Open Market Operations and Financial Markets The last 15 years have been the most dramatic for changes to the concept and practice of central banking This book lies at the heart of how central banks manage to influence the economy and financial markets, exploring how central banks work, how they have changed and how they are likely to change in the future The contributors bring together a unique combination of practical experience from around the world, including chapters from Japan, USA, Australia and the Euro area Over recent years a new consensus has appeared over what monetary policy is and how it should be implemented This volume takes a critical look at that consensus and argues that some of its foundations are weak It considers the changing role of open market operations and the consequence of forcing markets to ‘need’ the central bank through required reserves There is a detailed study of the US and an exploration of how the Bank of Japan had to innovate to try to continue to have an influence when interest rates were zero, as well as detailed attention to countries across Europe The issues discussed within this volume are applicable to all countries with an active monetary policy, whatever their stage of economic development As such the book will be useful to academics working in the area of banking, monetary economics and finance as well as professionals working with central banks across the world David G Mayes is Advisor to the Board at the Bank of Finland, Professor of Economics at London South Bank University, Adjunct Professor at the University of Canterbury and Visiting Professor at the University of Auckland Jan Toporowski is a Research Associate in Economics at the School of Oriental and African Studies, University of London, UK and Research Associate in the History and Methodology of Economics at the University of Amsterdam, the Netherlands [12:49 2007/4/5 4892-mayes-fm.tex] Ref: 4892 MAYES: Open Market Operations and Financial Markets Page: i 1–14 Routledge International Studies in Money and Banking Private Banking in Europe Lynn Bicker Bank Deregulation and Monetary Order George Selgin Money in Islam A study in Islamic political economy Masudul Alam Choudhury The Future of European Financial Centres Kirsten Bindemann Payment Systems in Global Perspective Maxwell J Fry, Isaak Kilato, Sandra Roger, Krzysztof Senderowicz, David Sheppard, Francisco Solis and John Trundle What is Money? John Smithin Finance A Characteristics Approach Edited by David Blake Organisational Change and Retail Finance An Ethnographic Perspective Richard Harper, Dave Randall and Mark Rouncefield The History of the Bundesbank Lessons for the European Central Bank Jakob de Haan [12:49 2007/4/5 4892-mayes-fm.tex] Ref: 4892 MAYES: Open Market Operations and Financial Markets Page: ii 1–14 10 The Euro A Challenge and Opportunity for Financial Markets Published on behalf of Société Universitaire Européenne de Recherches Financières (SUERF) Edited by Michael Artis, Axel Weber and Elizabeth Hennessy 11 Central Banking in Eastern Europe Edited by Nigel Healey and Barry Harrison 12 Money, Credit and Prices Stability Paul Dalziel 13 Monetary Policy, Capital Flows and Exchange Rates Essays in Memory of Maxwell Fry Edited by William Allen and David Dickinson 14 Adapting to Financial Globalisation Published on behalf of Société Universitaire Européenne de Recherches Financières (SUERF) Edited by Morten Balling, Eduard H Hochreiter and Elizabeth Hennessy 15 Monetary Macroeconomics A New Approach Alvaro Cencini 16 Monetary Stability in Europe Stefan Collignon 17 Technology and Finance Challenges for financial markets, business strategies and policy makers Published on behalf of Société Universitaire Européenne de Recherches Financières (SUERF) Edited by Morten Balling, Frank Lierman, and Andrew Mullineux 18 Monetary Unions Theory, History, Public Choice Edited by Forrest H Capie and Geoffrey E Wood 19 HRM and Occupational Health and Safety Carol Boyd [12:49 2007/4/5 4892-mayes-fm.tex] Ref: 4892 MAYES: Open Market Operations and Financial Markets Page: iii 1–14 20 Central Banking Systems Compared The ECB, The Pre-Euro Bundesbank and the Federal Reserve System Emmanuel Apel 21 A History of Monetary Unions John Chown 22 Dollarization Lessons from Europe and the Americas Edited by Louis-Philippe Rochon & Mario Seccareccia 23 Islamic Economics and Finance: A Glossary, 2nd Edition Muhammad Akram Khan 24 Financial Market Risk Measurement and Analysis Cornelis A Los 25 Financial Geography A Banker’s View Risto Laulajainen 26 Money Doctors The Experience of International Financial Advising 1850–2000 Edited by Marc Flandreau 27 Exchange Rate Dynamics A New Open Economy Macroeconomics Perspective Edited by Jean-Oliver Hairault and Thepthida Sopraseuth 28 Fixing Financial Crises in the 21st Century Edited by Andrew G Haldane 29 Monetary Policy and Unemployment The U.S., Euro-area and Japan Edited by Willi Semmler 30 Exchange Rates, Capital Flows and Policy Edited by Peter Sinclair, Rebecca Driver and Christoph Thoenissen 31 Great Architects of International Finance The Bretton Woods Era Anthony M Endres [12:49 2007/4/5 4892-mayes-fm.tex] Ref: 4892 MAYES: Open Market Operations and Financial Markets Page: iv 1–14 32 The Means to Prosperity Fiscal Policy Reconsidered Edited by Per Gunnar Berglund and Matias Vernengo 33 Competition and Profitability in European Financial Services Strategic, Systemic and Policy Issues Edited by Morten Balling, Frank Lierman and Andy Mullineux 34 Tax Systems and Tax Reforms in South and East Asia Edited by Luigi Bernardi, Angela Fraschini and Parthasarathi Shome 35 Institutional Change in the Payments System and Monetary Policy Edited by Stefan W Schmitz and Geoffrey E Wood 36 The Lender of Last Resort Edited by F.H Capie and G.E Wood 37 The Structure of Financial Regulation Edited by David G Mayes and Geoffrey E Wood 38 Monetary Policy in Central Europe Miroslav Beblavý 39 Money and Payments in Theory and Practice Sergio Rossi 40 Open Market Operations and Financial Markets Edited by David G Mayes and Jan Toporowski [12:49 2007/4/5 4892-mayes-fm.tex] Ref: 4892 MAYES: Open Market Operations and Financial Markets Page: v 1–14 [12:49 2007/4/5 4892-mayes-fm.tex] Ref: 4892 MAYES: Open Market Operations and Financial Markets Page: vi 1–14 Open Market Operations and Financial Markets Edited by David G Mayes and Jan Toporowski [12:49 2007/4/5 4892-mayes-fm.tex] Ref: 4892 MAYES: Open Market Operations and Financial Markets Page: vii 1–14 First published 2007 by Routledge Park Square, Milton Park, Abingdon, OX14 4RN Simultaneously published in the USA and Canada by Routledge 270 Madison Avenue, New York, NY 10016 Routledge is an imprint of the Taylor & Francis Group, an Informa business © 2007 selection and editorial matter David G Mayes and Jan Toporowski; individual chapters, the contributors This edition published in the Taylor & Francis e-Library, 2007 “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” All rights reserved No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Open market operations and financial markets/edited by David G Mayes and Jan Toporowski p.cm Includes bibliographical references and index ISBN-13: 978-0-415-41775-4 (hb) Banks and banking, Central Monetary policy I Mayes, David G II Toporowski, Jan HG1811.O64 2007 332.1’14–dc22 2006031332 ISBN 0-203-93402-4 Master e-book ISBN ISBN-10: 0-415-41775-9 (hbk) ISBN-13: 978-0-415-41775-4 (hbk) [12:49 2007/4/5 4892-mayes-fm.tex] Ref: 4892 MAYES: Open Market Operations and Financial Markets Page: viii 1–14 Contents Contributors Preface xi xiii Introduction DAVID MAYES AND JAN TOPOROWSKI Monetary Policy and its Theoretical Foundations 14 DAVID LAIDLER Comment – J A N TOPOROWSKI The Scope and Significance of Open-Market Operations 36 WILLIAM A ALLEN Comment – F R A N C O BRUNI Open Market Operations – Their Role and Specification Today 54 ULRICH BINDSEIL AND FLEMMING WÜRTZ Comment – W I L L I A M T GAVIN Monetary Policy in a Changing Financial Environment: A Case for the Signalling Function of Central Banks’ Operating Framework 86 LAURENT CLERC AND MAUD THUAUDET Comment – I N G M A R VAN HERPT The Interplay Between Money Market Development and Changes in Monetary Policy Operations in Small European Countries, 1980–2000 120 JENS FORSSBÆCK AND LARS OXELHEIM Comment – C H R I S T I A N [12:49 2007/4/5 4892-mayes-fm.tex] Ref: 4892 EWERHART MAYES: Open Market Operations and Financial Markets Page: ix 1–14 References 339 Grilli, V., Masciandaro, D and Tabellini, G (1991) ‘Political and monetary institutions and public financial policies in the industrial countries’, Economic Policy, 13(October): 342-92 Grønvik, G (1994) ‘Bankregulering og bankatferd 1975-1991’, Occasional Paper No 22 (PhD dissertation), Oslo: Norges Bank Guthrie, G and Wright, J (2000) ‘Open mouth operations’, Journal of Monetary 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How Fast?: 125-58, Cambridge: Cambridge University Press Zimmermann, G (2003) ‘Optimal monetary policy: a New Keynesian view’, Quarterly Journal of Austrian Economics, 6(4): 61-72 Zurlinden, M (1996), ‘Devisenmarktinterventionen der Schweizerischen Nationalbank 1986-1994’, Schweizerische Nationalbank Quartalsheft, 14(2): 163-87 [12:51 2007/4/5 4892-Mayes-References.tex] Ref: 4892 MAYES: Open Market Operations and Financial Markets Page: 348 331–348 Index aggregate liquidity shock 228 allotment 260 volume 71 ambiguity 270 American auction 76 announcement day effects 282 announcement effect 288 asset-backed securities 107 asymmetry 292 Augmented Dickey-Fuller test 284 Australia 12, 281–92 autonomous factors 10, 152, 179, 204, 206, 212, 215, 222, 229 autonomous liquidity factors 255 averaging 210 averaging facility 118 averaging provision 215, 252 averaging reserve requirement 246–9 balance sheets 33, 34 balanced budget 301 bands 277 Bank Acceptable Bill 282 Bank of England 2, 42, 44, 57, 276–9 Bank of Japan 98, 107, 225, 321–6 banking crisis 323 bankruptcy risk 316 base money bidding behaviour 260 borrowed reserves 80, 201, 205, 207 targeting 56 boundary conditions 154 branching restrictions 124 brokered funds 176 bubble 306 bubble economy 25 [12:50 2007/4/5 4892-Mayes-Index.tex] Ref: 4892 buffer 210 function 227–9 stock buffering 105 function 107–8 calendar effects 258 Calvo contracts 28 Calvo pricing 33 Canada 25 Capital mobility 158 cash flow 34, 45 management 41, 46 cash fund add 281 drain 281 cash rate 281, 288 cash ratio 105 cashless economy 6, 20, 21, 25, 27 central bank CDs 135 central projection 276 certificates of deposit 126, 148 chain-letter mechanism 295–6, 298, 301, 304 Chancellor of the Exchequer 280 channel mechanism 98 collateral 8, 90, 109 requirements 89 collateralized credit operations 59 collateralized lending 38 commercial paper 130 Commonwealth Government Securities 283 communication 90–1, 207 confidence crisis 306 corridor 3, cost-benefit analysis 263 cost-push 15 MAYES: Open Market Operations and Financial Markets Page: 349 349–354 350 Index counterparties credibility 268 credit deadlock 26 derivatives 113 restrictions 123 risks 90 spreads 323 current account targeting 322 expectations 21, 34, 149, 271, 328 augmented Phillips curve 28 extended carryover 81 external capital flows 166 debt deflation 34, 166 debt management policy 306–14 debt trap 294 default risk 315 deflation 6, 294, 321 deflationary spiral 326 delisting 165 demand for money 16, 19, 22, 29, 83, 113 reserves 183, 222–4, 228 deposit facility 239 deregulation 124–5 derivatives 126 derivative instruments 130 discount facility 62, 65 window 3, 81, 106, 169 discursive data 275 discursive signals 274 disintermediation 87 dollarization 10 Dutch auction 76 dynamic stochastic general equilibrium models 267 economic public 265 efficiency 283 electronic money 88–9, 109 eligible assets 89, 92 eligible collateral 107 emerging markets 9, 157–77 enlargement 108 EONIA 70, 224, 247 Euro area 257, 260, 262 European Central Bank 39, 40, 47, 50, 210, 248, 256, 279 Eurosystem 98, 115, 117–8 Eurozone 256 excess reserves 179, 201 exchange rate 158 futures 288–9 stabilization 171 targeting [12:50 2007/4/5 4892-Mayes-Index.tex] Ref: 4892 fan charts 11, 276–8, 280 Fannie Mae 196, 202 Federal funds market 203–4 Federal funds rate 178–202, 208, 211 Federal Home Loan Bank 196, 202 Federal Reserve 3, 37, 42, 46, 54, 64–5 Federal Fedwire 196 financial deregulation 135 financial futures markets 281–92 fine tuning operations 259 first world war 55, 56 fiscal consolidation 293 fiscal deficit 295 fiscal discipline 47, 50 fiscal failure 319 Fiscal Investment and Loan Programme 307, 320 fiscal reconstruction constraint 317 Fiscal Structural Attempt 293 Fisher effect 18 Fixed rate tenders 51, 60, 74, 76 flow of funds 37 Federal Open Market Committee 46, 86, 185–6, 200–3 foreign direct investment 167 foreign exchange markets 126 forward looking 267 Freddie Mac 196, 202 free reserves 80 frequency 210–26 frictions 14, 19, 228 futures 282 giro clearing system global uncertainty 271–3 gold standard 1–2, 36 Governing Council 259, 261 government debt 117 high powered money 35 household saving 34 hyper-inflation 30 imperfect information 235, 269 incentives for bidding 323 indexed debt 303–4 inflation depreciation 302 inflation neutrality 267 MAYES: Open Market Operations and Financial Markets Page: 350 349–354 Index Inflation Report 276, 278 inflation targeting 11, 16, 27, 31, 139, 268 inflationary bias 267 inflationary taxes 302–6, 319 information 218 inefficiencies 208 initial borrowing assumption 179, 201 inside money 159, 160 interbank lending 236 market 69–70, 126, 135, 228, 234 interest rate controls 122 differentials 151 futures 288 gap 18, 28 smoothing 80 targeting 2, 49–50, 82 volatility 63, 67, 108 intra-day credit 42–4, 50 intra-day liquidity 114 inventory model 212 inventory theoretic approach 222–4 investment restrictions 123 issuance 123 issuing restrictions 123 Japan 6, 48, 293–328 Japanese Government Bonds 294–5, 307–8 judgement 273–5 Kalecki, Michał 32 Koizumi Administration 293 Kreditanstalt 34 late interventions 248 Latin America 158–66 Leibniz Rule 237 lender of last resort 81, 107, 162 lending facility 239 leverage effect 290 Liberal Democratic Party 293 line of business regulation 124 liquidity 9, 10, 67, 71 absorbing 260 crunches 323 deficit 108 effect 187–99, 202, 207–9 providing 260 shock 68, 234 trap 225 [12:50 2007/4/5 4892-Mayes-Index.tex] Ref: 4892 351 Lombard facilities 151 lower bound Lucas supply function 307, 311 macroeconomic dynamics 302 maintenance period 3, 11, 45, 51, 60, 180, 206, 240 market development 146 market entry rules 124 market uncertainty 272 maturity 73 maturity structure 312–3 means of exchange 15, 17 Mexico 157–77 minimum reserves Minsky, Hyman P 34 minutes 276 misspecification 269 model selection criteria 273 model uncertainty 264, 265, 271–3 Monday dummy 289 monetarism 15 monetary aggregates 1, 15 monetary base control 46 Monetary Control Act 57, 58 monetary policy 1, 8, 14–31, 37, 39, 52, 55, 58–77, 86–116, 264–80 monetary transmission mechanism money growth targeting 16 market 154–5 liquidity 141–7 volatility 231–56 multiplier 54, 56, 58 stock 267 supply 267 -surprise model 16 moral hazard 41, 56, 302 moral suasion 79 morning call 184, 201, 206 Monetary Policy Committee 11 NAFTA 24, 167 neutral rate 19 New Consensus 1, 3, 5, 110, 160, 176 New Keynesian Economics 266–7 models 107 New Zealand 12 MAYES: Open Market Operations and Financial Markets Page: 351 349–354 352 Index nominal interest rate rule 83 nominal neutrality 267 non-borrowed reserves 57, 58, 180, 204–5 non-performing loans 323 Norman, Montagu 57 offsetting160 open market desk 82 mouth operations 11 opportunity cost 222, 321 of holding money 22 optimal rule 261 optimizing algorithm 247–8, 253 output gap 6, 18, 28, 30, 163, 172 outright operations 59, 72–3, 78 outside money 158, 160 overbidding 51 overlapping generations framework 306 model 20 overnight interest rate 60–66 ownership restrictions 124 parametric uncertainty 265 path dependency 149 payment system 43, 50–52, 88–9 risk 85 People’s Bank of China 63 Phillips curve 18, 266 policy ineffectiveness 266 reaction functions 28 price stability 31 property rights 19, 21 Ponzi finance 295, 298, 299, 303 Post-Keynesian economics 30 potential demand 163 probability distribution 277 procyclicality 176 public debt 293–320 quantitative easing 27, 37 policy 321–8 quantitative restrictions 130 Radcliffe Committee 15 rate of interest rational expectations 266, 311 real time data 219 real time gross settlement 42, 47, 89 [12:50 2007/4/5 4892-Mayes-Index.tex] Ref: 4892 real time information 220 reference value 31 refinancing operations Regulation Q 198 regulatory bonds 171 regulatory policy 141 Reichsbank 4, 61–2 repurchase agreements 40, 59, 130, 136, 150, 155–6, 283 reputation risk 323 required reserves 213 reserve averaging 36, 44–46, 48, 50–51, 62, 68 reserve band 63, 79 Reserve Bank of Australia 281–92 reserve demand 187 reserve operations 72 reserve position doctrine 54, 55, 58, 80 reserve requirements 4, 8, 10, 44, 50–52, 105, 108–9, 115, 118, 133, 161, 180–3, 205, 210, 228, 242–3 reserve supply 195 reverse operations transactions 105 Ricardian equivalence 31 risk 278 risk free rate 52 risk spreads 52 robust control 268 robust policy 268 search theory 30 second best 310 secondary market 165 securities houses 167 securitization 88–9, 113 securitized assets 117 seigniorage 24, 105, 133, 309 settlement dates 239 settlement fund rate 282 settlement systems 114 settlement Wednesday 180 shocks shorting 171 signal uncertainty 271–3 signalling 2, 7, 10, 11, 86–116, 157, 258, 260, 264–80 skewness 278 solvency constraint 297 spike 247, 252 staggered reserve accounting 81 MAYES: Open Market Operations and Financial Markets Page: 352 349–354 Index standing facilities 2, 3, 8, 38, 47, 54, 58–77, 92, 105, 130, 163, 210, 214, 215, 235, 250 state-owned banks 125 stock market capitalization 167, 168 strong epistemic hypothesis 268, 270 structural deficits structural inflation 166 subjective expected utility 278 subjective probability 303, 305 sustainability 294–306 Sveriges Riksbank 98, 244 swaps 136, 286, 288, 289 sweep account 205 sweep programmes 185 Sydney Futures Exchange 283 target rate 240 tender bidding policies 256 Tesobonos 167 Thornton, Henry 160 time consistency 266 Tinbergen principle 226 trading desk 10, 178, 189–95 transaction costs 24, 70, 72 [12:50 2007/4/5 4892-Mayes-Index.tex] Ref: 4892 353 transfer payments 298 transmission mechanism 39, 87, 272 transparency 24, 87, 90–1, 264, 265, 267, 274 Treasury balances 185 Treasury bills 136, 148 two pillars 31 uncertainty 264–80 indicators of 274 under-bidding 13, 51, 68, 92, 258, 259, 321–3 unit of account 20 United States 257, 262 Treasury bonds 72 variable rate tenders 7, 60, 75 velocity of circulation 15 volatility 210, 211, 215, 220, 222, 258–61, 282 Volcker, Paul 57–8 Volcker, Paul experiment weak epistemic hypothesis 268 Wicksell, Knut 33 MAYES: Open Market Operations and Financial Markets Page: 353 349–354 ... MAYES: Open Market Operations and Financial Markets Page: ix 1–14 x Contents Open Market Operations in Emerging Markets: the Mexican Experience 157 NOEMI LEVY ORLIK AND JAN TOPOROWSKI Open Market Operations. .. Market Operations and Financial Markets Page: vi 1–14 Open Market Operations and Financial Markets Edited by David G Mayes and Jan Toporowski [12:49 2007/4/5 4892-mayes-fm.tex] Ref: 4892 MAYES: Open. .. MAYES: Open Market Operations and Financial Markets Page: 11 1–13 12 David Mayes and Jan Toporowski market operations affect not just interest rates but also the spot and futures markets for