sep-01
Mar-01
Sep-00
Mar-00
Sep-99
Mar-99
Sep-98
Mar-98
Sep-97
0
Monetary Transmission Mechanism
ECB Web Site
Interbank Market: Zero Interest
Rates
iIB
S′′
D
iTGT
iTGT′
0=iTGT′′
S
S′
Clearing Balances
ZIRP: Japan
JP: Call Rate: Uncollaterized: Overnight
% pa
10
9
8
7
6
5
4
3
2
1
0
Jul-1985
Jul-1988
Jul-1991
Jul-1994
Jul-1997
Jul-2000
Jul-2003
Jul-2006
ZIRP & Quantitative Easing
• Since 1999 (w/ a brief break in 2000), Japan has
operated a policy of maintaining a zero interest
rate.
• Since 2001, central bank followed a policy of
“quantitative easing” in which the bank targeted
the quantity of current account balances (reserve
accounts) and sought to increase the supply of
current account balances by purchasing a variety
of assets from banks including corporate bonds,
equity, foreign currency assets.
• With deflation easing and the economy growing
again, BOJ reversed QE in April and raised
interest rates in 2006
Monetary Policy:
Tools
•
The central bank has 3 main operating
instruments to conduct policy in interbank
markets
1. Asset Transactions with Banks – Buy or sell
assets from banks in exchange for reserves
• Open Market Operations (BoJ, Fed, ECB..)
• Currency Market Operations
• Rediscounting (Bank of Japan)
• Gold Standard (History)
• Etc.
Operating Instruments, Part II
2. Discount Window Lending – Lend reserves
directly to banks or take deposits
•
Interest rates set at above IBOR to discourage over
use.
3. Reserve Requirements Directly control the
demand for reserves
•
Not used to control money multiplier or money
supply but may be used to fine tune supply vs.
demand in interbank market.
Sharp increase in demand for liquidity
Discount Window Lending: USA
Billion US$
4.000
3.500
3.000
2.500
2.000
1.500
1.000
0.500
0.000
Jan- Feb- Mar- Apr- May- Jun- Jul- Aug- Sep- Oct- Nov- Dec- Jan- Feb01 01 01 01 01 01 01 01 01 01 01 01 02 02
Financial System and Liquidity
• Financial crises might occur in which
financial market participants might be
reluctant to provide short-term credit.
• Central banks follow the advice of Walter
Bagehot from 1850’s to lend freely against
good collateral?
• Does this lead to moral hazard as
investors follow risky strategies confident
that the central bank will bail them out.
Can the Central Bank Control the
Money Multiplier
• The government’s main tool to control the
multiplier is the required reserve ratio. However,
this regulatory tool is less effective if banks
reserve holdings exceed requirements.
• In other economies, such as the US and
Euroland, the reserve requirement is low and the
regulation seldom binds.
• In many economies, including HK, Australia,
Canada and the UK there is no reserve
requirement.
China Reserve Ratios
14
13
12
11
10
9
8
7
6
5
97
98
99
00
01
02
M2 Multiplier
03
RR
04
05
Principles of Central Bank Design
1. Independence: Central Bank must be
insulated from direct political influence.
Strategies for Insulation
– Central Bank sets monetary policy free of
direct government control.
– Long-terms of Office for Central Bank
Policymakers, difficult for Central Bankers to
be Fired.
– Central Bank has independent sources of
revenue.
Q: How do you monitor
the central bankers?
More Principles of Central Bank Design
How to monitor the central bank.
2. Decision Making by Committee
Power should be diffuse within the central
bank.
3. Accountability and Transparency
Banks should make information about
their intentions and actions.
4. Policy Framework
Banks should have a clear guideline for
setting their policy which meets the
consensus of society.
Trend toward Independence
• In late 1998, the Bank of Japan, and the Bank of
England, were removed from the direct control of
the Ministry of Finance and the Chancellor and
the Exchequer respectively.
• In 1997 and 2003 revisions of the Bank of Korea
Act, the Bank of Korea were removed from the
direct and indirect control of the Ministry of
Economy and Finance.
Conclusion
• OECD Central banks adopting price level
as a nominal anchor with inflation targeting
as a communication strategy.
• Monetary policy implemented using open
market operation as a tool and interbank
interest rate as an operating target.
• Central bank independence becoming the
norm.
Bibliography
• Cecchetti, Money, Banking and Financial
Markets, 2004, McGraw Hill
• Mishkin, Chapter 1, Monetary Policy Strategy
Forthcoming
• Mishkin, Schmitt-Hebbel, One Decade of
Inflation Targeting in the World: What Do We
Know and What Do We Need to Know?
• Ito and Mishkin, Two Decades of Japanese
Monetary Policy and the Deflation Problem,
NBER Conference Ease Conference Volume
2004
• Rose, A. A Stable International Monetary
System Emerges: Inflation Targeting is
Bretton Woods, Reversed, Working Paper
2006.
• Websites of IMF, BoJ, Fed BoG, ECB, etc.