Monetary Policy

Chapter 13, 14

Operating Instruments: Target Interest Rates

• On a day to day basis, central banks express their policy in terms of a single easily observed, easily controlled financial market price or quantity.

• In many economies, central banks use the interest rate in interbank market as an operating instrument

Fed Federal Funds Rate

BoJ Uncollateralized Call Money Rate

ECB Main Refinancing Rate

BoK Overnight Call Rate

UK Official Bank Rate

Interbank Market

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D

iIBR

Reserve Accounts

iTGT

i*

Open Market Practice

• On a daily basis, a central bank will provide instructions to engage in open market transactions that will adjust supply to keep the interbank interest rate near the target rate.

• Example: If there is an excess demand for reserves, the traders might engage in an open market purchase of bills, increasing the supply of reserves pushing down the rate until it is near the target.

Interbank Market:OMO to meet demand for reserves

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Reserve Accounts

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Keeping close to target

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Market Rate Target

http://research.stlouisfed.org/fred2/categories/118

Defensive Transactions

• An open market transaction to keep interest rate near the target is referred to as a defensive tranaction.

• If excess demand/supply for reserves is felt to be temporary, OMO will be done with a repo/reverse repo transaction.

• What is a repo transaction?

Why Interbank Rate as Instrument?

• Easy to observe

• (Mostly) easy to control since banks keep reserves at the bank.

• Clear transmission to economy

Dynamic Transactions and Policy Changes

• Central bankers shift monetary policy by changing the interest rate target.

• In order to enact the change, the bank’s traders are instructed to engage in dynamic transactions.– A dynamic purchase of bills will be

implemented to reduce interest rates.– A dynamic sale of bills will be implemented to

increase interest rates.

Interbank Market: Policymakers decide to increase target

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iIBR

Reserve Accounts

iTGT1

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iTGT'

Interbank Market:Policymakers decide to reduce target

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iIBR

Reserve Accounts

iTGT

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iTGT'

Fed Funds Rate & Money Market Rates

• If iFF < iMM, banks can borrow money in Fed Funds market and buy higher yielding investments. – Purchase of the limited number of these

instruments would push down rates.

• If iFF > iMM, banks would sell money market instruments to fund lending in Fed Funds market.– Sale of these instruments would push up

interest rates.

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AS

Cutting Interest Rates will shift out the AD curve

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AD2

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Monetary Transmission Mechanism

Interbank Interest Rate

Money Market Rates

Forex

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Economy

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ricesLT

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est R

ates

Policy Framework

• Fed Objective Humphrey Hawkins Act (1978): Fed instructed by Congress to be “conducting the nation's monetary policy .. in pursuit of maximum employment, stable prices, and moderate long-term interest rates “

• ECB Objective “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.”

• Japan Objective: Bank of Japan Act Article 2 Currency and monetary control by the Bank of Japan shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy

Why Price Stability?

1. High inflation generates high money interest rates and taxes

2. Unpredictable inflation generates risk for borrowers and lenders.

3. Stabilizing price level stabilizes output when driven by demand shocks.

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AD’

Demand Driven Recession w/ Counter-cyclical

monetary policy

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YP

AD

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1. Economy goes into a recession. Fed detects deflationary pressure

2. Monetary Policy Cuts Interest Rate

3. Demand shifts back returning both price and output to LR levelOutput Gap

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Intermediate Target: Expected Inflation

• Intermediate Target: How the central bank measures the economy and the impact that it is having on it.

• Since interest rates hit the economy with a lag, measure the future path of inflation to judge impact of monetary policy

• Problem: Expected inflation is not perfectly measurable. – Economic data and models– Financial market info (TIPS spreads, yield spreads,

futures)

Policy Feedback: Taylor Principle

• Real interest rate impacts demand for goods in economy.

• Real interest rate is rt = it - E[πt+1]

• When E[πt+1] rises, central bank should increase it more than 1-for-1 to raise real interest rate, limit demand and limit inflation.

• When E[πt+1] falls, central bank should reduce it more than 1-for-1 to drop real interest rate, raise demand and avoid deflation.

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

*1 12 2.025 ( )TGT

t t t ti Output Gap

The Taylor Rule Download

Inflation Targeting

• A growing number of central banks, beginning in New Zealand in the 1980’s conduct monetary policy under the framework of “inflation targeting”

• Bank states an explicit target for inflation and publishes inflation forecasts under current conditions. Policy is set in order to bring actual inflation within a range around the target.

• Central bankers are judged by their ability to hit target and repeated failures may result in policymakers losing their jobs.

List of Inflation Targeting CountriesRose A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed

Bank of England Target • The inflation target

The inflation target of 2% is expressed in terms of an annual rate of inflation based on the Consumer Prices Index (CPI). The remit is not to achieve the lowest possible inflation rate. Inflation below the target of 2% is judged to be just as bad as inflation above the target. The inflation target is therefore symmetrical.

• If the target is missed by more than 1 percentage point on either side – i.e. if the annual rate of CPI inflation is more than 3% or less than 1% – the Governor of the Bank must write an open letter to the Chancellor explaining the reasons why inflation has increased or fallen to such an extent and what the Bank proposes to do to ensure inflation comes back to the target.

• A target of 2% does not mean that inflation will be held at this rate constantly. That would be neither possible nor desirable. Interest rates would be changing all the time, and by large amounts, causing unnecessary uncertainty and volatility in the economy. Even then it would not be possible to keep inflation at 2% in each and every month. Instead, the MPC’s aim is to set interest rates so that inflation can be brought back to target within a reasonable time period without creating undue instability in the economy.

Chart 2 CPI inflation projection based on market interest rate expectations and £175 billion asset purchases

The fan chart depicts the probability of various outcomes for CPI inflation in the future. It has been conditioned on the assumption that the stock of purchased assets financed by the issuance of central bank reserves reaches £175 billion and remains there throughout the forecast period. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that inflation in any particular quarter would lie within the darkest central band on only 10 of those occasions. The fan chart is constructed so that outturns of inflation are also expected to lie within each pair of the lighter red areas on 10 occasions. In any particular quarter of the forecast period, inflation is therefore expected to lie somewhere within the fan on 90 out of 100 occasions. The bands widen as the time horizon is extended, indicating the increasing uncertainty about outcomes. See the box on pages 48–49 of the May 2002 Inflation Report for a fuller description of the fan chart and what it represents. The dashed line is drawn at the two-year point.

Bank of England Inflation report

Japan and the Liquidity Trap

• BBC Story Download • During the 1990’s and this decade Bank of

Japan reduced their nominal interest rate ultimately implementing ZIRP – Zero Interest Rate Policy

• Interest rate cannot be set at a rate below zero because of the existence of an alternative financial instrument that always pays better than negative rates.

Money Market at ZIRP

0

iDM

PWhen nominal interest rate reaches zero, demand for money turns infinite since money pays just as good an interest rate as bonds.

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Money Market at ZIRP

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The central bank can shift out the money supply and even push the real interest rate negative as long as expected inflation is positive.

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Money Market at ZIRP

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Once the real interest rate drops to the negative of expected inflation, people will be willing to hold all additional money created and the real interest rate will not drop

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ZIRP: Japan

Jul-1985 Jul-1988 Jul-1991 Jul-1994 Jul-1997 Jul-2000 Jul-2003 Jul-2006

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JP: Call Rate: Uncollaterized: Overnight% pa

Post-2008 Environment

• Deep business cycle recession

• Shaky financial sector

Recession Worsening

Zero Lower Bound

• Recession environment suggest expected deflation

• Taylor rule suggests negative interest rates but…

• Interest rates can’t decline below zero, since no one would lend reserves (which pay at least zero interest) and accept a negative return.

Big differential between interest rate suggested by Taylor rule and zero.

ZIRP: Japan

Jul-1985 Jul-1988 Jul-1991 Jul-1994 Jul-1997 Jul-2000 Jul-2003 Jul-2006

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JP: Call Rate: Uncollaterized: Overnight% pa

Large Scale Expansion in Monetary Base

Monetary Base

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€200,000

€400,000

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€800,000

€1,000,000

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ECB (Million Euro)

Bank of England (MillionPound)

Federal Reserve Board(US$ Million)

Final Question

• Can Fed Withdraw Funds when expected inflation no longer low?– Maybe, Japan has done it before.– But will financial firm profits disappear without

easy funding? Can Fed accept that?

Learning Outcomes

• Use the model of the bank reserves market to qualitatively derive and describe the impact of defensive and dynamic transactions on interbank rate and quantity of reserves.

• Use the model of the money market and AS-AD to qualitatively derive and describe the impact of monetary policy transactions on the economy.

• Use the Taylor principle to qualitatively describe and the Taylor rule to quantitatively describe the impact of economic conditions