Download Monetary Policy

Monetary Policy &
Interest Rates
Central Banks
What is a central bank?
• Central banks began as banks to the government.
• Today controls the level of liquidity by operating
the payment system.
– Control the printing of notes/currency
– Control the accounts used for interbank payments.
Base Liquidity
Cash
+
Reserve
Accounts
Used by banks to
Back up deposits
Monetary
Aggregates
Cash
+
Deposit
Accounts
Money Supply The stock of the medium of exchange.
Types of Financial Assets
M1
Currency in Hands of the Public [C] + Demand
Deposits [D]
M2
M1 + Savings Deposits + “Small” Time Deposits +
[Liquid Money Market Instruments inc/ “Small” NCD’s]
M3
M2 + LTD [“Large” Time Deposits and NCD’s]
Money & Inflation: 1975-1994
Inflation & Money OECD Countries
0.2
0.18
Average Inflation Rate
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
0
0.02
0.04
0.06
0.08
0.1
0.12
Average Money Growth
0.14
0.16
0.18
Policy Framework
• Japan Objective: Bank of Japan Act Article 2
Currency and monetary control by the Bank of Japan
shall be aimed at achieving price stability, thereby
contributing to the sound development of the national
economy
• ECB Objective “The primary objective of the ECB’s
monetary policy is to maintain price stability. The
ECB aims at inflation rates of below, but close to, 2%
over the medium term.”
Look forward to Inflation Targeting
KEY GOAL OF CENTRAL BANKS:
PRICE STABILITY
HKMA Link
Great Inflation of the 70’s & 80’s
CPI Inflation, % Annual Rate
35
30
25
20
15
10
5
OECD
East Asia
Subsaharan Africa
20
09
20
05
20
01
19
97
19
93
19
89
19
85
19
81
19
77
19
73
19
69
19
61
-5
19
65
0
Latin America
Troubles with Inflation
1. Unpredictable inflation generates risk for:
- borrowers and lenders
- workers and employers
2. High inflation generates losses of purchasing
power for people who hold money.
Money is a tool of liquidity, becomes less useful when
subject to a high inflation tax.
• Hyperinflation: Inflation reaching growth of 50% per
month.
CPI Inflation, Annual %
Argentina
Brazil
Peru
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
8000
7000
6000
5000
4000
3000
2000
1000
0
Hyperinflation in China
Shanghai
Price Index
Sep-45
May-49
100
105000000000
Dynamics of Hyperinflation in China 1945-1949 TW Hu, 1970
1945
1947
1949
Monetary Policy Framework
•
•
•
•
Goals – Overall objectives
Anchors – Benchmarks of Performance
Policy Instruments – Day-to-day operations
Transmission Mechanism – How central bank
activities affect the economy
Nominal Anchors
• Nominal Anchors act as the measure of currency value
maintenance which orient the activities of the central
bank.
• Exchange Rate Targets: Maintain value
relative to another currency or basket of
currencies.
• Inflation Targets: Maintain value relative
to a basket of goods.
Importance of Nominal Anchors
• Commitment to nominal anchor can stabilize
the value of money and implement low and
stable inflation.
• Visible, credible commitment to nominal
anchor implements low inflation expectations
in financial markets and private sector.
Adjusting Interest Rates for Inflation
• Payoff on 1 year, 1 period loan is $1+i, but
what is the purchasing power of the payoff?
• Convert the payoff into the prices prevailing in
initial loan year by dividing the pay-off by the
trajectory of prices.
• Inflation adjusted interest rate is sometime
referred to as real interest rate.
1  it
P
1  rt 
 rt  it  gt 1
Pt 1
Pt
Monetary Policy and the Fisher Effect
In the long-run, real interest rate unaffected by
monetary policy.
• High long term inflation path translates into
high inflationary expectations.
• High inflationary expectations lead to high
interest rates.
it  rt  E[ g ]
P
t 1
Fisher Effect: OECD Economies Great
Inflation of 1970’s
20
18
Interest Rates-1984
16
14
12
10
8
6
4
2
0
0
2
4
6
8
10
12
Average Inflation 1970-1984
14
16
18
Inflation Targeting
What is IT?
• Using price of goods as a nominal anchor.
• Set specific numerical targets for future
inflation
• Report regular forecasts of expected inflation
under current economic conditions.
• Set interest rate policy to push future inflation
back into bounds.
Target the Forecasts
• Monetary policy decisions must be made on
the basis of expected inflation because policy
does not have immediate impact on inflation.
• Variety of approaches toward forecasting
inflation including statistical and theoretical
modeling.
• Stabilizing expected inflation stabilizes interest
rates by limiting Fisher effect.
List of
Inflation
Targeting
Countries
Rose
A Stable International Monetary
System Emerges: Inflation
Targeting is
Bretton Woods, Reversed
Operating Instruments
• On a day to day basis, most central banks will
choose to set either interbank interest rates or
exchange rates.
– Central bank provides liquidity for interbank
payments and can determine interest rates in the
interbank market.
– Central bank can also govern the degree of
liquidity in forex market (which is mostly made up
of banks).
RBI Report of the Working Group on Monetary Policy...
Capital Market Rates
Money Market Rates
Treasury Bill Rates
Commercial Paper Rates
Negotiable CD Rates
Usually,
price of
liquidity
issued at
regular
intervals
by central
bank
Government Bond Rates
Corporate Bond Rates
Lending Rates
Maturity Above 1 Year
Policy
Rates
Maturity 1 Day to 1 Year
Interbank Rates
Transmission Mechanism
Long-term
Rates
Policy
Rates
Short-term
Rates
Domestic
Demand
Asset
Prices
(Stocks/RE)
Exchange
Rates
Inflation
&
GDP
External
Demand
Transmission Lags
• Monetary policy works by changing decision
making of private individuals.
• Individual decision making is characterized by
inertia.
• Effects of monetary policy not fully felt until a
year.
Bank of England Estimates of Effect of
Interest Rate
• Raising policy interest rates reduces liquidity in
money markets and raises short-term rates.
– Less liquidity for inventory or credit purchases.
• Raising money market rates attracts liquidity from
stock, RE and bond markets reducing stock and RE
prices and raising LT bond rates.
– Higher LT rates reduces corporate investment and
reduced wealth hurts
• Raising money market rates attracts cash from other
economies, leading to appreciation of domestic
currency.
– Expensive domestic currency makes net exports less
competitive.
Short-term Stabilization
Japan
3
2
Inflation Acceleration
1
0
-8
-6
-4
-2
0
-1
-2
-3
Output Gap
2
4
6
• When short-term
output is below trend,
inflation tends to be
decelerating.
Stablilizing inflation
can also stabilze the
business cycle
Inflation Acceleration =
InflationToday  InflationLastYear
Watching Central Banks
• Monetary policy and market expectations of
monetary policy have strong impact on stock
and bond markets.
Link
Link
Exchange Rate Anchors
Monetary Authorities
Fixed Exchange
Rates
constantly maintain the external value
of the currency.
Crawling Peg
adjusts currency periodically in small
amounts at a fixed rate or in response to
changes in selective indicators.
Managed Floating attempt to influence the exchange rate
without having a specific exchange rate
path or target. Indicators for managing
the rate are broadly judgmental.
De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks
Exchange rate
arrangement
(Number of
countries)
Monetary Policy Framework
Exchange rate anchor
U.S. dollar (66)
Currency board
arrangement (13)
Hong Kong SAR
Other conventional
fixed peg
arrangement (68)
Bangladesh
Mongolia
Sri Lanka
Vietnam
China
Crawling peg (8)
Managed floating
Cambodia
with no preLao P.D.R.
determined path for Myanmar
the exchange
rate (44)
Independently
floating (40)
Composite
(15)
Singapore
Vanuatu
Inflation
targeting
framework
Other
(7)
Brunei
_
(44)
Other
_
(33)
Indonesia
Thailand
Malaysia
Pakistan
India
Korea
Philippines
Japan
Why Exchange Rate Stability?
Why Exchange Rate Anchor?
• Easily measurable & visible benchmark for
maintaining value of the currency.
• Stabilizes international trade and finance.
Why Exchange Rate Instrument?
• Forex markets most liquid market in frontier
markets.
Link
• Fixed exchange rates stabilize both the value
of the domestic currency relative to the
anchor currency but also stabilizes the
domestic interest relative to the interest rate
of the anchor currency.
8
7
6
5
4
3
2
1
0
20
00
年
20 3月
01
年
20 3月
02
年
20 3月
03
年
20 3月
04
年
20 3月
05
年
20 3月
06
年
20 3月
07
年
20 3月
08
年
20 3月
09
年
20 3月
10
年
20 3月
11
年
3月
%
Money Market Rates
Hong Kong
USA
Exchange Rate Misalignment
Over-valuation/Undervaluation
of Currency
• Exchange rate
misalignment: when price
of currency differs from
relative prices of goods
making domestic goods
relatively
cheap/competitive or
relatively
expensive/uncompetitive
Overvalued/
Uncompetitive
Undervalued/
Competitive
S<
Pj
S>
Pj
PANC
PANC
Exchange rate misalignment tends to be
resolved through either 1) exchange rate
adjustment; or 2) inflation/deflation in
domestic prices.
Currency Wars
• Developed economies believe that some
Asian central banks are acting in FX
markets to keep S high and undervalue
currencies.
• Measuring proper valuation is difficult
because it is hard to determine the proper
price level.
PPP conversion factor (GDP) to market exchange rate
ratio
1.8
1.6
1.4
1.2
PPP/S
1
0.8
0.6
0.4
0.2
0
0
10000
20000
30000
40000
50000
GDP per Capita (PPP, 2005)
60000
70000
80000
Short-term measures of competitiveness
• Unit labor costs – Total Labor Costs/Constant
Dollar GDP
ULCt =
Labor Costst Wage Ratet × Labor Hourst
Wage Ratet
=
=
GDPtConstant$
GDPt Constant$
GDPt Constant$
Labor Hourst
• ULC is cost of wages relative to real
productivity.
• Unit of measure: Domestic Currency