The transmission mechanism of
monetary policy
Banco Central do Brasil conference:
“One year of inflation targeting”
10th July 2000
Alec Chrystal
Bank of England
www.bankofengland.co.uk
Structure of remarks
• Briefly outline main elements of the transmission
mechanism of monetary policy as set out by the
UK Monetary Policy Committee. (BoE Quarterly
Bulletin, May 1999; available on web site.)
• Does “money” have a role?
• Suggest some aspects that might differ in other
countries and other institutional arrangements
• Discuss some puzzles and problems for monetary
policy makers
The transmission mechanism
Official
rate
?
Inflation
The transmission mechanism
Market
rates
Asset prices
Official
rate
Expectations/
confidence
Exchange rate
Official rate changes other market rates
• Bank of England sets 2 week repo rate
• This affects other market short rates similarly
• Banks adjust their “base” lending rates, mortgage
rates, and savings rates
• Long rates respond to any new information about
course of future short rates and expected inflation
Asset prices
• Equity and bond prices respond to new
information about term structure of discount rates,
real growth prospects, and inflation prospects
• House and other property prices adjust (maybe
slowly) to new borrowing costs
Expectations and confidence
• Policy actions and policy announcements have
effects on expectations of future growth in real
activity and inflation
• They also affect the confidence with which such
expectations are held and the credibility of the
monetary authorities themselves
• Specific policy decisions may have small effects
in this regard but the cumulative impact of
decisions and pronouncements can be important
• Credibility is hard to gain but easy to lose
The exchange rate
• Official rate changes may create changes in the
FX value of domestic currency
• Lower rates generally cause depreciation and vice
versa
• BUT anything can happen, depending on impact
on market expectation
• ALSO interest rate changes explain only small
part of variation in the exchange rate
The transmission mechanism
Market
rates
Asset prices
Official
rate
Expectations/
confidence
Exchange rate
Domestic
demand
Total
demand
Net external
demand
Interest rates, asset prices, expectations, and
the exchange rate affect domestic and net
external demand
• Consumer spending: interest rates, wealth effect,
confidence, income and employment prospects
• Investment: cost of capital, asset values,
prospective demand, confidence
• Net trade: affected by domestic demand relative to
supply and real exchange rate
• Total demand relative to supply leads to domestic
inflationary pressure
The transmission mechanism
Market
rates
Asset prices
Official
rate
Expectations/
confidence
Exchange rate
Domestic
demand
Total
demand
Net external
demand
Domestic
inflationary
pressure
Domestic inflation results from combination
of domestic inflationary pressure and
imported inflation
• Imported inflation depends on world inflation (in
foreign currency) combined with the exchange
rate
• So depreciating currency will be associated with
higher inflation for given world inflation rate
• NB: domestic price level and exchange rate are
two different measures of the same thing: the
value of domestic money
The transmission mechanism
Market
rates
Asset prices
Official
rate
Expectations/
confidence
Domestic
demand
Total
demand
Domestic
inflationary
pressure
Net external
demand
Inflation
Importe
d
inflation
Exchange rate
Note: For simplicity of exposition, this chart does not show interactions between variables,
but these can be important.
How long does it take for a change in the
official rate to affect output and then
inflation?
• Old rule of thumb was: one year to output and two
years to prices
• Simulation with Bank model suggests similar
order of magnitude
• However, truth may be different in different
circumstances and may be asymmetrical
• Range of outcomes based on different reaction
functions
Some simulations
Effect on real GDP, relative to base, of 100 bp increase
in the official rate maintained for 1 year
Some simulations
Effect on inflation rate, relative to base, of 100 bp
increase in the official rate maintained for 1 year
Estimated average length and strength of transmission mechanisms1
months
50
45
40
35
Bars (left-hand scale) represent
estimated average time for full
impact of change in policy
instrument to affect inflation
percentage points
2
Points (right had scale) represent estimated
average strength of full impact of change in
interest rates on inflation
1.5
1
30
25
0.5
20
15
10
0
-0.5
5
0
Source: Bank of England survey of Monetary Frameworks
-1
Implications of lags for policy
• Latest inflation level is history: cannot do
anything about it.
• The same is true for some time in the future.
• Decisions taken today do start to have effects a
year or so later.
• Inflation forecast takes on key role.
• “Inflation forecast targeting”
The role of money
• ‘inflation is ... a monetary phenomenon’?
• Long-run relationship between M and P.
• For each path of official rate, there is an
implied path for M.
• With inflation target, monetary aggregates
are not instruments or targets, but indicators.
• Possible shocks to the monetary system.
• Credit aggregates may be at least as useful.
Potential elements of MTM in other systems
• Other instruments:
– monetary base
– exchange rate
– credit controls
– exchange controls
– prudential controls on banks
– fiscal policy constraints
• These may have direct and more powerful effect on domestic demand
and net trade
• So lags and scale of impact may be very different in different countries
• Institutional differences and different inflation history also create a
different response to policy rate changes---especially until credibility
of the regime is established.
Puzzles and problems I
• Easy to tell what lags and scale of impact are in
specific model but very hard to know in reality
• Policy is designed to offset shocks, so successful
policy changes may not appear to have any
relationship with targets
• Taylor Rules: OK?
• It is simple to cause ripples but it is very hard to
offset exogenous shocks and internal cycles to
achieve stability
• Business cycles have been around a long time. It
requires great optimism (or stupidity?) to believe
that they have been eliminated
Puzzles and problems II
• Does the recent benign inflation environment in
many countries result from successful inflation
targeting and understanding of the MTM?
• Good policy or good luck?
• To what extent does inflation control depend on
credibility rather than actual policy decisions?
• Does uncertainty about MTM mean that it is better
to do too little rather than too much?
• Or do the lags involved mean that pre-emptive
action is better than delayed reaction?
The End