Monetary policy

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Monetary policy has become the preferred policy instrument that is used in the pursuit of economic stability. It is implemented for regulatory purposes by open market operations in support of discount rate changes made in response to the degree of capacity utilisation in the economy. It has also been used for the purpose of expanding the money supply as a temporary expedient to counter the threat of deflation - a practice termed quantitative easing (and popularly known as "printing money"). The practice of routinely targeting of monetary policy on the money supply in order to counter inflationary tendencies has generally fallen into disuse, however.

Proposals to use monetary policy instruments to prevent the destabilising buildup of speculative asset price bubbles, have generally been rejected as impracticable.

The monetary policy consensus

The current policy consensus assigns primary responsibility to monetary policy for the pursuit of stability in both the price level and the growth of the economy. Fiscal policy came briefly into use to reinforce the use of monetary in the course of the Great Recession but has not regained its former acceptance as an instrument of general macroeconomic policy.

That consensus is the outcome, however, of the series of post war experiments in economic management that have taken place since the second world war. During the early post-war years, fiscal policy was the principal instrument of stabilisation. It was replaced in the late 1970s by a series of attempts at stabilisation by the control of the money supply before that was abandoned in favour of the monetary policy techniques described in this article[1].

Regulatory policy

Policy objectives and their implementation

It is now generally accepted practice for the government's role in monetary policy to be confined to the stipulation of objectives, leaving the implementation of policy entirely in the hands of the central bank. This has been referred to as "indirect implementation" because it involves action designed to influence the conduct of the banks rather than the imposition of instructions concerning their conduct. Conventional "free market" arguments have been advanced in favour of that option[2] and it can also be argued that it increases the credibility of policy action by reducing the risk of time inconsistency in face of pressure to relax an unpopular measure.

The remits of the major central banks differ mainly in respect of the relative weights to be given to their main objectives. The remit of the United States Federal Reserve Board is "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates" [3]. The remit given to the European Central Bank, on the other hand, assigns overriding importance to price stability by requiring it "without prejudice to the objective of price stability" to "support the general economic policies in the Community" including a "high level of employment" and "sustainable and non-inflationary growth". [4]. The British Government's 1997 remit to the Bank of England also gives priority to the control of inflation by requiring it to "deliver price stability" ..."and without prejudice to that objective to support the Government's policies including its objectives for growth and employment" [5] supplemented by the stipulation of a target range for the inflation rate</ref>. (There is, however, no evidence to suggest that the Bank of England’s inflation target has compelled it to be more aggressive in pursuit of low inflation than the Federal Reserve[6]).

Choice of the target discount rate is usually guided by empirical data concerning the relation between interest rates, the inflation rate and the output gap and the principles of the Taylor rule. Since it takes about a year for interest rate changes to affect output and about two years to affect inflation, the decision depends upon judgements concerning the future of the economy. The authorities make use of economic forecasting models to assist those judgements, but they usually take account also of a range of factors including inflationary expectations (as indicated by the differences between the prices of fixed-interest and index-linked bonds) and the state of the housing market. Having taken the decision, the central bank normally announces its intended discount rate and supports the announcement by open market operations, including temporary loans of money by repurchase operations and the buying or selling of securities. The techniques employed differ only in detail as between the major central banks [7] [8][9].

In most countries, discount rate decisions are taken by committees of leading bankers or of experts chosen for that purpose. In the United States they are taken by "Federal Open Market Committee[10][11], in the Eurozone the decisions are taken by the European Central Bank Governing Council[12][13]., and in Britain they are taken by the Bank of England's Monetary Policy Committee [14]. In the United States and Britain, each decision is followed after an interval by the publication of an account of the reasons for taking it.

The monetary transmission mechanism

The term "monetary transmission mechanism" refers to the ways in which discount rate changes contribute to policy objectives.

The Bank of England has identified the expected effects of an increase in its discount rate on the British economy as

  • a general increase in short-term interest rates;
  • a rise in the exchange rate as the interest rate increase raises the relative returns on domestic assets, making imported goods cheaper;
  • a reduction in consumer spending because it stimulates saving and discourages borrowing;
  • an increase in mortgage rates, leaving householders with less to spend;
  • a fall in house prices as the mortgage rate raises the cost of buying a house, which reduces homeowners' opportunities to finance their purchases by extending their mortgages [15]

(the last two effects are, of course, peculiar to countries in which flexible mortgage rates are customary)

The Bank estimates the full effect on prices price inflation to take up to about two years and the maximum effect on output to take up to about one year (the output effect is generally expected to be transitory).

An account of the monetary transmission mechanism issued by the European Central Bank[16] states that changes to its discount rate are expected to:

  • affect banks and money-market interest rates;
  • influence expectations of future inflation, which promotes price stability by reducing people's motives to raise their prices for fear of higher inflation or reduce them for fear of deflation;
  • affect asset prices for comparable reasons;
  • affect saving and investment decisions since higher interest rates make it less attractive to take out loans for financing consumption or investment;
  • have have an impact on aggregate demand via the value of collateral that allows borrowers to get more loans and/or to reduce the risk premia demanded by lenders/banks, and by creating tighter or looser conditions in the labour and intermediate product markets;
  • affect the supply of credit as higher interest rates increase the risk that borrowers may default on repayment of loans, and banks cut back on loans to households and firms.

The Federal Reserve Board has issued a statement on similar lines [3].

Quantitative easing

The effectiveness of discount rate reductions in countering recessions is limited by the fact that negative rates are not feasible and that liquidity trap effects tend increasingly to rob them of impact as they fall below 1 per cent. The only remaining monetary policy instrument is then a major increase in the money supply, brought about by some form of quantitative easing

Monetary policy techniques that can be roughly categorised as quantitative easing include:

  • "credit easing" - direct lending to the private sector (as practised in 2009 by the Federal Reserve Board's Open Market Committee[17]).
  • the purchase of government securities from the non-bank sector (as practised in 2009 by the Bank of England [18][19]).
  • very large-scale open market operations (as practised in 2009 by the European Central Bank[20] and 2001-6 and 2009 by the Bank of Japan[21]).

The principal effects of central banks' purchases of securities from private sector are:

  • bank lending tends to rise in response to the extra money that becomes available from asset sales to the central bank, resulting in the creation of money; and,
  • the prices of other assets tend to be driven up as the private sector seeks to replace the bonds purchased by the central bank, reducing the cost of non-bank finance [22].

The unusual persistence of the 1990s recession in Japan has been taken to indicate that the quantitative easing actions by the Bank of Japan were ineffective, but some econometric studies suggest that without it, the recession would have been deeper [23][21]. A study of the Bank of England's use of quantitative easing in 2009 and 2010 concluded that as a consequence, the yield on government bonds had been about 100 basis points lower than it would otherwise have been, and that it appeared to have had favourable effects on other asset markets [24]. A further analysis suggested that the peak effect on the level of real GDP had been an increase of between 1½ and 2 percentage points[25]. The mechanisms thought to be responsible have been explained by David Miles (External Member of the Monetary Policy Committee)[26].

Monetary policy and asset-price regulation

The IMF staff's 2000 proposal

An article by staff economists in the IMF World Economic Outlook of May 2000 proposed the use of monetary policy as an instrument of financial regulation to prevent large asset price swings undermining the stability of the financial sector. They recommended a tightening of monetary policy under three circumstances:-

  • when there are signs of serious overvaluation of several different assets and, in particular, when both stock prices and property prices rise well above historical trends;
  • when asset price inflation is accompanied by rapid credit and money growth;
  • when there are marked falls in savings ratios and private sector balances, and large rises in investment ratios and external current account deficits[27].

Pre-crash responses

In a 2002 speech, Federal Reserve Governor Ben Bernanke opposed the use of monetary policy to target the asset markets, arguing that it would be "neither desirable nor feasible" for the Federal Reserve to act as an "arbiter of security speculation or values" [28]; and in a 2005 lecture, Jean-Claude Trichet, the President of the European Central Bank, argued that not all bubbles threaten financial stability, and that if policy-makers attempted to eliminate all risk from the financial system, they either fail or they would "hamper the appropriate functioning of a market economy"[29].

It is clear from their speeches that Ben Bernanke and Jean-Claude Trichet were more concerned about the practical aspects of the proposal than with free-market ideology, and Bernanke himself subsequently failed to recognise the house price bubble the bursting of which led to the crash of 2008 [30]

Post-crash responses

In the October 2009 World Economic Outlook, the IMF economists acknowledged that "even the best leading indicators of asset price busts are imperfect", so that attempts to prevent them pose a risk of making a costly mistake. They no longer recommend an automatic response to asset price surges, but suggest rather that central banks should "examine what is driving" them and "be prepared to act in response"[31]. In September 2009 Professor Hyun Song Shin of Princeton University had advocated the direct use of monetary policy to regulate the development of leverage cyles[32], and the second Warwick Commission, reporting in November 2009, considered that low interest rates had contributed to the housing booms that preceded the crash, suggesting a need to reconsider the design of monetary policy; and concluded that "Inflation targeting, however, needs to be supplemented by some form of regulation specifically aimed at calming asset markets when they become overheated" [33].

A discussion paper issued by the Bank of England in November 2009 argued that the use of monetary policy to counter the development of bubbles such as the pre-crash house price bubble would have consequences inconsistent with the inflation objective, and would tend to destabilise the real economy. The authors suggest that "the optimal policy response would assign macroprudential instruments the task of dampening credit shocks, leaving monetary policy to focus on inflation and real output" [34]. It was argued that, although there would be overlaps and interactions between monetary and macroprudential policies, they should nevertheless be assigned separate roles. Similar approaches had previously been advanced by Mark Carney, the Governor of the Bank of Canada[35], and by Federal Reserve Board Governor Frederic Mishkin [36]

Dissenting views

The founder of the Chicago School of Economics, Milton Friedman was opposed to the discretionary use of monetary policy in response to cyclical developments[37], and his collaborator, Anna Schwartz has registered her objections to the policy of quantitative easing [38].

Notes and References

  1. For an account of post-war developments, see the article on macroeconomic policy
  2. William A Allen: Implementing Monetary Policy, July 2004
  3. 3.0 3.1 Monetary Policy and the Economy, United States Federal Reserve Board, 2009
  4. Objective of Monetary Policy, European Central Bank, 2009
  5. Letter from the Chancellor of the Exchequer to the Governor of the Bank of England dated 6th March 1997 [1]
  6. Kenneth N Kuttner and Adam S Posen: How flexible can inflation targeting be and still work?, Bank of England External MPC Unit, October 2011
  7. Cheryl L. Edwards: Open Market Operations in the 1990s, Federal Reserve Bulletin November 1997
  8. The Development of the Bank of England’s Market Operations, A consultative paper by the Bank of England, October 2008
  9. Open Market Operations, European Central Bank, 2009
  10. The Federal Open Market Committee, Federal Reserve Bank of New York 2009
  11. Federal Open Market Committee: Frequently Asked Questions, Federal Reserve Board, 2009
  12. The ECB Governing Council, European Central Bank, 2008
  13. The Implementation of Monetary Policy in the Euro Area, European Central Bank, November 2008
  14. The Monetary Policy Committee, Bank of England, 2009
  15. How Monetary Policy Works, Bank of England, 2009
  16. The Transmission Mechanism of Monetary Policy, European Central Bank
  17. Ben Bernanke: The Crisis and the Policy Response, Federal Reserve Board 2009
  18. Quantitative Easing Explained, Bank of England, 2009
  19. Michael Joyce, Ana Lasaosa, Ibrahim Stevens and Matthew Tong: The financial market impact of quantitative easing, Bank of England, July 2010
  20. Jean-Claude Trichet's press conference, European Central Bank, 7 May 2009
  21. 21.0 21.1 Eric Girardin and Zakaria Moussa: The Effectiveness of Quantitative Easing in Japan, September 2008
  22. A rise in the price of a fixed-interest bond reduces interest payments on it as percentage of their purchase price, which reduces the interest rates that have to paid on new loans
  23. Hiroshi Ugai: Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses, Bank of Japan, July 2006
  24. Michael Joyce, Ana Lasaosa, Ibrahim Stevens and Matthew Tong: The financial market impact of quantitative easing, Working Paper No. 393, Bank of England, July 2010
  25. Michael Joyce, Matthew Tong and Robert Woods: The United Kingdom’s quantitative easing policy: design, operation and impact, Bank of England Quarterly Bulletin 2011 Q3, 20 September 2011
  26. David Miles: Monetary policy and financial dislocation, Speech to the Royal Economic Society, London, 10 October 2011
  27. Asset Prices and the Business Cycle, World Economic Outlook, Chapter 3, International Monetary Fund, May 2000
  28. Ben Bernanke: Asset-Price "Bubbles" and Monetary Policy (Speech to the New York Chapter of the National Association for Business Economics, New York, New York, October 15 2002) Federal Reserve Board 2002
  29. Jean-Claude Trichet: Asset price bubbles and monetary policy,(Mas lecture, 8 June 2005) European Central Bank, 2005
  30. Bernanke: There's No Housing Bubble to Go Bust, Washington Post October 27, 2005
  31. Lessons for Monetary Problems from Asset Price Fluctuations, (World Economic Outlook October 2009 Chapter 3) International Monetary Fund 2009
  32. Hyun Song Shin: Interview with Ramesh Vatilingam, 4 September 2009
  33. The Warwick Commission on International Financial Reform: In Praise of Unlevel Playing Fields, (The report of the second Warwick Commission) University of Warwick, November 2009
  34. The Role of Macroprudential Policy, a discussion paper, Bank of England, November 2009
  35. Mark Carney, Governor of the Bank of Canada: Some Considerations on Using Monetary Policy to Stabilize Economic Activity, (Speech to the Foreign Policy Association, New York, 19 November 2009)Bank for International Settlements, 2009
  36. Frederic Mishkin: How Should We Respond to Asset Price Bubbles, Board of Governors of the Federal Reserve System, October 2008
  37. Milton Friedman: Essays in Positive Economics, page 139, Phoenix Books, 1953
  38. Dump Ben Bernanke,, July 2009