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CENTRAL BANK OF NIGERIA
UNDERSTANDING
MONETARY POLICY SERIES
NO 24
HOW CENTRAL BANKS ACHIEVE
PRICE STABILITY
POLICY DEPA
RY
10
TH
T
MEN
RT
MONE
TA
Stanislaus A. Ukeje
Anniversary
Commemorative
Edition
c 2012 Central Bank of Nigeria
Central Bank of Nigeria
33 Tafawa Balewa Way
Central Business Districts
P.M.B. 0187
Garki, Abuja
Phone:
+234(0)946236011
Fax:
+234(0)946236012
Website: www.cbn.gov.ng
[email protected]
E-mail:
ISBN: 978-978-52863-0-4
© Central Bank of Nigeria
Central Bank of Nigeria
Understanding Monetary Policy
Series 24, December 2012
EDITORIAL TEAM
EDITOR-IN-CHIEF
Moses K. Tule
MANAGING EDITOR
Ademola Bamidele
EDITOR
Charles C. Ezema
ASSOCIATE EDITORS
Victor U. Oboh
David E. Omoregie
Umar B. Ndako
Agwu S. Okoro
Adegoke I. Adeleke
Oluwafemi I. Ajayi
Sunday Oladunni
Aims and Scope
Understanding Monetary Policy Series are designed to improve monetary policy
communication as well as economic literacy. The series attempt to bring the
technical aspects of monetary policy closer to the critical stakeholders who may not
have had formal training in Monetary Management. The contents of the publication
are therefore, intended for general information only. While necessary care was
taken to ensure the inclusion of information in the publication to aid proper
understanding of the monetary policy process and concepts, the Bank would not
be liable for the interpretation or application of any piece of information contained
herein.
Subscription and Copyright
Subscription to Understanding Monetary Policy Series is available to the general
public free of charge. The copyright of this publication is vested in the Central Bank
of Nigeria. However, contents may be cited, reproduced, stored or transmitted
without permission. Nonetheless, due credit must be given to the Central Bank of
Nigeria.
Correspondence
Enquiries concerning this publication should be forwarded to: Director, Monetary
Policy Department, Central Bank of Nigeria, P.M.B. 0187, Garki, Abuja, Nigeria,
Email:[email protected]
iii
Central Bank of Nigeria
Mandate
§Ensure monetary and price stability
§Issue legal tender currency in Nigeria
§Maintain external reserves to safeguard the international
value of the legal tender currency
§Promote a sound financial system in Nigeria
§Act as banker and provide economic and financial
advice to the Federal Government
Vision
“By 2015, be the model Central Bank delivering
Price and Financial System Stability and promoting
Sustainable Economic Development”
Mission Statement
“To be proactive in providing a stable framework for the
economic development of Nigeria through the
effective, efficient and transparent implementation
of monetary and exchange rate policy and
management of the financial sector”
Core Values
§Meritocracy
§Leadership
§Learning
§Customer-Focus
iv
MONETARY POLICY DEPARTMENT
Mandate
To Facilitate the Conceptualization and Design of
Monetary Policy of the Central Bank of Nigeria
Vision
To be Efficient and Effective in Promoting the
Attainment and Sustenance of Monetary and
Price Stability Objective of the
Central Bank of Nigeria
Mission
To Provide a Dynamic Evidence-based
Analytical Framework for the Formulation and
Implementation of Monetary Policy for
Optimal Economic Growth
v
FOREWORD
The understanding monetary policy series is designed to support the
communication of monetary policy by the Central Bank of Nigeria (CBN). The series
therefore, provides a platform for explaining the basic concepts/operations,
required to effectively understand the monetary policy of the Bank.
Monetary policy remains a very vague subject area to the vast majority of people; in
spite of the abundance of literature available on the subject matter, most of which
tend to adopt a formal and rigorous professional approach, typical of
macroeconomic analysis. However, most public analysts tend to pontificate on
what direction monetary policy should be, and are quick to identify when in their
opinion, the Central Bank has taken a wrong turn in its monetary policy, often
however, wrongly because they do not have the data for such back of the
envelope analysis.
In this series, public policy makers, policy analysts, businessmen, politicians, public
sector administrators and other professionals, who are keen to learn the basic
concepts of monetary policy and some technical aspects of central banking and
their applications, would be treated to a menu of key monetary policy subject areas
and may also have an opportunity to enrich their knowledge base of the key issues.
In order to achieve the primary objective of the series therefore, our target
audience include people with little or no knowledge of macroeconomics and the
science of central banking and yet are keen to follow the debate on monetary
policy issues, and have a vision to extract beneficial information from the process,
and the audience for whom decisions of the central bank makes them crucial
stakeholders. The series will therefore, be useful not only to policy makers,
businessmen, academicians and investors, but to a wide range of people from all
walks of life.
As a central bank, we hope that this series will help improve the level of literacy in
monetary policy as well as demystify the general idea surrounding monetary policy
formulation. We welcome insights from the public as we look forward to delivering
content that directly address the requirements of our readers and to ensure that the
series are constantly updated as well as being widely and readily available to the
stakeholders.
Moses K. Tule
Director, Monetary Policy Department
Central Bank of Nigeria
CONTENTS
Section One: Introduction ..
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Section Two: Conceptual Issues ..
2.1
Price Stability ..
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2.2
Sources of Instability in Prices ..
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Section Three: Monetary Policy Frameworks for Achieving Price Stability
3.1
Monetary Targeting ..
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3.2
Exchange Rate Targeting .. ..
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3.3
Price Level Targeting.. ..
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3.4
Inflation Targeting..
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3.5
Mixed Policy.. ..
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Section Four: Monetary Policy Tools and their Effects on Price Stability
4.1
Price-based and Indirect (market) Tools
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4.1.1 Policy Rate
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4.1.2 Reserve Requirements..
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4.1.3 Discount Window..
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4.1.4 Open Market Operations (OMO)
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4.1.5 Central Bank Bills..
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4.2
Quantity-based and Direct (non-market) instruments
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4.2.1 Credit Ceiling ..
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4.2.2 Sectoral Allocation of Credit ..
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4.2.3 Interest Rate Control ..
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4.2.4 Moral Suasion ..
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Section Five: Conclusion
Bibliography
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HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
HOW CENTRAL BANKS ACHIEVE PRICE
STABILITY1
Stanislaus A. Ukeje2
SECTION ONE
Introduction
Every modern State has a central bank or monetary authority which has a
monopoly in the issuance of legal tender currency and responsibility for policies
relating to the supply of money and credit. Acceptability of notes and coins
issued by central banks as means of exchange, unit of account, store of value
and standard for deferred payments depends on public confidence. Prior to the
20th Century, confidence in legal tender currency was derived from their gold
value. This monetary regime was called the gold standard but as commerce
expanded, the supply of gold could not match the demand for money. The Bank
of England had to adopt the „responsibility doctrine‟ as proposed by Walter
Bagehot, undertaking to lend to other banks on acceptable collateral, to enable
them meet their needs.
After the World War I, the gold standard weakened, resulting in widespread
macroeconomic instability including; high inflation, reduced economic growth
and high unemployment. Global efforts to restore the gold standard revealed
that each country needed to maintain internal and external stability to
guarantee confidence in the fiat money.
The introduction of the Bretton Woods system of fixed exchange rate, backed by
gold through the United States‟ dollar reduced concern about inflation and the
value of money. When this system failed in 1971, inflation and growth became
once again a public issue. To confront high inflation and low growth (stagflation)
1This
publication is not a product of vigorous empirical research. It is designed specifically
as an educational material for enlightenment on the monetary policy of the Bank.
Consequently, the Central Bank of Nigeria (CBN) does not take responsibility for the
accuracy of the contents of this publication as it does not represent the official views or
position of the Bank on the subject matter.
2Stanislaus
A. Ukeje is an Assistant Director in the Monetary Policy Department, Central
Bank of Nigeria
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HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
of the 1970s, Paul Volcker, Chairman of the United States‟ Federal Reserve
(central bank), implemented a policy of reducing the rate of growth of money
supply and increased interest rates to levels that exceeded the rate of inflation.
Price stability was restored and sustained in the advanced economies for many
years until the 2007 global financial crises. This prompted some analyst to aver
that business cycle and inflation had ceased to be a major economic problem in
the advanced economies. Indeed, there were several proposals to remove
banking regulation from central banks to some independent bodies. However,
the collapse of Lehman Brothers and the subsequent global economic turmoil
that started in 2007 brought to the fore once again, the towering responsibility of
central banks for financial sector stability, output growth, and employment.
Following this introduction, section II contains conceptual issues, while Section III
presents monetary policy framework for achieving price stability. Section IV
discusses the tools of monetary policy and their effects on price stability. Section
V conclusions the paper.
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HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
SECTION TWO
Conceptual Issues
2.1
Price Stability
Price stability is a situation where the average change in prices of goods and
services is just sufficient to support the growth of the economy. Price stability does
not necessarily mean that prices are not changing in the economy, but rather
connote a situation where the average increase in the general price level is
matched with a corresponding growth in the aggregate economy. It is a situation
where there is no deflation or inflation in the economy. It means that prices on
average are relatively stable over time.
The change in the general price level, also termed inflation, can be stable,
variable, and/or unpredictable. The stable form of inflation provides a suitable
environment for economic planning and investments, while the variable and
unpredictable form of inflation create uncertainties and are not conducive for
sound economic decisions.
Inflation in a country, region or globally is measured in terms of changes in an
index of prices over a period of time, mostly over 12-months. The index may be
broad or narrow. A widely used price index is the Consumer Price Index (CPI)
based on the market cost of living on a representative basket of consumer goods
and services purchased by households. Other indexes include: Producer Price
Index (PPI) which is a measure of changes in the price of the final products of
domestic producers; Wholesale Price Index (WPI); the Personal Consumption
Expenditures Price Index or PCEPI; and the Gross Domestic Product Deflator. There
are other indexes based on the price of precious metals such as gold, the
average of nominal wages and the average of asset (securities) prices.
Annual change in the general level of prices within the range of 1 and 3 per cent
is generally regarded as low and stable inflation rate in many countries. Thus price
stability does not mean the stability of the average level of prices and does not
refer to price changes in the short-term such as a day or a week.
As there are different indexes adopted to capture change in the general price
levels, there are also different inflation measures, namely; core, headline and
food. “Core” or underlying inflation refers to inflation measured by changes in
CPI, PCEPI or the GDP Deflator but excluding certain volatile prices, such as food
and energy prices. “Headline” inflation is a measure of the total inflation within an
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HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
economy, including food and energy, which may experience sudden price
spikes. Households are more concerned about this measure of inflation because
it reflects the true cost of living.
Central banks are usually concerned about the “Core” inflation rate because it
shows the effects of demand and supply on the gross domestic product of a
country. It is the measure of persistent inflation, excluding short-term and
reversible price movements, which the central bank should resist using monetary
policy tools. This is because it is now generally accepted, both in policy and
academic spheres that the primary objective of central banks is to achieve price
stability. In the evaluation of price developments, most central banks use the CPI
because it covers goods and services consumed by most households, the public
at large are accustomed to it and it is available regularly.
2.2
Sources of Instability in Prices
Price instability manifests as price volatility, where volatility refers to the pace at
which prices move higher or lower, and how wildly they swing. It is the frequency
and severity with which the general price level rises and falls. In general, price
instability is caused by factors including money supply, seasonality, and market
sentiment that produce wild swings in demand and supply.
The assertion that inflation is always and everywhere a monetary phenomenon
(Friedman, 1963) has almost been accepted as a truism, because in every
instance that the general price level in a country is high for a sustained period of
time, the rate of money supply growth is also high. This is so because price stability
is closely associated with money and its functions. As the amount of money in
circulation in an economy increases, the pressure for output to increase rises.
When this happens, prices rise and the value of money declines because more
money will have to be spent to buy the same amount of goods and services.
Accommodative monetary policy in the United States by the Federal Reserve
from 2001 (Taylor, 2007), contributed to stimulating the demand for housing and
asset prices. A lot of capital flowed into the United States about the same time
from China and commodity exporters, which supported the credit growth and
financial innovations that eventually resulted in the global financial crisis of 2007.
In Nigeria, the accommodative monetary policy of the Central Bank of Nigeria
from 2004 (fuelled by high oil prices and stable exchange rate regime) caused
banks to grow their loan books rapidly, especially by financing the acquisition of
privatized State enterprises (e.g. Nigerian Telecommunications Ltd) and grant
margin loans to stock market firms. Bank failures and credit freeze followed in
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HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
2009, and the government enacted the Asset Management Company of Nigeria
Act 2010, to rescue the banking system from total collapse.
The Euro area has been in recession because of unsustainable sovereign debt,
owed mainly to private banks which have had to take enormous losses. All three
examples above, show that price instability follows any time money supply grows
very rapidly for a considerable time.
Another factor that produces price instability is seasonality. During some long
festivals, such as Lent, Easter, Ramadan and Eid el kabir for instance, transport
and many other prices rise sharply and fall also sharply, after the festivals. In this
case, the festive season changes demand. A factor similar to seasonality that
causes price instability is weather. Food prices depend on the supply and the
supply depends on favorable weather for bountiful harvest. Volatility of food
prices is one important source of general price instability, because food is a major
component of the standard consumer basket of goods and services in Nigeria.
Market sentiment is yet another factor that causes price instability. The price
volatility of stocks and commodities, is often aggravated by the anxious
expectation of stock brokers and commodities traders. The movements in stock
and oil prices in recent times have been fuelled by the speculative behavior of
traders, and this is transmitted through the financial channel, resulting in the
volatility of the general price level.
It should be noted that all the factors discussed above are critical in aggravating
price instability, if the money supply responds in support of demand.
5
HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
6
HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
SECTION THREE
Monetary Policy Frameworks for Achieving Price Stability
A central bank as an institution must have a clear mandate under the law
establishing it. It is important, however, to emphasize that experience and
empirical studies have shown that central banks may pursue other auxiliary
objectives to facilitate the attainment of the price stability mandate.
Central banks conduct monetary policy within a given monetary policy regimes
(monetary policy frameworks), which provide structures for making monetary
policy decisions. . A monetary policy framework is the setting, within which a
central bank modifies its key instruments. Mc Nees (1987) defined it as comprising
“the institutional arrangements under which monetary policy decisions are made
and executed”. The defining characteristics of a monetary policy framework are;
(i) target variables set to be achieved and the set of instruments used by the
central bank to achieve its goal and (ii) the central bank‟s long-term objective. In
addition to facilitating making monetary policy decision, a monetary policy
regime or framework enables monetary policy decisions to be communicated
easily to banks, financial markets and the general public.
Below are widely known and used monetary policy frameworks and their
associated instruments, target variables and long-term objectives (Table 1)
Table 1: Typical Monetary Policy Frameworks
Monetary Policy
Framework
Target Market Variable
Long-term Objective
Monetary Aggregates
Rate of growth of money
supply
Target rate of change in the CPI
Fixed Exchange Rate
The nominal exchange rate
of the domestic currency
The nominal exchange rate of the
domestic currency
Price Level Targeting
Overnight rate of interest
Given level or range of CPI
Inflation Targeting
Overnight rate of interest
A given rate of change in the CPI
Gold Standard
The spot price of gold
Low inflation as measured by the price
of gold
Mixed Policy
Generally interest rates
Generally the rate of unemployment
and change in CPI
Central bank mandate is realised within its monetary policy framework, which is
normally determined by the political authority of the country through legislation.
In Nigeria, two principal Acts guide the monetary policy framework today. These
are the Banks and Other Financial Institutions Act (1991) and the Central Bank of
7
HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
Nigeria Act 2007. In selecting a framework, the monetary authority usually takes
into account the structure and depth of the financial sector, the level of fiscal
discipline, the extent of trade openness of the economy, the structure of the
economy (in particular, the dependence or otherwise of the economy on a
particular sector), the ease of transmission of monetary policy to economic
activities and inflation and other factors. Besides, it is important that there is a
sufficient degree of expertise on monetary policy issues both inside and outside
the central bank, especially in the Ministry of Finance and the Statistical Agency.
Some of the distinguishing features of monetary policy frameworks are discussed
below:
3.1
Monetary Targeting
In this framework, monetary policy aims to control various monetary aggregates
in order to keep inflation down, and requires a level of stability in the velocity of
money, that is, the speed with which money circulates in the economy. The
framework focuses on the growth rate of a chosen monetary aggregate such as
RM (reserve money); M0 or narrow money (consisting of coins and currency
notes, whether in circulation or in the vaults of banks); MB or monetary base
(made up of M0 and mandatory (i.e. minimum) and excess reserves held by
banks); M1, the most liquid measure of money supply (consisting of notes and
coins in circulation and assets that can be readily converted to cash); M2 or
broad money (consisting of M1 and assets that can be converted to cash but not
immediately such as savings and fixed deposits, money market funds and
overnight repos); M3 a broad money aggregate (made up of M2 and large time
deposits and liquid assets, large money market funds and short-term repos usually
held by institutional investors); and an aggregate of the liquidity in an economy,
money with zero maturity (MZM), which is composed of M2 plus all money market
funds less fixed deposits because they are not redeemable at par on demand).
A central bank using this framework must choose the appropriate monetary
aggregate to target. Monetary targeting framework is based on the assumption
that there exist a long-run positive relationship between price growth and money
supply growth. The aggregate target becomes the nominal anchor or
intermediate target of monetary policy. But financial liberalization and innovation
have made it more difficult to monitor aggregate measures of money supply and
have also affected the stability of the velocity of money. The relationship
between monetary aggregates and the price level has weakened because of
the changing nature of financial sector due to financial innovations. It is also the
case that the monetary aggregate selected by a central bank may not be
amenable to precise management and control.
8
HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
3.2
Exchange Rate Targeting
This is a monetary policy regime in which interest rates are set, with a view to
achieving a target exchange rate, between the currency of a country and the
currency of another country or a basket of currencies. The currency against
which the domestic currency is benchmarked is termed the nominal anchor, and
is usually a stable currency. Otherwise, currencies targeting it will experience
volatility, which will negatively affect output and inflation in such countries. In
open economies, international trade is very important and the stability of the
exchange rate determines the performance of the economy. In the period
following the end of the Bretton Woods system of fixed exchange rate, many
developed countries adopted exchange rate targeting as a means of stabilizing
their economies.
A common danger to the integrity of this framework is large international capital
flows and speculation, which could weaken the resolve of the monetary
authorities to maintain the exchange rate target indefinitely. The Monetary
Authority of Singapore (MAS) has successfully used this framework to maintain
price stability as a sound basis for sustainable economic growth. A majority of IMF
member countries, mainly small open economies, use exchange rate targeting
frameworks and adopt the United States dollar as the anchor currency.
3.3
Price Level Targeting
This is a monetary policy regime under which the overall goal is to keep the price
level stable or at a pre-determined level. The Central Bank or Monetary Authority,
alters the policy interest rate in order to keep the consumer price index (CPI) at a
specific level over a period. Thus, if the CPI reads 8 per cent at the end of a given
year, whereas the central bank‟s price target was 4 per cent, interest rate will be
altered to ensure that CPI will be 4 per cent at year-end. Price targeting,
therefore considers previous periods‟ inflation to determine future course of policy
actions. In this case, price level targeting would reduce uncertainty in inflation
outlook. If economic agents accept the price level target set by the central
bank, the potential outcome would be reduced variability of output and
inflation. However, only Sweden in the 1930s ever adopted price level targeting
as a monetary policy regime. The Bank of Canada is currently undertaking
research on the feasibility of adopting it.
3.4
Inflation Targeting
In inflation targeting, unlike price level targeting, a central bank publicly preannounces official quantitative targets (or a succession of targets) for the inflation
rate that it is to achieve over one or more time horizons. Inflation targeting is
9
HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
forward-looking, and involves active and direct shaping of inflation expectations.
Central banks that adopt this regime of monetary policy, set the inflation target
on the basis of a vast array of information on the rate of employment, nominal
and real exchange rates, output gap, producer prices, import prices, nominal
and real interest rates, the total fiscal deficits, the primary deficits and other
variables. The data from these various sources helps the central bank to forecast
the likely path of inflation. In an inflation targeting regime, the fiscal authorities
undertake to coordinate policies in ways that would support the achievement of
the target inflation. In practice, inflation targeting has enabled central bank to
control inflation expectation, and in a number of cases successfully lower inflation
outcome. Typically, inflation-targeting central banks assign monetary policy
making to the Monetary Policy Committee (MPC), made up of central bank
officials and external members; the Committee is given policy independence
and required to operate transparently and be accountable.
3.5
Mixed Policy
Whereas price stability is almost universally accepted as the primary goal of
central banks, in many jurisdictions, monetary policy regimes continue to pay
attention to monetary aggregates, exchange rate and interest rate. The Bank of
England has adopted inflation targeting as its monetary policy framework, but it
continues to intervene in the foreign exchange market, conduct open market
operations and engage in asset purchase programmes. In practice, most
countries adopt an admixture of policy regime.
10
HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
SECTION FOUR
Monetary Policy Tools and their Effects on Price Stability
Monetary policy tools are used to control interest rates, inflation, exchange rate
and other macroeconomic indicators, in order to achieve price stability. There
are broadly two classes of monetary policy tools used by central banks to
achieve price stability. Meyer (1980) classified the control tools into two, general
or selective. The monetary base and the money multiplier are two variables that
have unrestricted impact on money supply. Thus general control tools impact on
monetary aggregates through either the monetary base or the money multiplier.
The general controls are price-based, and include ratios such as reserve
requirements; instruments with interest rates, (central bank rates); open market
operations (OMOs); and central bank bills. These instruments are indirect and are
market based. The selective controls are quantity-based instruments, which are
almost all non-market based and direct instruments. Selective controls are able to
alter the choice among alternative uses in the allocation of credit. Credit can be
allocated to loans for acquiring securities through margin or down-payment
transactions or to hedge on interest rate (floors and or ceilings) received by bank
depositors on their savings or paid by borrowers to banks on loans.
4.1
Price-Based and Indirect (Market) Tools
Indirect monetary policies are according to Gidlow (1998), monetary policy
decisions of central banks or Monetary Authorities aimed at achieving monetary
policy objectives by influencing financial market behaviour with regard to lending
and borrowing. The behaviour of financial market participants in response to
central bank policy actions are directed at taking advantage of incentives or
avoiding disincentives embedded in price and interest rate changes. Examples of
price-based policy tools are:
4.1.1 Policy Rate
Central banks‟ policy rate is an indicator of the monetary policy stance; raising it
indicates monetary tightening while lowering it indicates monetary easing. It
influences market interest rates towards „targets‟ set by the Bank through lending
to DMBs or purchasing and selling bonds to the banks. Usually, a central bank will
not lend money to a DMB below the policy rate (MPR) nor will it take deposits
from a DMB at a rate above the policy rate. In market economies, bond prices
move in an opposite direction to money market rates; and money market rates
move in response to the policy rate. Thus by changing the monetary policy rate,
central banks are able to influence the demand for money and inflation
expectation and outcome.
11
HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
There are jurisdictions in which the policy rate is the interest rate charged on
repurchase agreements („repos‟ or „RPs‟) with Deposit Money Banks/Discount
Houses and Primary Dealers in the financial market by the central banks. A repo is
an agreement to sell a financial asset (such as a bond, stock or bank deposit
receipt) and repurchase the same asset at a slightly higher rate overnight or such
agreed short period. The repo is terminated in a „reverse repo‟. By adjusting their
official/target repo and reverse repo rates, central banks influence decision of
economic agents to borrow or lend, depending on the attendant costs and
benefits.
4.1.2 Reserve Requirements
Central banks impose reserve requirements on depository institutions for system
liquidity management and for prudential regulation. Reserve requirements limit
the amount of funds that DMBs can give as loans to their customers. There are
two types of reserve requirements: cash and liquidity reserves. The cash reserve
requirement is generally called the Cash Reserve Ratio or CRR while the liquidity
requirement is termed Liquidity Ratio or LR because they are measured relative to
the total deposit liability of a financial market (bank) entity. CRR, also called
primary reserve requirements, is that proportion of the total deposit liabilities (i.e.
the sum of demand, savings and time deposit liabilities) of a DMB that the
Monetary Authority shall drain and hold as reserves for the entity concerned over
a maintenance period. LR on the other hand is the proportion of the liquid assets
which a DMB shall hold relative to its total deposit liabilities. It (LR) is composed of
assets that should be freely and readily convertible to cash without a significant
loss, and free from any charge, lien or encumbrance. The other name for reserve
held under Liquidity Ratio is secondary reserve requirement.
Over and above the CRR, DMBs also hold voluntary reserves with the central
bank to meet clearing balance requirements or as flight to safety. The level of the
reserves affects the interbank rate (i.e. the overnight interest rate in the interbank
market in which banks lends and borrows from one another without collateral).
CRR is a particularly blunt instrument, which impacts on the interbank rate without
a lag. Central banks alter reserve requirements in response to price
developments; a rise in reserve requirements generally will lead to increase in
interbank rates, thereby increasing short-term and long-term interest rates, which
can cause a reduction in credit and growth of money supply. A reduction in
reserve requirements would have the opposite effects.
12
HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
4.1.3 Discount Window
This is a monetary policy instrument by which a central bank provides
accommodation (lends short-term) to eligible institutions to enable them meet
liquidity shortage. Repurchase (repos) and reverse repurchase (reverse repos or
RRPs) take place at the Discount Window. The interest rate at the Discount
Window is called discount rate, base rate or repo rate charged on such loans is
called the discount rate, repo rate or base rate. It is an important tool for
maintaining financial and banking system stability. In some jurisdictions, the
discount window mechanism is referred to as Standing Facility. In Nigeria, there is
the Standing Lending Facility (SLF) through which the Central Bank the Central
Bank lends to banks and the Standing Deposit Facility (SDF) through which the
DMBs place funds with the Central Bank. Increase in lending through the Discount
Window increases money supply through enlarging the monetary base while
decrease contracts money supply by contracting the monetary base (Mishkin,
1997).
4.1.4 Open Market Operations (OMO)
This is a tool used by central banks to change the level of money supply. It is
purchase or sale of government securities by a central bank to the banking and
non-banking public for liquidity management purposes. When a central bank
notices there is excess liquidity in the system, it sells securities to reduce DMBs‟
reserves (monetary base). But to increase money supply in the economy, a
central bank buys securities from DMBs and by doing so injects liquidity into the
system. By injecting or withdrawing liquidity from the banking system, central bank
affects money market and other interest rates in its desired direction. Interest rate
is a key macroeconomic price which has impact on asset prices, the exchange
rate and the general price level. Thus OMO can be used to ensure price stability.
4.1.5 Central Bank Bills
These are short-term securities (unlike Treasury bills) issued by the central bank for
periods not exceeding 12 months. Banks holding the bills do not add them in the
determination of liquidity reserve requirements. In that way, the bills affect
liquidity and interest rate in the money market. Also, central bank bills cannot be
discounted for cash at the central bank or accepted by the central bank as
collateral in a repo transaction. Therefore, unlike treasury bills, issue of central
bank bills reduces DMBs‟ reserves by the amount of the issue for the duration of its
tenure. OMO transactions using central bank bills are sterilisation operations in
local currency and can be used to prevent depreciation of the domestic
currency.
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HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
4.2
Quantity-Based and Direct (Non-Market) Instruments
Direct monetary policy instruments are tools used central banks to achieve
monetary policy objectives by setting aggregate monetary, credit and interest
rate targets for DMBs and other financial institutions. Through regulations, direct
instruments operate by setting or limiting either quantities (e.g. amounts of credit
outstanding) or prices (e.g. interest rates). By the term “direct”, it means that
there is a one-to-one correspondence between the tool and the policy goal
objective (Alexander, Baliño, and Enoch, 1996). Direct instruments are commonly
used in countries where the financial market is not highly developed, even
though it exists to different degrees in all jurisdictions.
4.2.1 Credit Ceiling
A central bank may direct DMBs to limit the amount of credit to the private sector
within a period, issuing the directive well before the beginning of the period.
Accordingly, both credit institutions and credit customers would be aware of the
directive. The goal is to control the expansion of bank credit. Recent experience
with public sector debt sustainability has resulted in some central banks similarly
capping credit to the government from time to time. By directly limiting credit
expansion, the central bank controls the contribution of money supply growth to
inflation.
4.2.2 Sectoral Allocation of Credit
Where a government (the fiscal authority) has preferred economic sectors in her
growth and development agenda, central banks would issue directives to the
DMBs, requiring them to allocate either specified percentages or amount of
credit to the preferred sectors. Considerations about equity and social justice
sometimes make governments and monetary authorities to identify economic
and geographical regions, social groups and gender for priority allocation of
credit. Apart from controlling the expansion of credit and money supply, sectoral
allocation of credit influences the use of credit and its impact on inflationary
development and aggregate demand.
4.2.3 Interest Rate Control
Interest rate represents the price of capital; it influences savings mobilisation and
financial intermediation. Free market interest rate in an uncompetitive market
situation may discourage financial intermediation, and encourage financial
repression. Where this is the case, experience shows that much of the currency
issued by the central bank is outside the banking system, thus limiting the velocity
of money. To counter this, central banks in some jurisdictions set interest rate floors
for savings and ceilings for credit. By controlling interest rate, a key component of
macroeconomic prices that feeds into inflation is controlled
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HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
4.2.4 Moral Suasion
Regulatory powers of central banks over financial institutions, especially deposit
money banks, provide opportunity for persuading them to pursue suggested
strategies and policies such as intensifying savings mobilisation, reducing charges,
increasing or restricting credit and others. The DMBs yield to the persuasion of the
Monetary Authorities in order to maintain harmonious relations. In this way,
strategies and policies that moderate inflation can be implemented by DMBs
contrary to their profit-maximising behaviour.
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HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
16
HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
SECTION FIVE
Conclusion
Price stability is a situation where the average change in prices of goods and
services is just sufficient to support the growth of the economy. Price stability does
not necessarily mean that prices are not changing in the economy, but rather
connote a situation where the average increase in the general price level is
within a narrow range. Consumer Price Index (CPI) is the most widely used price
index, based on the cost of living on a fixed basket of goods and services. It was
discussed that there are different indices of change in the general level of prices
as there are also different inflation measures, namely headline, core, and food.
In general, price instability is caused by factors (such as money supply,
seasonality, market sentiment, among others) that produce wild swings in
demand and supply. Several monetary policy frameworks such as monetary
aggregates, fixed exchange rate, price level targeting, inflation targeting, and
mixed policy were extensively discussed. Two major categories of monetary tools,
namely; price-based and indirect (market) and quantity-based direct instruments
are deployed in the monetary policy management.
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HOW CENTRAL BANKS ACHIEVE PRICE STABILITY
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