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Lecture 11
• 1. Introduction
• 2. Monetary Policy transmission
mechanisms
• 3. Monetary Policy and the global financial
crisis
• 4. Post crisis reform of financial regulation
and the macro policy framework
• 5. Exam Preparation
1. Introduction
• Monetary policy plays a central role in contemporary macro
economic management
• Generally, we know that CB’s use the IS-PC-MR model to guide
them in using the interest rate instrument (r) to achieve short-run
AD management as well as the beneficial macro economic objective
of attaining πT
• In this lecture it is useful to round-off our knowledge by:
– Formalising our understanding of how changes in r transmit through
the economy to ultimately influence the inflation rate – the so-called
monetary policy transmission mechanism
– Reflecting on the current debate as to whether CB’s should extend
their mandate to also explicitly target asset price bubbles (dampen
the financial cycle) or simply confine their role to mopping-up after
they burst by providing liquidity
– Reflecting on the effectiveness and potential dangers of relatively new
unconventional monetary policies such as QE, and
– Reflecting on current debates regarding banking regulation and
macro-prudential policy
2. Monetary Policy transmission
mechanisms
• If y ≠ ye there are four main channels through
which interest rates can affect expenditure
(and thereby boost AD (and y) by cutting r, or
reducing AD (and y) by raising r)
• Market rates
• Asset prices
• Expectations / Confidence
• Exchange rate
Figure 13.4
Market rates
• r  C  and I (=>AD y>ye and inflationary
pressure)
• Official rates directly influence market rates e.g. short-term
money market rates,
– home loan or bond rates which in SA are usually linked to what
bank’s call the prime interest rate (which is a few % points above
the repo rate)
– Long-term rates as shown by the yield curve
• Lower interest rates will stimulate AD
• Lower interest rates mean that consumption and
investment rises as lower interest rates make:
– borrowing more desirable and
– savings less desirable
Asset prices
• r  house prices  (=>AD y>ye and inflationary
pressure)
• Market interest rates affect asset prices, such as
equities and house prices
• Lower interest rates encourage borrowing that can be
spent on assets, pushing up their prices If households
perceive that they have permanently increased their
wealth due to higher house prices then their
consumption increases (as per the permanent income
hypothesis)
• For example, in some countries higher house prices
mean that households can take out additional
borrowing by refinancing their mortgage (home equity
loans)
Expectations / Confidence
• r  business confidence  (=>AD y>ye and
inflationary pressure)
• Interest rate changes provide information about
the CB’s future policy stance and this affects
current behaviour
• For example, a rate reduction could signal a
commitment to an accommodative policy stance
• This could assist in bringing business and
household expenditure plans forward, therefore
boosting AD
Exchange Rate
• r  exchange rate  (θ more competitive for as long
as there are not off-setting price rises) (=>AD y>ye
and inflationary pressure)
• In globally integrated financial markets interest rates
directly effect exchange rates
• Exchange rates effect both:
– net external demand (i.e. if r cut and θ is more competitive
/ weaker then X and M therefore AD rises)
– Import prices feed into rising inflation i.e. this is called
pass-through as exchange rate weaknesses passes through
to domestic prices (θ = P*.e/P i.e. once there is 100%
pass through from the exchange rate deprecation to
increased domestic inflation then there is no longer any
competitiveness due the currency deprecation and there is
no further boost to AD)
Transmission mechanism
• As r  =>AD y>ye and inflationary pressure
• In labour market AD effects employment ,
wage costs  and workers expectations of
inflation  this feeds through to producers prices
(PPI) and eventually to consumer prices (CPI)
• Empirically, lags are important (e.g. in UK):
– The impact of r on output is estimated to take up
to (a maximum of) one year
– The impact of r on inflation is estimated to take
up to (a maximum of) two years
3. Monetary Policy and the global
financial crisis
• Conventional monetary policy guided CB activity before the global
financial crisis
• CB’s target price stability (aiming for πT) either:
– (1) with the implicit understanding that achieving πT will create a favourable
environment for economic growth and employment e.g. EU, SA
– (2) as part of a dual mandate to achieve both price stability and full
employment e.g. Sweden, Australia and the US
• CB’s that have a dual mandate
– do not target both output and inflation, as it is assumed that there is a unique
equilibrium rate of unemployment (at ye), such that in the medium run
targeting a lower level of U (or y > ye) will only lead to higher inflation and no
output and employment gain (in theory this may for a limited time be
achievable with ever accelerating inflation)
– Rather such CB’s put a greater focus on output (giving deviations from output
a greater weight in their loss function), and being more likely to follow a
gradualist approach to disinflation
• Empirical studies estimate Taylor rules to show how CB’s actually respond
in practice by changing their nominal interest rate (It) when there are
deviations from their inflation (πT) and output (ye) targets:
It = I + ϒ1(πt – πT) + ϒ2(yt-ye), see results in Table 13.2
New policy areas for CB
• In addition to the conventional role of
inflation targeting, CB’s are being asked to
consider their roles in new areas:
– (1) The role of CB’s in identifying and dealing with
asset price bubbles
– (2) The role of CB’s in stimulating the economy in
unorthodox ways during episodes such as the
Great Recession
(1) CB’s and Asset price bubbles
• Asset price bubbles occur when financial market valuations far
exceed fundamental values
• Asset prices are undesirable as they distort resource allocations,
affect CB target variables (πT and ye) and can cause financial
instability
• The key debate: should CB’s (1) intervene ex ante to burst asset
price bubbles or (2) intervene ex post at mopping up after bubbles
burst?
• Key prior questions / criteria for the success of ex ante intervention:
– (1) Can CB’s identify bubbles before financial markets
– (2) Can CB’s refrain from identifying bubbles that do not exist
– (3) Can CB’s burst bubbles without causing excessive damage to the
wider economy
• The Greenspan doctrine strongly believed that CB could not fulfill
these criteria and therefore advocated ex post intervention only
CB’s and Asset price bubbles
• If we assume that CB’s are capable of achieving the
three pre-conditions for successful ex ante
interventions, then:
• The CB instrument for bursting asset bubbles is the
interest rate (r), but this is a blunt instrument:
– It may not be able to burst a bubble (i.e. would investor be
concerned by a small rise in interest rates when they are
expecting 100% returns)
– It is not possible to target the rise in r only at the asset
bubble and C and I in the whole economy would be effected
by a rise in r
• CB banks are trying to develop new instruments to deal
with asset price bubbles and related financial cycles –
these instruments are coming into shape under the CB’s
emerging new mandate of macro-prudential regulation
(2) Unorthodox monetary policy in the Great Recession
•
•
•
•
•
Fig 13.5 shows that in many developed countries monetary policy (nominal interest
rates) hit the zero lower bound during the great recession
this rendered conventional monetary policy an ineffective tool for macro economic
stabilisation
In Fig 13.6
– the black lines show the actual CB interest rate (near zero bound)
– The grey lines show the interest rates implied by the Taylor rule (if U aversion is
low (0.5)) (interest rate should be negative to stimulate output)
– The dotted lines show the interest rates implied by the Taylor rule (if U aversion
is high (1)) (interest rate should be even more negative to stimulate output)
In the US , Japan and the EU the zero bound for the nominal interest rate meant
that rates were above those implied by the Taylor rule (so monetary policy could not
provide enough stimulus)
In the UK, the CPI was above target during the recovery phase of the financial crisis
which meant that the Taylor rule implied interest rates above the actual nominal
rates set by the CB, but the higher inflation rate was due to increases in VAT and the
weakened pound currency (one-off events not persistent inflation, now UK has
deflation)
Figure 13.5
Quantitative easing
• Conventional monetary policy was not able to
provide sufficient stimulus to AD after the
crisis, so unconventional QE was adopted
• What is QE? A CB uses its ability to create
money to buy financial assets e.g. govt bonds
bought in secondary markets (UK) and MBS
and govt bonds (US), this serves to push up
the price of financial assets, and push down
long-run interest rates, boosting AD and π
• Fig 13.6 shows the transmission mechanism of
QE
Figure 13.6
Transmission mechanism of QE
• How do CB asset purchases affect the real
economy?
• QE works as it raises asset prices, leading to:
– increased wealth effects
– Reduced longer term interest rates in financial
markets (potentially boosting C, I and AD)
Transmission mechanism of QE
•
As per Fig 13.6, the transmission of QE to AD can be summarised as follows:
– Confidence improves pushing up asset prices
– Policy signalling – QE signals the CB’s commitment to the inflation target
(when there is a risk of deflation) and might help to anchor inflation
expectations (ito the Fisher equation r = i – πe, if πe fall then this raises the
real interest rate r depressing AD
– Portfolio balancing – CB purchase of govt bonds pushes up the price of govt
bonds directly and the price of other assets indirectly, this is because the
purchase of govt bonds will result in increased money holding for those that
sell bonds, as bong sellers rebalance their portfolios and buy assets the price
of these other assets rise as well, rising asset price lead to reduced interest
rates, stimulating AD
– Market liquidity – QE encourages trading on the financial markets in times of
financial distress
– Money – sellers of bonds gain cash which they deposit in financial institutions
which then have increased liquidity allowing them to lend more
Does QE work?
• One difficulty is the lack of a counterfactual i.e. we
do not know what would have happened in the
absence of QE
• Empirically studies provide some evidence that QE:
– led to falling interest rates by 100 basis points
(1%) in the US
– Increased output (via AD) by 1.5% in the UK
– Increased CPI by 125 basis points in the UK
• Certain studies found that the QE was equivalent to
150-300 basis point cut in the UK policy rate and 200
basis point cut in the US federal fund rate
Is QE dangerous?
• Fig 13.7 shows how QE expanded the assets
on CB balance sheets rapidly in Aug 2008 in
the US and UK and later in the EU
• CB assets increased due to (1) liquidity
support for the financial system (short-term
loans) and (2) the direct purchase of financial
assets (QE)
• What are the key risks associated with QE?
Figure 13.7
Key risks associated with QE?
• Central bank independence and credibility – CBs banks have taken on
new roles such as QE and may now be subject to greater levels of political
interference
• Inflation expectations – some argue that QE may result in higher inflation
in future (but not as yet)
• Financial cycle – prolonged QE and low interest rates may sow the seeds
for the next asset bubble
• Excess reserves – during crisis and due to QE banks hold large excess
reserves in the CB, this creates an inflationary risk as banks can quickly
crate new loans and deposits pushing up the money supply without any
change in CB policy
• Exit – exiting from QE does not occur wen the purchase of assets stops,
but when assets on CB balance sheets mature or are sold back into the
market – this creates risk of putting downward pressure on inflation and
reducing AD
QE exit strategies
• In theory exiting QE should result in asset prices falling,
interest rates rising , and AD and inflation falling
– If QE is exited too fast – could cause economic contract and deflation
– If QE is exited too slowly – could result in rising inflation
• US is cognisant of these effects and is carefully managing the
timing of its exit, as it will have macroeconomic consequences
in the US and beyond
• The US Fed has signalled that it is intent on “normalising”
monetary policy
– First, tapering via the gradual reduction in its purchase of
financial assets
– Second, gradually selling its large holdings of financial
assets back into the market (though its System Open
Account or SOMA)
Forward guidance by CB’s
• Forward guidance describes CB communication
which is aimed at signalling the likely future path of
policy rates
• This creates greater certainty for firms and
households that long run rates will be lower for
longer – facilitating investment decisions
• E.g. (1) in the US the Fed said in Jan 2012 that the
interest rate would be kept very low at least until late
2014
• (2) In Dec 2012 Fed said that they would not raise
interest rates until unemployment fell below 6.5% (as
long as inflation stayed close to target)
4. Post crisis reform of financial regulation and the
macro policy framework
• Post the 2008-09 crisis CB’s took on more
responsibility for banking regulation and for
monitoring system risk and financial stability
• Key policy reforms for a safer financial system:
• Policy 1: Higher capital ratios
• Policy 2: Living wills, resolution schemes, bail-ins
• Policy 3: Structural reform – retail v investment
banking
• Policy 4: Macro-prudential regulation
Policy 1: Higher capital ratios
• When a bank has high leverage (assets:equity ratio) then even a small fall in
the value of assets, can mean that the losses>equity and the bank is
insolvent
• The solution is for banks to hold higher capital / equity ratios (which is
required ito Basel III)
• Banks can increase their capital / equity by (1) selling more shares or (2) not
paying dividends (or bonuses) for a few years
• See Fig 13.8(a) initial low capital ratio
• Fig13.8(b) higher capital ratio achieved by by increasing equity either by
selling shares or reducing dividends
• Fig13.8(c) higher capital ratio achieved by reducing assets
• Banks have opposed substantially higher capital ratios for a number of
reasons.
• One reason is that banks favour debt finance over equity due the fact that
tax systems favour debt. See this article:
http://www.economist.com/news/leaders/21651213-subsidies-makeborrowing-irresistible-need-be-phased-out-great-distortion
Figure 13.8
Policy 2: Living wills, resolution schemes, bail-ins
• Policy seeks to replace a situation in which failing banks are rescued by
taxpayer funded bailouts
• The interests of the taxpayer should be placed above the bond holder
• When an ordinary company becomes insolvent:
–
there is a clear pecking-order – the firm’s resources are distributed in the form of payments
to suppliers, wags to workers and taxes owed to govt,
– only when these have been paid do bond holders receive something for their bonds (the size
of the haircut depends on the size of the remaining assets of the firm)
– Equity holders typically receive nothing
• When a systemically bank nears insolvency:
– Govt steps in and bails out the bank by providing capital in exchange for shares
– The value of shares my fall hurting equity holders
– Bondholders go unscathed (unless the bank is allowed to fail)
• Solution is that more of the losses must be absorbed by the private sector
and the state rescue must be avoided (or reduced in size)
• How? Bail-ins, living wills and resolution schemes would include the
conversion of bonds into equity and / or the specification of compulsory
haircuts to be applied to bond holders that will reduce the value of bonds
when banks are on point of failure
Policy 3: Structural reform – retail v
investment banking
• Govt’s seek to introduce a policy of structural reform so that it will
be presumed that govt will only rescue those parts of banks that
offer core banking services (retail banking), whereas other parts
of a bank (such as those engaged in investment banking) can be
taken through partial bankruptcy or resolution procedures
• Retail banking provides core basic services such as the payment
system, deposit taking and lending to households and firms
• This is distinct from investment banking which offers services
regarding mergers and acquisitions, as well trades in financial
securities
• Universal banks combine retail and investment banking
operations
Policy 4: Macro-prudential regulation
• Financial policy committees are being set up – whose objective it
is to stabilise the financial cycle (such polices are called macroprudential policies)
• E.g. during a financial cycle upswing – the upswing could be
dampened by reducing the loan to value (LTV) ratio (from say
100% to 80%) and by raising bank capital ratios
• During a financial cycle downswing – the cycle could be
stimulated (e.g. housing demand could be stimulated) by raising
the loan to value ratio (from say 80% to 100%) and by lowering
bank capital ratios
• Goodhart (2013) suggests a paradox – after the 2008-09 financial
crisis regulators wish to raise bank capital ratios whereas macroprudential theory would suggest that bank capital ratios should be
reduced (to stimulate the cycle)
Business cycle vs financial cycle
• At times there may be tensions between the two policies (1) of
stimulating the (shorter wavelength) business cycle and (2)
dampening the (longer wavelength) financial cycle (or vice versa
– dampening business cycle and stimulating the financial cycle)
• For example, in the situation post- the 2008-09 financial crisis,
the is tension between the objectives of:
– (1) stabilising the business cycle be reviving banks so they can
increase their lending and contribute to rising AD and y (e.g.
by lowering bank capital ratios or raising LTV ratios (say from
80% to 100%) in addition to cutting r and QE, etc.)
– (2) dampening the financial cycle by making the banking
system safer (e.g. by rising bank capital ratios or lowering LTV
ratios (say from 100% to 80%))