Key Points:
- Monetary policy refers to the central bank’s actions that influence interest rates, inflation and credit availability through changes in the supply of money available in the economy.
- Besides conducting the monetary policy, a central bank performs other roles such as: monopoly supplier and guardian of a currency, lender of last resort and holder of gold and foreign exchange reserves.
- The tools used by central banks to attain their objectives are thoroughly described below. Furthermore, we look at the whole picture in order to understand why, under certain circumstances, monetary policy falls into a “liquidity trap”.
Monetary policy and fiscal policy refer to the two most widely recognized tools conducted by the government to achieve its macroeconomic objectives. Monetary policy refers to the central bank’s actions that influence the quantity of money and/or the level and the structure of interest rates. It is a tool to smooth fluctuations in the business cycle with the goals of maintaining stable prices and producing positive economic growth. When the central bank expands money supply in an economy, the policy is said to be expansionary (or accommodative or easy). Similarly, when the central bank reduces liquidity in an economy, the policy is said to be contractionary (or restrictive or tight). Fiscal policy refers to changes in the level and structure of government spending and taxation to influence the economy.
A central bank can affect short-term interest rates by increasing or decreasing the money supply. An increase in the money supply will put downward pressure on interest rates whereas a decrease in money supply results in an increase in the interest rates. Interest rates are used to influence aggregate demand, employment and inflation in an economy. The Federal Reserve (Fed) is responsible for monetary policy in the United States and sets the official interest rate whereas the European Central Bank (ECB) perform the same role in Europe.
The determination of the source of inflation is very important as the monetary authority may adjust the monetary policy accordingly. Contractionary policy is appropriate when inflation is above its target. However, this policy would exacerbate the downturn in case inflation is higher due to supply shocks, such as higher food or energy prices, and the economy is operating below full employment. For example, in the United States, the Fed focuses on core inflation (it takes out the effect of food and energy prices).
A central bank has these key roles, among others:
– Monopoly suppliers and guardians of a currency: they have the sole authority to supply fiat money (money not backed by any tangible value such as the gold backing). Fiat money will continue to serve as a medium of exchange as long as it holds value over time and it is accepted for transactions. As a consequence, central banks may determine the conditions at which banks borrow from them;
– Lender of last resort: it has the ability to print money and supply the funds to banks with shortages. The government bank deposit insurance aims at preventing bank runs by assuring depositors their funds are safe;
– Holder of gold and foreign exchange reserves: most central banks are responsible for managing its gold reserves and their country’s foreign exchange reserves;
– Conductor of monetary policy: Central banks control both the quantity and the growth of money supplied in an economy.
The objectives of Central Banks
The overreaching objective of most central banks is to control inflation in order to promote price stability. Imagine a world with high inflation. Imagine a situation in which we know that the average cost of prices and services will rise by 5%. If this figure could be fully anticipated, an expectation of 5% inflation may be factored into salary negotiations. In such an imaginary world, we would not care about inflation. Unfortunately, we live in a world where inflation is uncertain. If inflation turned out to be higher than expected, lenders would be hampered as the real value of their borrowing declines. On the other hand, if inflation turned out to be lower than expected, the real value of payment on loans would increase, making life harder for borrowers. That said, if inflation were unstable, the cost of borrowing would be higher as lenders would demand a premium (higher interest rates) to compensate for the additional risk. Consequently, this inflation uncertainty would put a strain on economic activity. Unexpected inflation can also serve to misinterpret the fundamental information that market prices convey which may misguide entrepreneurs.
For example, imagine a situation in which a manufacturer thinks that a sharp increase in the price of surgical masks (significantly higher than expected inflation) is attributable to rising demand or falling supply. To take advantage of higher prices, the company will expand production, employ more workers and purchase more machinery. When attempting to sell masks, he finds out that the increase in the price was not driven by fundamental forces but instead was due to an unexpected rise in inflation. The manufacturer now faces a difficult situation due to the destabilizing impact of unanticipated inflation. That said, high and variable inflation harms long-term growth and employment.
In addition to control inflation, central banks have, normally, other objectives when setting monetary policy:
– The stability in exchange rates with foreign currencies: a rise in the value of a currency makes exports more expensive whereas a decline in the value of currency leads to domestic inflation. Extreme adverse movements in a currency can have a severe impact on exporting industries and may also have serious inflationary consequences if the economy is relatively dependent on imported goods. Therefore, ensuring the stability of foreign exchange markets is very important;
– Maximum employment: this objective does not mean that zero unemployment is a preferred policy goal. A certain level of unemployment (i.e. natural rate of unemployment) is often felt to be necessary for the efficient operation of a dynamic economy;
– The economic prosperity and welfare: the goal of steady economic growth is closely related to that of maximum employment because firms are more likely to invest when unemployment is low. Furthermore, the financial market stability is influenced by stability of interest rates. Increases in interest rates may, for example, lead to a decrease in the value of bonds resulting in losses for bondholders;
– Interest rate stability: volatility in interest rates creates uncertainty about the future and this can adversely impact on business and consumer investment decisions (such as the purchase of a house). Expected higher interest rates levels deter investment.
At first glance, these objectives are consistent with one another. However, conflicts do arise. The objective of price stability may conflict with the objectives of interest rate stability and full employment (at least in the short-run) because as an economy grows and unemployment declines, this may result in inflationary pressures forcing up interest rates (which will probably cause unemployment to increase).
Inflation targeting is the most used tool for making monetary policy decisions. The most common inflation rate target used by central banks is 2%. This figure is far enough away from the risks of negative inflation, known as deflation, which is disruptive to the smooth functioning of an economy. Note that central banks target inflation two years ahead as the current and headline inflation (disclosed every month) is a result of prior policy and events.
Some countries, especially developing countries, choose to operate their monetary policy by using exchange rate targeting rather than targeting inflation. They target a foreign exchange rate against a major currency (often the dollar), with the respective domestic central bank providing support by buying and selling the domestic currency when required. For example, consider a developing country that has set an exchange rate target against the dollar. If the domestic currency depreciates against the dollar, the central bank would sell foreign reserves to purchase their own currency (reducing money supply, increasing short-term interest rates and bringing down inflation) in order to remain close to the target exchange rate. Conversely, if the domestic currency appreciates above the target, the monetary authority will sell its own currency (increasing money supply and reducing short-term interest rates) to reach the target exchange rate.
There are limits on much influence the central banks can have on exchange rates over time – a country may, for instance, run out of foreign reserves when the value of its domestic currency is below the target exchange rate. When a central bank chooses to follow an exchange rate target, the domestic monetary policy, regardless of domestic economic circumstances, must adapt to accommodate this target and as a result, interest rates and money supply may face greater volatility.
The major currencies are floating currencies – their value change according to how the currency trades in global foreign exchange markets. Most developing nations choose fixed exchange rates for their currencies. Some peg, for instance, their currency to the U.S. dollar, especially if their main source of income is paid in dollars. These countries seek to stabilize their economies and keep their inflation rates low.
The three main monetary policy tools (used by Central Banks)
– Open Market Operations: purchase or sale of securities by the central bank. For example, when the central bank buys government bonds from commercial banks, more funds are available for lending to corporations and households, the money supply increases and short-term interest rates fall. Similarly, sales of government bonds by the central bank have the opposite effect. These operations are the most common used instruments of monetary policy in developed economies;
– Policy rate: it is the interest rate at which a central bank is willing to lend money to commercial banks to meet short-term liquidity needs. Through this interest rate, a central bank can control the availability of money in the system. For example, a lower policy rate will expand the money supply. In Europe, the rate at which banks can borrow from the ECB overnight it is called the marginal lending facility rate. If banks need money for a longer period of time (a week), banks may borrow from the central bank at a main refinancing operations (MRO) rate. When banks deposit money with the ECB overnight, they have been paying, since 2014, a deposit facility rate (this is set every six weeks).
In the United States, the Fed requires their member banks to have a reserve requirement (the amount of cash a bank must have each night) for member banks. If a bank does not have enough “federal funds” to fulfill the reserve requirement, it will try to borrow from other banks at the federal funds rate. This is the interbank lending rate on overnight loans of reserves. This rate affects many consumer interest rates including rates on deposits, bank loans, credit cards, mortgages and so forth. The Federal Open Market Committee (FOMC) reduces or adds reserves to the banking system through open market operations to move the federal funds rate to a target level. In case the FOMC wants a lower rate, the Fed will purchase securities – usually Treasury Notes – from banks, giving them additional reserves. If banks have temporary liquidity needs (perhaps they have lent out too much to other banks and they need to borrow money overnight to meet the reserve requirement), they may also borrow reserves directly from the Fed at a discount rate. Most banks try to avoid this as this rate higher than the fed funds rate. The discount window is a back-up plan for those banks who are unable to increase its reserves elsewhere.
Another way to lend money to banks is through a repurchase agreement (Repo). This is a form of short-term collateralized lending and is used to raise short-term capital. For instance, if the central bank wants to increase the supply of money, it might buy securities from commercial banks with a deal to sell them back, in the near future, at a slightly higher price. The small price difference between the purchase price and the repurchase price is the repo rate. Normally, these agreements last from overnight to two weeks.
Imagine the central bank announces an increase in its policy rate. This will lead to an increase in commercial banks’ cost of funds, discouraging lending. A lower policy rate has the opposite effect – even though the commercial banks might not pass the entire rate cut to customers. Businesses and households will tend to borrow more (if of course they are willing to borrow and banks are willing to lend). The former increases investment on capital goods like plant and equipment whereas the latter consume and invest more (houses, autos and durable goods and so forth). Lower interest rates support rising asset prices (such as housing and equities), which, in turn, increase household financial wealth (may lead to higher consumption and housing investment) and make it easier for households and businesses to borrow (given the rising value of the asset used as collateral on loans). The decline in real interest rates (relative to other countries) also induces investors to shift their funds to foreign assets. This also causes the domestic currency to depreciate which makes foreign goods and services more expensive and exports less expensive. Increases in net exports, investment and consumption gives a boost to aggregate demand, inflation (stronger demand tend to put upward pressure on inflation as well as a weaker currency, which increases the prices of imports), employment and real GDP;
– Reserve Requirements: in other words, this is the percentage of deposits that banks are required to retain as reserves. By decreasing reserve requirements, a central bank increases the amount of funds that are available for lending which will tend to decrease interest rates. This is on the assumption that (i) banks are willing to lend; (ii) businesses and households are willing to borrow. By increasing reserve requirements, a central bank achieves exactly the opposite.
For a central bank to succeed in its inflation-targeting attempts, it must be:
– Independent from political interference, theoretically. This principle helps the monetary authority to focus on long-term goals as well as preventing manipulation of monetary policy for political reasons. In practice, separating political influence from control is nearly impossible as government officials normally choose the heads of central banks. There are different degrees of independence. Some central banks set the policy rate independently (operational independence), others determine how inflation is calculated, set the target inflation level and define the horizon over which the target is to be achieved;
– Credible: A respected central bank should follow through on its stated intentions. If a central bank sets an inflation target and if the market believes that a central bank is serious about achieving its target, the belief can become self-fulfilling and the actual inflation will then be close to the target level;
– Transparent: Many central banks periodically disclose inflation reports containing their views on a set of indicators and other factors they consider in their interest rate setting policy. By being transparent in their decision-making, central banks seek to gain reputation and credibility along with making policy changes easier to anticipate and implement.
Limitations of monetary policy
However, sometimes, the monetary policy does not produce the intended results. Long-term interest rates are influenced by the market expectations on the path of short-term interest rates. Nevertheless, long-term interest rates may not rise or fall with short-term interest rates. These are the limitations of monetary policy:
– Suppose that a central bank cuts short-term interest rates to stimulate economic activity. This leads to an increase in expected inflation rates and hence investors require higher yields to be rewarded for the added risk. As a result, long-term bond yields rise and bond prices fall, even with falling short-term rates. This would make borrowing more expensive to households and businesses, slowing down the economy. Now, imagine the opposite, in which the central bank increases short-term rates in order to slow economy activity and ease inflationary pressures. Markets expect lower future inflation rates. As long-term bond yields include a premium for expected inflation, long-term interest rates may decline, making borrowing cheaper to households and businesses. This would stimulate economic activity, rather than slowing it down. Nevertheless, these contrarian effects on monetary policy will be quite marginal in case the central bank’s policy is deemed as credible;
– In an environment of zero (or low) interest rates, monetary policy could actually become ineffective, as:
- People may prefer to hold cash rather than investing in low-yielding debt (alongside credit risk, bondholders would have to bear the risk of possible rises in rising interest).
- If businesses borrow, they will either not expand or modernize their production. They may use the money to pay off debts, buy back shares and pay dividends, boosting stock prices.
- As referred above, there is little banks can do if firms and households are not confident and not willing to borrow money. Similarly, banks might tend to raise their lending requirements and avoid further lending as additional capital provides a cushion in difficult times.
- With weak aggregate demand, the phenomenon of deflation can also occur, reducing people incentive to consumer and invest now. Moreover, firms will neither increase salaries nor hire employees. Deflation also increases the real value of debt.
If these massive injections of money into the banking system fail to spur the real economy, this is called “liquidity trap”. No demand, no economic growth!
With short-term near zero, poor economic growth and a real threat of deflation, central banks began an unconventional approach to monetary policy known as quantitative easing, a monetary tool used a few times during the previous and current crisis with important results – its impact on the US dollar, stocks, bonds will be explained in the next article. Stay tuned!
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