From Micro to Macro

1. Goals/Economic Outcomes

2. Intermediate Targets: Nominal Anchor

3. Operating Targets

4. Tools

6 Aspects of Monetary Policy Strategy: Economic Goals

1. Expansionary Monetary policy cannot increase economic growth in the long-run.

2. As inflationary policy becomes expected, wage inflation rises in tandem eliminating impact on inflation on output or unemployment.

3. High inflation has large negative impacts on economic welfare & financial stability

4. Nominal Anchor Needed to avoid inflation.

6 Aspects cont.(Mishkin, Monetary Policy Strategy, Forthcoming)

5. Nominal Targets are subject to “time consistency” issues – In the short-run, the government may be tempted to dilute the currency making it difficult to build credibility for a nominal target.

6. Independent central banks have better credibility and bring better outcomes.

Credibility

A nominal anchor w/o credibility

• leads to high inflationary expectations and high interest rates.

• leads to increasing wage demands and potentially a wage-price spiral.

Nominal Anchors

1. Monetary Aggregates: M1, M2

2. Exchange Rates

3. Price Stability• Inflation Targeting

Money Supply The stock of the medium of

exchange supplied by the central bank.

Types of Financial Assets

M1 Currency in Circulation [C] + Demand Deposits [D]

M2 M1 + Savings Deposits + “Small” Time Deposits +

[Liquid Money Market Instruments inc/ “Small” NCD’s]

M3 M2 + LTD [“Large” Time Deposits and NCD’s]

Anchoring the Money SupplyPopular in 1970s and 80s,

Used by ECB till 2003

Monetary

Base

Money

Multiplier

Money

Supply* =

Banknotes & Reserve Accounts under the control of central bank

Fractional reserve banking

US M2 Money

Multiplier

M2 Multiplier

7

8

9

10

11

12

13

14

Jan-

59

Jan-

64

Jan-

69

Jan-

74

Jan-

79

Jan-

84

Jan-

89

Jan-

94

Jan-

99

Jan-

04

•The history of volatility of the M2 multiplier has convinced the Fed that it is impossible to control the money supply through their control of the monetary base.

Link between Money Supply and Economy

Money

Supply

Velocity Nominal Spending Power

* =

Speed of circulation of money supply

Velocity Hard to Predict

1.5

1.6

1.7

1.8

1.9

2.0

2.1

2.2

60 65 70 75 80 85 90 95 00 05

US M2 Velocity

Price Stability: Long Term

• Big central banks focus on price and/or output stability. – ECB: “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.”

– BoJ: “currency and monetary control shall be aimed at, through the pursuit of price stability, contributing to the sound development of the national economy."

– FED: “to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates”

Five Pillars of of Inflation Targeting

1. Institutional commitment to price stability.

2. No other nominal anchors.

3. Absence of Fiscal Dominance

4. Policy Instrument Independence

5. Transparency and Accountability

A medium term communication strategy

• Clear statement of numerical target for inflation over the medium (1-2 year) term.

• Communication with public about current forecasts of inflation and policy actions used to achieve target.

• Central Bankers accountable for achieving goals.

Adoption of Inflation Target Regimes

• New Zealand, 1989

• Canada, 1991

• UK and Israel, 1992

• Australia, Sweden and Finland, 1993

• Regionally: Thailand, Philippines, and S. Korea all have adopted inflation targeting in recent years.

How seriously does ECB take inflation target?

EU Harmonized Inflation

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

Jan-

02

Apr-0

2

Jul-0

2

Oct-02

Jan-

03

Apr-0

3

Jul-0

3

Oct-03

Jan-

04

Apr-0

4

Jul-0

4

Oct-04

Jan-

05

Apr-0

5

Jul-0

5

Oct-05

Jan-

06

Apr-0

6

Jul-0

6

Will USA shift to explicit inflation targeting?

• To date, US has used a cult of personality approach to build credibility for price stability of target.

• New guard at central bank may prefer a more explicit approach.

Bernanke et al

Big Current Questions

• Can monetary policy that stabilize goods price inflation allow to much volatility in asset price inflation?

• Should monetary policy take into account asset prices which adjust more quickly than goods prices?

• Will efforts to keep stock prices from falling lead to monetary expansion and inflation?

Fed cut effective funds rate in August before announcing decline

in target in September. Effective Fed Funds Rate

4.60

4.70

4.80

4.90

5.00

5.10

5.20

5.30

5.40

5.50

7/6/

2007

7/13

/2007

7/20

/2007

7/27

/2007

8/3/

2007

8/10

/2007

8/17

/2007

8/24

/2007

8/31

/2007

9/7/

2007

9/14

/2007

EFF

Exchange Rate Targets

• Outside the G7, a number of economies focus monetary policy on maintaining a stable exchange rate. – No independent currency, currency board,

conventional exchange rate peg.

• Some economies will target money and other domestic nominal anchors or target the exchange rate as the occasion calls for– Intermediate regimes called managed floating,

crawling peg, exchange rate bands.

IMF Exchange Rate Classification

0

10

20

30

40

50

60

No Currency CurrencyBoard

FixedExchange

Rate

Band CrawlingPeg

ManagedFloat

Free Float

Source http://www.imf.org/external/np/mfd/er/2005/eng/1205.htm

Bipolar Hypothesis

• Fixed exchange rates are subject to speculative attacks.

• One theory is that central banks should:1. Make the fixed exchange rate impervious to

attack through currency board or dollarization

or2. Adoption floating exchange rate

Controversy remains about this theory

Operating Targets• A target for monetary policy that can be

achieved on a day to day basis.

• Characteristics of an operating target1. Observable

2. Controllable

3. Linked to Goals & Nominal Anchors

Consensus on Operating TargetsCecchetti p. 475

a) The reserve requirement can be used to control demand for reserves but is not useful for controlling money multiplier.

b) Central bank lending is necessary to insure financial stability but not for day to day monetary policy control.

c) Short-term interest rates is the main tool for controlling inflation

Operating Target

• Examples of an operating target1.Inter-bank Interest Rate

2.Level of Bank Reserves

3.Exchange Rate

Operating Targets: Target Interest Rates

• Most big country CB’s target interbank interest rates, the rate at which banks lend reserves to one another (in HK, this is called what?)

Fed Federal Funds Rate

BoJ Uncollateralized Call Money Rate

ECB Main Refinancing Rate

BoK Overnight Call Rate

UK Official Bank Rate

Interbank Market

S

D

iIBR

Reserve Accounts

iTGT

Targeting the Inter-bank Rate• Inter-bank rate set by supply and demand

in inter-bank market. – Central bank sets supply of reserves.

• Banks would like to have a certain amount of funds in their reserve accounts.– The higher the inter-bank rate, the fewer

reserves they would like to hold themselves and the more they would like to lend to others.

• Central bank must set supply of reserves equal to demand at the target rate.

Linked to Goals: 2 Directions

Operating Target

Nominal Anchor

Monetary Policy

Committee

Monetary TransmissionMechanism

Nominal Anchor

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

Setting the Interbank Interest Rate

• Raise interest rate target when inflation threatens to rise above the target level.

• Reduce interest rate target when inflation threatens to fall below the target level.

Tends to stabilize output in the face of demand shocks

Supply shocks may require adjustment of the inflation target.

Target Rates Affect Money Market Rates

Money Market Rates USA

0

1

2

3

4

5

6

7

Sep

-97

Mar

-98

Sep

-98

Mar

-99

Sep

-99

Mar

-00

Sep

-00

Mar

-01

Sep

-01

Mar

-02

Sep

-02

Mar

-03

Sep

-03

Mar

-04

Sep

-04

Mar

-05

Sep

-05

Mar

-06

C.P. Rate Fed Funds T-Bill 3 Mo

CEIC Database

Monetary Transmission Mechanism

ECB Web Site

Interbank Market: Zero Interest Rates

S

D

iIB

Clearing Balances

iTGT

S′iTGT′

S′′

0=iTGT′′

ZIRP: Japan

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

10

9

8

7

6

5

4

3

2

1

0

JP: Call Rate: Uncollaterized: Overnight% pa

ZIRP & Quantitative Easing• Since 1999 (w/ a brief break in 2000), Japan has

operated a policy of maintaining a zero interest rate.

• Since 2001, central bank followed a policy of “quantitative easing” in which the bank targeted the quantity of current account balances (reserve accounts) and sought to increase the supply of current account balances by purchasing a variety of assets from banks including corporate bonds, equity, foreign currency assets.

• With deflation easing and the economy growing again, BOJ reversed QE in April and raised interest rates in 2006

Monetary Policy: Tools

• The central bank has 3 main operating instruments to conduct policy in interbank markets

1. Asset Transactions with Banks – Buy or sell assets from banks in exchange for reserves• Open Market Operations (BoJ, Fed, ECB..)• Currency Market Operations• Rediscounting (Bank of Japan)• Gold Standard (History)• Etc.

Operating Instruments, Part II

2. Discount Window Lending – Lend reserves directly to banks or take deposits

• Interest rates set at above IBOR to discourage over use.

3. Reserve Requirements Directly control the demand for reserves

• Not used to control money multiplier or money supply but may be used to fine tune supply vs. demand in interbank market.

Sharp increase in demand for liquidity

Discount Window Lending: USA

0.000

0.500

1.000

1.500

2.000

2.500

3.000

3.500

4.000

Jan-01

Feb-01

Mar-01

Apr-01

May-01

Jun-01

Jul-01

Aug-01

Sep-01

Oct-01

Nov-01

Dec-01

Jan-02

Feb-02

Bill

ion

US

$

Financial System and Liquidity

• Financial crises might occur in which financial market participants might be reluctant to provide short-term credit.

• Central banks follow the advice of Walter Bagehot from 1850’s to lend freely against good collateral?

• Does this lead to moral hazard as investors follow risky strategies confident that the central bank will bail them out.

Can the Central Bank Control the Money Multiplier

• The government’s main tool to control the multiplier is the required reserve ratio. However, this regulatory tool is less effective if banks reserve holdings exceed requirements.

• In other economies, such as the US and Euroland, the reserve requirement is low and the regulation seldom binds.

• In many economies, including HK, Australia, Canada and the UK there is no reserve requirement.

China Reserve Ratios

5

6

7

8

9

10

11

12

13

14

97 98 99 00 01 02 03 04 05

M2 Multiplier RR

Principles of Central Bank Design1. Independence: Central Bank must be

insulated from direct political influence. Strategies for Insulation– Central Bank sets monetary policy free of

direct government control.– Long-terms of Office for Central Bank

Policymakers, difficult for Central Bankers to be Fired.

– Central Bank has independent sources of revenue.

Q: How do you monitor the central bankers?

More Principles of Central Bank DesignHow to monitor the central bank.

2. Decision Making by CommitteePower should be diffuse within the central bank.

3. Accountability and TransparencyBanks should make information about their intentions and actions.

4. Policy FrameworkBanks should have a clear guideline for setting their policy which meets the consensus of society.

Trend toward Independence

• In late 1998, the Bank of Japan, and the Bank of England, were removed from the direct control of the Ministry of Finance and the Chancellor and the Exchequer respectively.

• In 1997 and 2003 revisions of the Bank of Korea Act, the Bank of Korea were removed from the direct and indirect control of the Ministry of Economy and Finance.

Conclusion

• OECD Central banks adopting price level as a nominal anchor with inflation targeting as a communication strategy.

• Monetary policy implemented using open market operation as a tool and interbank interest rate as an operating target.

• Central bank independence becoming the norm.

Bibliography• Cecchetti, Money, Banking and Financial Markets,

2004, McGraw Hill• Mishkin, Chapter 1, Monetary Policy Strategy

Forthcoming• Mishkin, Schmitt-Hebbel, One Decade of Inflation

Targeting in the World: What Do We Know and What Do We Need to Know?

• Ito and Mishkin, Two Decades of Japanese Monetary Policy and the Deflation Problem, NBER Conference Ease Conference Volume 2004

• Rose, A. A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed, Working Paper 2006.

• Websites of IMF, BoJ, Fed BoG, ECB, etc.