ECO 4 Monetary Policy

A central bank sits at the center of a modern economy because it is the one institution allowed to create the national currency. Monetary policy is the set of central bank actions meant to steer how much money and credit circulate in an economy, and it is arguably the most visible thing a central bank does. Beyond running policy, a typical central bank fills six roles.

• Sole supplier of the domestic currency.
• Banker to the government and to the commercial banks (the bankers’ bank).
• Lender of last resort.
• Overseer and standard-setter for the payments system.
• Operator of the country’s monetary policy.
• Supervisor of the banking system.

Fiat money and the guardian of its value

Early money could be swapped at a bank for a fixed amount of a precious commodity, usually gold, and private banks issued their own notes. Britain kept this convertibility until 1931, when the Bank of England stopped redeeming its notes for gold, and most large economies dropped the gold standard around the same stretch of the twentieth century. Currency today is not convertible into any commodity; it is legal tender, meaning it must be accepted in settlement of goods, services, and debts. Money of this kind, valuable only because the state declares it so and because everyone else takes it in payment, is called fiat money. Once a country runs on fiat money, whoever supplies that money becomes far more important, since in principle the supply could be expanded without limit, so central banks act as both the source and the guardian of their currency’s value.

Lender of last resort and bank supervision

Because a central bank can create money, it can hand emergency liquidity to a bank in trouble, which is what being the lender of last resort means. The knowledge that this backstop exists, together with deposit insurance, is meant to stop bank runs before they start. That safety net is not always enough, though, as the run on Northern Rock during the 2007 credit squeeze demonstrated.

Supervision of the banks is a role that not every central bank holds. In some countries a separate agency does it, and in a few, such as Germany and the United States, more than one body shares the task. The United Kingdom is a useful illustration of the swings in this arrangement: the Bank of England ran banking supervision until May 1997, when the job passed to the new Financial Services Authority; after the Northern Rock episode exposed the risks of that split, supervision returned to the Bank of England in 2013.

The overarching objective: price stability

Central banks list a range of aims on their websites, from financial-system stability to full employment, but nearly all single out one goal above the rest: maintaining price stability. Since a workable money must hold a reasonably steady value from one period to the next, that goal is really the same as keeping inflation under control. The Bank of Korea and the Central Bank of Brazil name price stability outright; the European Central Bank makes it the primary objective and supports wider economic goals only when they do not conflict with it; the US Federal Reserve pairs stable prices with maximum employment and moderate long-term interest rates.

A central bank has three primary levers for changing the money supply: open market operations, its official policy rate together with related actions in the repo market, and reserve requirements.

Open market operations

Open market operations are purchases and sales of government bonds between the central bank and the commercial banks or designated dealers. When the central bank buys bonds, it credits the selling banks with extra reserves; if those banks lend the surplus reserves to households and firms, broad money grows through the money multiplier. Selling bonds does the reverse: bank reserves shrink, lending capacity falls, and broad money growth slows. In running these operations the central bank may aim at a target level of bank reserves or at a target interest rate on those reserves.

The policy rate

The clearest signal of a central bank’s stance is the interest rate it announces, variously called the official rate, the policy rate, or the refinancing rate. It is usually the rate at which the central bank will lend to commercial banks, often delivered through short-term collateralized lending known as repo. In a repurchase agreement the central bank buys bonds from the banks and agrees to sell them back later, typically anywhere from overnight to two weeks out, which amounts to a secured loan on which the central bank earns the repo rate.

When the central bank raises its official rate, commercial banks generally lift their base rate, the reference rate off which they price loans to everyone else, so a strong corporate client might borrow at 1 percent over that base rate while a smaller one pays 3 percent above it. Banks follow the central bank up because they will not lend below the rate the central bank charges them, and the central bank can drain money from the system through open market operations, forcing banks to borrow from it at the official rate. Names differ across countries: the Bank of England uses a two-week repo rate, the European Central Bank calls its rate the refinancing rate, and the United States has both the discount rate for direct borrowing from the Federal Reserve and, more importantly, the federal funds rate, the overnight interbank rate on reserves that the Federal Open Market Committee steers toward a target and reviews about every six weeks.

Reserve requirements

The third lever is the reserve requirement. Because money creation runs stronger when the required reserve ratio is lower, raising the requirement restrains credit. Developed markets rarely use this tool now, and a few central banks, the Bank of England among them, keep no minimum reserve ratio at all, since frequent changes disrupt banks: a bank caught short might have to stop lending until it rebuilt reserves. Many emerging market central banks still use reserve requirements actively, and the tool remains available to those that have shelved it.

The transmission mechanism

Policy rates are very short term, often overnight, yet firms and households borrow over much longer horizons, so it is not obvious how a small change at the short end reaches the wider economy. That it does at all tells us central bankers believe money is non-neutral over short horizons, whatever holds in the long run. A rate change works through four interconnected channels.

• Short-term interest rates. Bank base rates and interbank rates follow the official rate, so the cost of borrowing rises across short and long maturities and businesses and consumers borrow less.
• Asset prices. A higher discount rate lowers the present value of future cash flows, so bond prices and the value of capital projects fall, trimming household wealth and consumption.
• The exchange rate. A rate rise tends to strengthen the currency, making exports dearer abroad and imports cheaper, which softens both external demand and imported inflation.
• Expectations. A rate move is read as a signal about future policy, and firms and households act on that read, so consumption, borrowing, and asset prices can shift on the expectation alone.

Taken together, weaker total demand and a firmer currency push down on the rate of inflation. The catch is that these channels are not independent, and the way they combine can change over time, which makes the transmission mechanism complex to predict.

Through the 1990s a consensus formed that the surest route to price stability was to set an explicit inflation target and then track a broad set of monetary, financial, and real indicators to hit it. New Zealand pioneered the framework: in 1988 the finance minister announced a goal of pulling inflation down from around 6 percent into a 0 to 2 percent band, and the 1989 Reserve Bank of New Zealand Act handed the central bank operational independence to set interest rates as it saw fit while remaining accountable and transparent. Many countries copied the model over the following decades. Whatever the local variation, the success of inflation targeting is thought to rest on three qualities: independence, credibility, and transparency.

Independence

An inflation-targeting central bank normally has some distance from its government, because politicians facing reelection might be tempted to hold rates too low before a vote and stoke inflation later. There are degrees of separation. The head of a central bank is almost always a government appointee, so full independence is unlikely. Beyond that, a bank can be operationally independent, meaning it chooses how to hit the target, and additionally target independent, meaning it also picks the inflation measure, the target level, and the horizon. The ECB has both kinds; the central banks of New Zealand, the United Kingdom, and Sweden are only operationally independent, hitting a definition and level of inflation set by the government.

Credibility

Confidence in the central bank is central to the framework. Imagine a heavily indebted government running its own inflation target: because inflation erodes the real value of debt, that government would have a motive to overshoot, so few would trust its commitment, and agents would expect high inflation whatever the stated target. When instead a respected central bank holds the target and people believe it will be met, the belief can be self-fulfilling: an expectation of 2 percent inflation gets written into wage claims and other contracts that help deliver 2 percent. This is why central banks watch inflation expectations so closely; if expectations jump, say after an oil-price spike, they can become embedded in wages and drive actual inflation up.

Transparency

One way to build credibility is to make decisions in the open. Most independent inflation targeters publish a regular assessment of the economy, often called an inflation report, running through broad money and credit conditions, then financial market conditions, then the real economy such as the labor market, and finally the evolution of prices, before offering a growth and inflation forecast over a medium-term horizon of roughly two years. Explaining its thinking helps the bank earn a reputation that makes it easier to steer expectations and hit the target.

The target itself

Many developed-economy central banks aim at 2 percent CPI inflation, with a band of about plus or minus 1 percentage point, so a 2 percent target means keeping inflation between 1 percent and 3 percent. Why not zero? Aiming at zero risks tipping into deflation, which conventional policy handles poorly. Why not 10 percent? Inflation that high is not price stability and brings volatility and uncertainty. Around 2 percent is judged far enough from deflation yet low enough to stay stable. And because the headline rate measures price changes over the past twelve months, and rate changes take time to work through, targeters focus not on current inflation but on inflation roughly two years ahead.

CPI: consumer price index. pp: percentage point.

Exceptions and hard cases

Two major central banks have not adopted a formal target on the New Zealand pattern. The Bank of Japan has fought persistent deflation for much of two decades, and an inflation-control framework has little purchase in an economy where prices keep falling, though some argue an announced positive target is exactly what Japan needs, provided people believe the bank can deliver it. The US Federal Reserve has no explicit target because a single-minded inflation focus could clash with its legal charge of maximum employment alongside stable prices and moderate long-term rates; in practice it treats core inflation near or just below 2 percent, measured by the personal consumption expenditure deflator, as consistent with stable prices, and markets watch that gauge closely.

Developing economies often struggle to run any monetary policy well. Common obstacles include the lack of a liquid market in government bonds or a developed interbank market for conducting policy, an economy changing so fast that the neutral rate and the link between money and activity are hard to read, rapid financial innovation that keeps redefining the money supply, a poor track record on inflation that undercuts credibility, and governments unwilling to grant the central bank real independence.

Rather than target domestic inflation, many developing economies run monetary policy by targeting the exchange rate, fixing a level or band against a major currency and defending it by buying and selling the home currency in foreign exchange markets. The logic is that tying the currency to that of a low-inflation anchor lets the domestic economy import the anchor’s inflation record. Developed economies have tried it too: in the 1980s, after failing to control inflation by aiming at money-supply growth, the United Kingdom set sterling to track a fixed value against the German deutschemark.

How the target constrains policy

Suppose a country pegs to the US dollar, and suppose to keep things simple that inflation starts out similar in both countries and the chosen rate matches relative price levels. Absent shocks, there is no reason for the rate to drift, and as long as domestic inflation tracks US inflation the currency stays near its target, which is the sense in which the peg imports foreign inflation. Now let domestic activity heat up and domestic inflation climb above the US rate. Under a float the currency would slide against the dollar; to defend the peg, the central bank runs down its foreign exchange reserves to buy back its own currency, which drains the domestic money supply and pushes up short-term interest rates. The economy tightens, and if that is expected to curb inflation, the currency firms back toward target. In the opposite case, if instead domestic inflation drops below the US rate, the bank does the reverse and sells its own currency, expanding money supply and easing rates.

The lesson is that once the exchange rate is the target, domestic interest rates, money supply, and conditions must bend to serve it, and they can turn more volatile as a result. The commitment also has to be credible; if it is not, speculators trade against it. Speculative attacks in 1992 pushed the pound out of the ERM, the European Exchange Rate Mechanism, after which the United Kingdom floated and eventually adopted a formal inflation target in 1997. In the Asian crisis of 1997 to 1998, Thailand defended the baht for months before admitting in July that its reserves were exhausted, and the devaluation that followed set off a regional debt crisis for borrowers who had funded themselves in foreign currency.

Despite the risks, many currencies stay pegged to the dollar, among them those of Bermuda, the Bahamas, Lebanon, Hong Kong SAR, Saudi Arabia, Qatar, and the United Arab Emirates. Some countries go further and dollarize, replacing their own currency with the US dollar entirely, which is stronger than a peg; examples include Panama (1904), Ecuador (2000), El Salvador (2000), East Timor (2001), and the Caribbean Netherlands (2011).

Central banks adjust liquidity mainly by moving the policy rate. Raising it to head off inflation is called contractionary, because it is meant to slow the growth of money and the real economy; cutting it when activity and inflation are weakening is called expansionary. But high and low relative to what?

The neutral rate

The usual benchmark is the neutral rate of interest, the rate that neither speeds up nor slows down the underlying economy and which should match the policy rate averaged across a full business cycle. Above the neutral rate, policy is contractionary; below it, expansionary. Economists disagree about its level, so they can disagree about the current stance, but they agree it has two parts.

The real trend rate of growth is the pace an economy can sustain over the long run with stable inflation. If a credible inflation targeter aims at 2 percent and an analyst judges sustainable growth at 2.5 percent, the neutral rate would be estimated as follows.

Policy above 4.5 percent would then be contractionary and policy below it expansionary. Estimating the neutral rate is more art than science, and analysts have marked down trend-growth estimates for many Western economies as households and governments there pay down debt after the credit boom.

Reading the source of a shock

Before tightening or loosening, the central bank should ask what is driving inflation. If rising confidence has lifted consumption and investment, that is a demand shock, and tightening to rein it in is appropriate. If instead a jump in oil prices is the cause, that is a supply shock, and raising rates could make things worse, deepening a downturn that consumers already face from higher fuel costs and eventually pulling inflation down sharply. Diagnosing the source matters before choosing a direction.

Limits of monetary policy

The transmission mechanism does not always carry the central bank’s intent cleanly. Long-term rates depend on the expected path of short rates, so if the bank raises rates but bond markets think it has overtightened and will undershoot its target, falling inflation expectations can pull long rates down, cheapening long-term borrowing and stimulating rather than restraining activity. So-called bond market vigilantes reinforce or fight the central bank: they can push long yields up if they think it is losing control of inflation, or down if they expect tight policy to trigger a slump. A more credible central bank keeps the long end steadier and needs the vigilantes less.

In extreme conditions the demand for money can turn infinitely elastic, with people willing to hold any extra money at an unchanged interest rate, so additional money no longer lowers rates or lifts activity. This is a liquidity trap, and it goes hand in hand with deflation. Deflation is a persistent, general fall in prices, and it is harder to fight than inflation, because nominal rates cannot be cut far below zero, as several European countries found in 2014 and Japan in 2016. Falling prices raise the real value of debt and tempt consumers to delay purchases, weakening demand and feeding further deflation, a trap Japan fell into after its property bubble burst in the early 1990s.

When conventional rate cuts run out of room at the zero bound, central banks can turn to quantitative easing (QE), which works like open market purchases but on a far larger scale, injecting reserves by buying assets. The Bank of England bought gilts, mostly with three to five years to maturity, hoping banks would lend the new reserves and expand broad money. The Federal Reserve leaned on mortgage bonds that Fannie Mae and Freddie Mac issue or guarantee, aiming to push mortgage rates down and support housing. A second round, QE2, was announced in November 2010: the Fed created 600 billion US dollars to buy long-dated Treasuries in equal tranches over eight months, aiming to hold long yields down. A third round, QE3, began in September 2012 at 40 billion US dollars a month of agency mortgage-backed securities, running until tapering was announced in December 2013, with purchases ending in October 2014. QE carries real risk: buying credit-risky assets that later sour could saddle the central bank with losses and threaten confidence in its own product, fiat money.

The deepest limit is structural. A central bank cannot control how much money households and firms leave on deposit, nor how willing banks are to expand credit, so it cannot always control the money supply itself. There are firm limits to what monetary policy can do.

Monetary and fiscal policy can both move aggregate demand, but they run through different channels and reshape the composition of demand differently, so they are not interchangeable. The effect of one depends on the stance of the other, which is why policy makers care about the combination in force. Assuming wages and prices are rigid, four broad mixes are worth distinguishing.

Interest rate direction assumes the monetary impact on rates dominates where the two pull in opposite ways.

Choosing the mix

Governments want to stabilize demand near full employment but also to grow potential output, which means encouraging private investment. That case favors accommodative monetary policy with low rates alongside tight fiscal policy, which frees up resources for an expanding private sector. At other times a weak workforce or poor infrastructure looks like the binding constraint, so expanded government spending becomes the priority; if it is not paid for with higher taxes, the fiscal stance turns expansionary, and pairing it with loose money risks inflation. The mix is also shaped by politics: a weak government may raise spending to satisfy competing interests, such as farm subsidies, so a restrictive monetary policy might be needed to hold back the resulting inflationary pressure.

Both policies are hampered by imprecise, lagged, and later-revised data about where the economy actually is. Fiscal policy carries two extra handicaps in the short run: capital projects take time to plan, procure, and build, and it is politically easier to loosen than to tighten, so tightening often comes only through automatic stabilizers. An independent central bank, by contrast, can raise rates without waiting for political consent, so monetary policy tends to act faster. The link also surfaces in Ricardian equivalence: if tax cuts do not lift private spending because people expect higher future taxes, policy makers may lean on monetary tools instead.

What an IMF study found

Working with the model the IMF calls its Global Integrated Monetary and Fiscal Model, researchers studied four kinds of coordinated fiscal loosening over two years, later reversed: higher social transfers to all households, a cut in labor income tax, higher government investment, and transfers aimed at the poorest. They paired these with two monetary responses: no accommodation, so rising demand lifts rates at once, or accommodation, holding rates unchanged for the two years. Without accommodation, government spending raised GDP about six times as much as equivalent social transfers, because the transfers were not seen as permanent, and targeted transfers to the poorest had roughly double the effect of untargeted ones. With accommodation, multipliers grew markedly, because rising demand and inflation lowered real rates and drew out extra private spending.

Cumulative multiplier: cumulative effect on real GDP over two years per unit of GDP of fiscal stimulus.

Monetization and the value of commitment

At the zero bound with deflation, fiscal stimulus can still raise demand and inflation, lower real rates, and spur private spending. But when the central bank buys government bonds on a very large scale, it is effectively bankrolling the budget shortfall, and monetary independence turns into a fiction. Economists fear this monetization of the deficit, which is separate from a conventional inflation target. The IMF work also warns that persistently high deficits push real rates up and crowd out private investment, and once agents see deficits as permanent, inflation expectations and long-term rates rise, cutting the value of the stimulus by half. If commitment to long-term discipline is lacking, for instance because of aging populations, and the US debt-to-GDP ratio rose by 10 percentage points permanently, the model implies global real interest rates would climb by 0.14 percent, which it ties to a lasting 0.6 percent drop in world GDP.