Lecture 9

1. Lecture 9 CONDUCT OF MONETARY POLICY:OBJECTIVES AND STRATEGIES

2. The monetary policy goals of the ECB • The primary objective of the European System of Central Banks (ESCB) is to maintain price stability.   • Without prejudice to the primary objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community. • In pursuing its objectives, the ESCB shall act in accordance with the principle of an open market economy with free competition, favoring an efficient allocation of resources.

3. Transmission processes of policies • Central banks, cannot control the price level directly. They face a complex transmission process from their own monetary policy actions to changes in the general price level. • These transmission mechanisms are characterized by the existence of several distinct channels, each with long, and variable reaction lags. • Moreover, the transmission mechanisms themselves are continuously evolving over time due to behavioral and institutional change.

4. Policy goals and targeting • The strategy of central banks is to aim at variables between the goals to be achieved and the tools available: • Intermediate targets. These can be monetary aggregates (M1, M2, M3) or interest rates (short, long). • Operating targets (or “instruments”): They can be directly adjusted (monetary base, reserves, minimum bid rate of the main refinancing operations).

5. Rs ist Rs’ ist* Rd Quantity of reserves What instruments has a central bank? • Open market operations.Purchases in the open market causes the short-term interest rate (federal funds rate) to fall.It affects the supply of reserves

6. Rs ist Rs’ ist* Rd Quantity of reserves What instruments has a central bank? • Discount lending.It also raises the quantity of reserves supplied which causes the short-term interest rate (federal funds rate) to fall.

7. Rs ist ist* Rd’ Rd Quantity of reserves What instruments has a central bank? • Reserve requirements.It increases the quantity of reserves demanded which causes the short-term interest rate (federal funds rate) to increase.

8. Advantages of OMOs • OMOs are under the full control of a central bank. This is not the case for discount operations. • OMOs can be carried out in small quantities to “smooth” developments. • OMOs can easily be reversed (repos). • OMOs can be implemented without delays.

9. Characteristics of discount policy • The main advantage is that the central bank can use it in its function as “lender of last resort”. • But there are three main disadvantages: • The announcement of a discount rate change can create confusion if it contradicts the policy stance. • If the discount rate is set at a given level, the spread between id and the market interest rate can vary wildly. • Discount operations are difficult to reverse.

10. Characteristics of reserve requirements • The advantage is that they affect all banks equally and have an effect on the supply of money. • But reserves requirements are hard to engineer because of multiple deposit contractions (expansions). • Raising reserve requirements can cause immediate liquidity problems.

11. Reserve requirements in the Euro area

12. Should reserve requirements be reformed? • Should they be abolished? • Reserve requirements should be retained to produce a more stable money multiplier, which facilitates monetary control. • Reserves should bear interest. • Should the reserves be 100 percent? • It would allow to strictly control the money supply. • But banks can no longer make loans.

13. Targeting : the NASA strategy • By analogy, NASA’s strategy of sending spaceships to the moon also works through “operating targets”. • The pace of spaceships is continuously adjusted to “intermediate targets”, and finally to the “goal”.

14. Example of central bank strategy: • Suppose the central bank’s price-level goal is consistent with a nominal GDP growth rate of 5%. • The bank may then feel that this goal can be achieved • by a 4% growth rate for M2 (intermediate target), and • by a 3.5% growth rate for the monetary base (operating target = tool).

15. Adjustments of central bank policy • After implementing the policy, the central bank may fine-tune, for instance • because the monetary base may be growing too slowly (which calls for an increase of OMO purchases); • or M2 may not grow in line with the monetary base (which also requires an adjustment of policy instruments such as OMOs).

16. Types of target variables • The central bank has the choice between two different types of target variables: • monetary aggregates (monetary base, reserve requirements, M1, M2, M3, etc.) • and interest rates. • Can a central bank pursue both targets at the same time?

17. Ms i* Md M* Quantity of money The answer is no! Why? • If a monetary aggregate is used, the control of the interest rate is lost:

18. iu Mdu i* il Mdl Quantity-oriented strategy: problem • If the money demand curve shifts unexpectedly, the interest rate will fluctuate: Ms Md* M* Quantity of money

19. Interest rate-oriented strategy: problem • In order to keep the interest rate at a given level (target), the central bank must accept variations in monetary aggregates: Ms Msl Msu Mdu Targetrate i* Md* Mdl Quantity of money

20. What criteria to decide on the target? • There are three criteria for choosing an intermediate target: • It must be accurately measurable, and the indicator should be available rapidly; • it must be controllable by the central bank; • and it must have a predictable effect on the policy goal.

21. Measurability • GDP figures and price indices become available only after a time lag, and they are often revised. • Monetary aggregates are obtained quicker (2 weeks), but are often revised. • Interest rates are obtained instantly and are not revised. • Are interest rates the best target? Be careful: What we need are real interest rates!

22. Controllability and predictability • A central bank has the ability to exercise a powerful effect on the money supply, although control is not perfect. • Although it appears that the central bank can also control interest rates, it cannot fully control inflationary expectations. • The linkage between intermediate targets and the policy goal is controversial, so the predictability issue is highly contentious.

23. A historical perspective: the Fed • When the Fed was created in 1914, the discount rate was the primary tool. • OMOs were not yet discovered, and the Federal Reserve Act had no provisions to change reserve requirements. • The policy was based on the “real bills doctrine” (loans only for “productive purposes”)  which papers are ‘eligible.’

24. The Fed after World War I • By the end of World War I, the (re-)discounting of eligible papers (including Treasury bills) had led to inflation, and the “real bills doctrine” became discredited. • The Fed abandoned its passive role, and it increased the discount rate from 4.75% to 7% in 1920, which (after a short recession in 1920-21) brought inflation under control. • This paved the way for the “Roaring Twenties”.

25. The discovery of OMOs • The Fed discovered open market operations by accident: • It revenue (mainly from discount loans to member banks) shrank during the 1920-21 recession, so the Fed was under pressure. • It reacted by purchasing income-earning securities to compensate for the losses. • It then discovered that reserves in the banking industry grew (credit multiplier).

26. World War I and the Reichsbank • In 1914, the Reichsbank had suspended redeemability of its notes in gold. • Much of the government borrowing was discounted by the Reichsbank. • At the end of the war, money in circulation had increased four-fold. • The consumer price index had risen 140% by December 1918. • Yet floating debt of the Reichsbank had increased from 3 to 55 billion marks.

27. The Reichsbank: After WW I • Inflation was fueled by • Germany’s reparation payments, which triggered a devaluation of the mark. • A decline in confidence in the mark. • Hoarded savings entered the market place. • By February 1920, the price index was 5 times as high as at armistice, but it held almost stable for 15 months. • This chance of monetary policy was spoiled.

28. The pace to hyperinflation • During these fifteen months the government kept issuing new money. • The currency in circulation increased by 50% and the floating debt of the Reichsbank by 100%, providing fuel for a new outbreak. • In May 1921, price inflation started again and by July 1922 prices had risen 700%. • After July 1922 the phase of hyperinflation began.

29. The German hyperinflation 1922-23

30. Stabilization program of 1923/24 • In November 1923, a currency reform was undertaken. • A new bank, the (private) Rentenbank, was to issue a new currency: the Rentenmark. • This money was exchangeable for bonds backed up by land and industrial plant • A fixed amount of 2.4 billion Rentenmarks was created, and each Rentenmark was valued at one trillion old paper marks. • The Rentenmarks held their value. Inflation ceased even for the Reichsmark.

31. Completing the 1923 reform • In August 1924 the reform was completed by the introduction of a new Reichsmark, equal in value to the Rentenmark. • The Reichsmark had a 30% gold backing. It was not redeemable in gold, but the government undertook to support it by buying in the foreign exchange markets as necessary. • The Reichsbank became independent from the government and government loans were limited. • Drastic new taxes were imposed, and with the inflation ended, tax receipts increased impressively. In 1924-1925 the government had a surplus.

32. The “Roaring Twenties” and the Fed • The stock market boom of 1928/29 created a dilemma for the Fed: • tempering the boom would have required a higher discount rate; • the Fed hesitated to do that because of “legitimate credit needs” • When the discount rate was finally raised (August 1929), it was too late.

33. The Bank Panics of 1930-33 • Substantial withdrawals from banks ended in a full-fledged panic at the end of 1930. • One bank after the other closed, but the Fed did not perform its role as lender of last resort. • It did not understand the impact of bank failures on money supply and economic activity. • Moreover there was political haggling that entailed policy inactivity.

34. The switch to monetary targeting • In the early 1970s (Arthur Burns), the Fed adopted a policy of monetary targeting, but its commitment to the new policy was weak. • (The Bundesbank followed in 1974.) • The policy was to pre-announce target ranges for the growth rates of money aggregates. • However the Fed continued to use the federal funds rate as an operating target. • In 1979 (Paul Volcker) the Fed officially changed its policy, using reserves as the instrument.

35. Returning to interest-rate policies • Once inflation was checked, the Fed deemphasized monetary aggregate targets and returned to a policy of smoothing interest rates. • In 1993, Alan Greenspan testified in Congress that the Fed would no longer use monetary targets. • During the 1990, with strong growth and low inflation, the Fed focused on interest rate policies, with a defensive stance.

36. The ECB’s monetary policy strategy • The ECB's stability-oriented monetary policy strategy consists of three main elements: a quantitative definition of price stability, and the two "pillars" used to achieve this objective. • These two pillars are: • a prominent role for money, as signaled by the announcement of a quantitative reference value for the growth rate of a broad monetary aggregate; • and a broadly based assessment of the outlook for price developments and risks to price stability in the euro area as a whole.

37. The definition of price stability • The Governing Council of the ECB has adopted the following definition: • “Price stability shall be defined as a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%”. • Price stability according to this definition “is to be maintained over the medium term”.

38. Quantitative reference value • To signal the prominent role it has assigned to money, the Governing Council announces a quantitative reference value for monetary growth as one pillar of the overall stability-oriented strategy.

39. Reference value: problems First, to ensure that the reference value is consistent with the maintenance of price stability, money must have a stable relationship with the price level. The stability of this relationship is typically assessed in the context of a money demand function. Second, substantial or prolonged deviations of monetary growth from the reference value signal risks to price stability over the medium term. It requires that monetary growth is a leading indicator of price developments.

40. Money demand (velocity) in the Euro area

41. The broadly based outlook for prices • It is based on a large number of indicators. • The range of indicators includes many variables that have leading indicator properties for future price developments. • They include, inter alia, wages, the exchange rate, bond prices and the yield curve, various measures of real activity, fiscal policy indicators, price and cost indices and business and consumer surveys.