Monetary Law and Monetary Policy

4. Monetary policy – instruments and policies

Dr Marek Porzycki

1. Basic function and purposes2. Approaches – restrictive vs. expansionary3. Monetary policy tools4. Transmission mechanism5. Unconventional tools applied during

current crisis6. Communication of monetary policy7. Sources and reading

Overview

Steering the money supply

- direct influence on the monetary base (M0)

- indirect impact on monetary aggregates (M1 and above) via the transmission mechanism

Basic function of monetary policy

price stability objective price stability vs other goals of monetary policy

- economic growth- high employment- stability on financial markets

Poland: since 1999 the direct inflation target strategy has been applied in the implementation of monetary policy. The Monetary Policy Council defines the inflation target and then adjusts the NBP basic interest rates in order to maximise the probability of achieving the target. Since the beginning of 2004, NBP has pursued a continuous inflation target at the level of 2.5% with a permissible fluctuation band of +/- 1 percentage point.

Note: legal aspects of central bank mandate will be discussed during the following courses

Inflation targetting and its alternatives

Expansionary (loose) monetary policy – expansion of money supply

- aiming at higher inflation (or at least accepting it)

- stimulating economic growth- lower interest rates = cheaper lending- „doves” Restrictive (tight, contractionary) monetary

policy –money supply expands more slowly than usual or even shrinks

- aiming to reduce inflation- cooling down overheated economy- higher interest rates = more expensive lending- „hawks”

Expansionary vs. restrictive policy

Reserve requirements (minimum reserves)- the proportion of total deposits that banks must hold as reserve with the central bank.

Standing facilities - aim to provide and absorb liquidity of banks, signal the general monetary policy stance and influence market interest rates.

Open market operations (OMO)- buying or selling assets (usually government bonds) on the open market from commercial banks and financial institutions

Instruments of monetary policy

a specified fraction of deposits kept with a commercial bank to be set aside in the central bank as mandatory reserve

deposits set aside as reserve cannot be used to finance lending - aims: ◦ limiting excess bank liquidity, putting upper limit on the

money multiplier◦ smoothing out the impact of movements in banking

sector liquidity on interbank interest rates Current values (as of 27.10.2015):- Poland: 3,5 % minus 500.000 EUR per credit

institution- euro area: 1% minus100.000 EUR per

institution

Reserve requirement

Starting from 18.01.2012, the ECB has lowered the reserve requirement from previous 2% to 1% as one of measures intended to support bank lending ( expansionary monetary policy)

press release: http://www.ecb.europa.eu/press/pr/date/2011/html/pr111208_1.en.html

However, this move did not reach its intended goal, as commercial banks preferred to deposit excess reserves at the ECB using the deposit facility.

Reserve requirement - example

SF are aimed at providing and absorbing overnight liquidity, signal the general stance of monetary policy and influence overnight market interest rates

Central bank acts as „bank of banks” taking deposits and extending loans to commercial banks.

„standing” = can be used on the commercial banks’ initiative

Credit-deposit operations serve to limit fluctuations of the shortest (especially overnight) interbank market rates;

Standing facilities (Credit-deposit operations)

primary credit or regular short-term lending (usually overnight)

- Eurosystem: marginal lending facility, banks obtain overnight liquidity from the NCBs against eligible assets

- Fed: discount window- NBP: lombard loans (kredyt lombardowy) extended to

banks against Treasury securities as collateral in order to cover their short-term liquidity shortfalls.

in usual conditions interest rate applied to central bank lending sets a ceiling on interbank interest rates

current rates (27.10.2015): 0,30% (ECB), 2.50% (NBP) to be distinguished from secondary lending or liquidity

support see below, unconventional tools

Standing facilities - lending

short-term (overnight) deposits with the central bank, available to commercial banks

Time deposits at the central bank allow commercial banks to manage their surplus liquidity, preventing short-term interbank market interest rates from falling below the deposit rate.

Interest rate on overnight deposits sets floor to interbank lending rates, as the deposit facility allows banks to „park” any amount of money at the central bank at the deposit rate

Deposit rate is the lowest of central bank interest rates. Current ECB interest rate on deposit facility (as of 27.10.2015): -0,20% ( negative interest rate)

Corresponding NBP rate: 0,50%

Standing facilities - deposits

Aim: to encourage banks to boost lending to each other, to consumers, and to businesses, in turn boosting the broader economy, while discouraging hoarding liquidity◦ instead of earning interest on money deposited with the central

bank, banks are charged by the central bank to park their cash with it

But: the consequences may be unwelcome:◦ banks can pass on to customers the costs they incur for

depositing money with the central bank◦ negative return on parking funds with the central bank might

encourage banks to invest in riskier assets to secure a return, potentially driving new asset bubbles

◦ banks are likely to increase their purchases of government bonds government borrowing costs are artificially low banks and governments could find themselves so intertwined and interdependent that they drag each other - and the economy – down; crowding out effect may occur

◦ Experience in Sweden and Denmark (no noticeable change in the interest rates charged by banks for bank loans)

Negative interest rates

initiated by the central bank Basic form: purchases or sales of assets (mostly

Treasury bonds) from financial institutions Purchases of assets expansion of monetary base,

providing liquidity Sales of assets shrinking of monetary base,

absorbing liquidity Dynamic vs. defensive open market operations

◦ Defensive OMO: in response to or in anticipation of other market events

Repos (repurchase agreements) and reverse repos – purchases/sales reversed on a specified time, subject to specified interest rate

Outright transactions (purchase/sale without an agreement to reverse the transaction)

Open market operations

Other instruments used – collateralised loans, issuance of debt certificates by the central bank, swaps, fixed-term deposits◦ NBP: issue of own-debt securities (7-day NBP money

market bills), whose minimum yield equals the reference rate adopted by the Monetary Policy Council.

Difference in aims and regularity (Eurosystem examples):◦ main refinancing operations: liquidity-providing transactions

with a weekly frequency and a maturity of normally one week

◦ long-term refinancing operations (LTRO, transactions with a monthly frequency and a maturity of normally three months; see also unconventional monetary policy)

◦ fine-tuning operations (conducted on an ad hoc basis in order to smooth the effects on interest rates caused by unexpected liquidity fluctuations in the market)

◦ structural operations, e.g. the issuance of debt certificates

Open market operations 2

From the ECB websiteDate: 06/06/2014Action: Fine-tuning operationCommunication:

As announced by the Governing Council on 10 May 2010, the ECB conducts specific operations in order to re-absorb the liquidity injected through the Securities Markets Programme (SMP). In this regard, the ECB will carry out a quick tender on 10 June 2014 at 11.30 in order to collect one-week fixed-term deposits with settlement day on 11 June 2014. A variable rate tender with a maximum bid rate of 0.15% will be applied and the ECB intends to absorb an amount of EUR 162.5 billion. (…).

Open market operations - example

Lending by central banks should be based on adequate collateral (assets submitted by commercial banks as security).

Treasury bonds and other marketable assets (e.g. credit claims) are usually used as collateral.

Lombard loans extended by the Polish NBP: collateral consists of Treasury securities and the amount of loan may not exceed 80% of their nominal value

Central banks maintain a list of eligible collateral and update it from time to time (example: http://www.ecb.europa.eu/paym/coll/assets/html/list.en.html)

Risky collateral, e.g. bonds with lower credit risk rating, may be eligible under certain circumstances but valuation haircuts may be applied to reflect higher risk.Example: use of Greek sovereign bonds as collateral for Eurosystem monetary policy operations

Eligible collateral

Institutions allowed to contract with the central bank within the monetary policy framework.

Broadly: commercial banks and similar institutions.

Eurosystem eligibility criteria – eligible institutions should be:

- subject to minimum reserve requirement- in financially sound condition- subject to financial supervision by competent

authorities- fulfilling operational criteria

Eligible counterparties

Interest rates applied by central banks to respective monetary policy instruments

Announced by the central banks and changed in reaction to monetary policy needs:

- rate increase – tightening the monetary policy, aimed at reduction of the money supply

- rate decrease – easing the monetary policy, aimed at expansion of the money supply

Influence on conditions on the money market (interbank market and transactions between banks and the general public) and in the general economy via the transmission mechanism.

Central bank interest rates

Examples: ECB http://www.ecb.europa.eu/home/html/index.en.html („Interest rates”)http://www.ecb.europa.eu/stats/monetary/rates/html/index.en.html NBPhttp://www.nbp.pl/ („Stopy procentowe NBP”)http://www.nbp.pl/homen.aspx?f=/en/dzienne/stopy.htm

Central bank interest rates

Reserve requirements - useful as a limit of possible money creation but not suitable for rapid changes in answer to changing conditions on the market.

Standing facilities – useful to influence interest rates on the market but not suitable for reacting to daily fluctuations.

Open market operations – more flexible, initiated by the central bank at any time and with any volume needed. Easily reversible.

Assessment of the respective monetary policy tools

combination of the monetary policy and the fiscal policy, as two channels influencing growth and employment

They are generally determined, respectively, by the central bank and the government

Monetary and fiscal policies affect each other, and the right policy mix is supposed to achieve desirable macroeconomic outcomes such as price stability, credit availability, economic growth and financial stability

An example of a policy mix would be tight monetary policy combined with easy fiscal policy.

„Policy mix”

Function of „bank of banks” central banks deal directly only with commercial banks but not with the general public.

Proper functioning of the monetary policy requires transmission of measures taken by the central bank through commercial banks to the economy.

Transmission channels include credit and deposit businesses of the commercial banks, asset prices, currency exchange rates and indirectly also wage and price-setting resulting from supply and demand of goods, services and labour.

Transmission mechanism is affected by events beyond control of the central bank, such as global economic developments, commodity prices, political events etc.

Transmission mechanism

Source: ECB, http://www.ecb.europa.eu/mopo/intro/transmission/html/index.en.html

Transmission mechanism 2

Specific problems with transmission of expansive monetary policy in periods of recession.

„Zero interest rate policy” („ZIRP”) and negative interest rates.◦ ZIRP: the central bank maintains a 0% nominal interest

rate.◦ central bank is no longer able to reduce nominal interest

rates Liquidity trap: injections of cash into the private

banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective◦ A liquidity trap is caused when people hoard cash because

they expect an adverse event such as deflation, insufficient aggregate demand, or war.

◦ Japan: the economy fell into a period of prolonged stagnation despite near-zero interest rates

Transmission mechanism 3

Expanding the monetary base does not increase money supply as long as banks do not start credit expansion.

Monetary policy alone is not able to kick-start economic growth.◦ Central banks can encourage money creation, but they

cannot force commercial banks to extend credit◦ money cannot be pushed from the central bank to

borrowers if they do not wish to borrow compared to „pushing on a string”

◦ "Monetary policy [is] asymmetric; it being easier to stop an expansion than to end a severe contraction.” (R.G. Sandilans)

Transmission mechanism 4

crisis-related, extremely expansive monetary policy in order to stimulate economic growth

applied when interest rate cuts have failed to stimulate monetary expansion („pushing on a string”) and further cuts are next to impossible (zero or negative interest rates)

asset purchases - quantitative easing (QE) Long term open market operations – LTRO liquidity support – e.g. Emergency Liquidity

Assistance (acting as „lender of last resort”) commitment to further actions

Unconventional tools

Central banks purchase large volume of financial assets (mostly Treasury bonds) from banks, creating new money to pay for them.

Direct effects of QE:◦ Raising the prices of those financial assets and lowering

their yield while simultaneously increasing the monetary base[

As banks buy Treasury bonds in order to re-sell them to the central bank, QE is sometimes considered to circumvent the prohibition on monetary financing (lending by the central bank to the Treasury). Purchases of Treasury bonds by the central bank are legal if occuring on the secondary market, but prohibited on primary market (directly from the Treasury).

Result: large expansion of the monetary base (M0) first applied in Japan since 2001, then by several central

banks after 2007

Quantitative easing

started in January 2015, intended to last at least until September 2016

monthly asset purchases amounting to €60 billion assets purchased include bonds issued by euro

area central governments, agencies and European institutions, in addition to private sector assets

justified by the need to „address the risks of a too prolonged period of low inflation” i.e. the ECB’s price stability mandate

monetary stimulus to the economy also mentioned

See more: http://www.ecb.europa.eu/press/pr/date/2015/html/pr150122_1.en.html

ECB expanded asset purchase programme

secondary lending or liquidity support Central bank acts as „lender of last resort”

providing liquidity to disstressed (but solvent) banks.

- Eurosystem: Emergency Liquidity Assistance (ELA) providing liquidity to solvent banks facing

temporary liquidity problems (e.g. withdrawal of deposits, lack of access to interbank lending).

function: preventing bank runs. Not applicable to insolvent banks which should be

subject to bank resolution tools or insolvency proceedings.

Liquidity support

On 21.3.2013 the ECB announced that Emergency Liquidity Assisstance to Cypriot banks would be continued only until 25.3, unless a programme to ensure their solvency is put in place. http://www.ecb.int/press/pr/date/2013/html/pr130321.en.html

On 25.3 a bailout deal was reached between Cyprus and the Eurogroup (Eurozone finance ministers).

On 25.3 the ECB decided to continue providing ELA to Cypriot banks, based on the assumption that the bailout maintained their solvency. http://www.ecb.int/press/pr/date/2013/html/pr130325.en.html

Liquidity support – example

Function: sending signals to the markets Example: speech by Mario Draghi, President of the

ECB, on 26.7.2012 „Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” http://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html

Understood as commitment to unlimited asset purchases.

Follow-up: launch of Outright Monetary Transactions on 6.9.2012 (never actually used)

http://www.ecb.europa.eu/press/pr/date/2012/html/pr120906_1.en.html

Commitment to further action

Does QE mean „printing money”? QE and other forms of unconventional monetary

policy result in a large expansion of central banks’ balance sheets expansion of monetary base (M0)

However, inflation results from the increase of total money supply, including not only M0 but mostly money created by commercial banks (M1, M2).

As banks mostly deposited additional funds obtained from QE as deposits in the central banks (excess reserves), lending expansion did not occur and there was no increase in total money supply.

Will QE cause inflation?

As long as commercial banks do not start credit expansion using the expanded monetary base, overall money supply remains low and inflation does not result.

Once credit expansion exceeds a certain degree, central banks would need to restrict monetary policy, including shrinking the monetary base in order to avoid inflation („exit strategy”).

Too early tightening of the monetary policy could push the economy into deep recession.

In case of a too late tightening, inflation can result from expanded monetary base being used to finance lending.

Will QE cause inflation? 2

In order to be efficient, monetary policy needs to be predictable.

explaining monetary policy in detail to the general public

publishing long-term strategies and policies declaring „approaches” in monetary policy regular meetings of the rate-setting bodies,

followed by press conferences publication of minutes of discussion of the

rate-setting bodies

Communication with the public and managing expectations

„Monetary Policy Guidelines” – a yearly strategy document by the NBP http://www.nbp.pl/polityka_pieniezna/dokumenty/zalozenia/zalozenia_pp_2016.pdf

ECB communication channels explained: http://www.ecb.europa.eu/mopo/strategy/comm/html/index.en.html

Communication - examples

F. Mishkin, The Economics of Money, Banking, and Financial Markets, Pearson, 10th ed. 2013

- monetary policy tools, p. 418-431 - price stability and other goals: Chapter 17, p. 434-461 ECB website

http://www.ecb.europa.eu/mopo/html/index.en.html (see menu on the left side of the website)

NBP website http://www.nbp.pl/homen.aspx?f=/en/onbp/informacje/polityka_pieniezna.html

Fed website http://www.federalreserve.gov/monetarypolicy/default.htm

For Polish readers: A. Sławiński (red.), Polityka pieniężna, Warszawa 2011

Additional reading and reference materials

most comprehensive and detailed description of the Eurosystem monetary policy

set in the ECB Guideline (EU) 2015/510 of 19 December 2014 on the implementation of the Eurosystem monetary policy framework  (ECB/2014/60)

http://www.ecb.europa.eu/ecb/legal/pdf/oj_jol_2015_091_r_0002_en_txt.pdf

ECB General Documentation

Try yourself in monetary policy – €CONOMIA - The Monetary Policy Game on the ECB website: http://www.ecb.europa.eu/ecb/educational/economia/html/index.en.html

On a lighter note…