How a Central Bank Executes Monetary Policy

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Copyright 2011  Pearson Canada Inc. 18 - 1 Chapter 18 What Should Central Banks Do? Monetary Policy Goals, Strategy and Tactics Copyright 2011  Pearson Canada Inc. 18 - 2 Monetary Targeting Strategy • Central bank announces it will achieve a certain value (the target) of the annual growth rate of a monetary aggregate. • Central bank then is accountable for hitting the target • Monetary targeting was adopted by several countries: Germany, Switzerland, Canada, the U.K., Japan and the U.S. Copyright 2011  Pearson Canada Inc. 18 - 3 Monetary Targeting • Flexible, transparent, accountable • Advantages – Almost immediate signals help fix inflation expectations and produce less inflation – Almost immediate accountability • Disadvantages – Must be a strong and reliable relationship between the goal variable and the targeted monetary aggregate Copyright 2011  Pearson Canada Inc. 18 - 4 Inflation Targeting • Public announcement of medium-term numerical target for inflation • Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal • Information-inclusive approach in which many variables are used in making decisions • Increased transparency of the strategy • Increased accountability of the central bank Copyright 2011  Pearson Canada Inc. 18 - 5 Inflation Targeting in New Zealand • Reserve Bank of New Zealand Act 1989 • Minster of Finance and Governor of Reserve Bank to make Policy Targets Agreement • Governor of the Reserve Bank was held accountable for the success of monetary policy. • Inflation brought down from above 5% to below 2% by the end of 1992 • Since 1992 NZ growth rate has been high and unemployment declined significantly Copyright 2011  Pearson Canada Inc. 18 - 6 Inflation Targeting In Canada • In 1991, the Minister of Finance and the Governor of the Bank of Canada established formal inflation targets • The target range was 2-4% by the end of 1992, 1.5-3% by June 1994 and 1-3% by December 1996 • After a new government took office in 1993, the target was set at 1-3% and has been kept at this level ever since • Canadian inflation has fallen dramatically since the adoption of targets, falling from 5% in 1991, to zero in 1995 and between 1-2% in the late 1990’s Copyright 2011  Pearson Canada Inc. 18 - 7 Inflation Targeting in the U.K. • Adopted inflation target as nominal anchor in October 1992 • Inflation target was initially set at 1-4% • May 1997 inflation target set at 2.5% and Bank of England was given power to set interest rates (provided independence) • December 2003, target was changed to 2%. • Growth in U.K. economy has been strong leading to reduction in the unemployment rate Copyright 2011  Pearson Canada Inc. 18 - 8 Inflation Rates and Inflation Targets Figure 18-1(a) Copyright 2011  Pearson Canada Inc. 18 - 9 Inflation Rates and Inflation Targets Figure 18-1(b) Copyright 2011  Pearson Canada Inc. 18 - 10 Inflation Rates and Inflation Targets Figure 18-1(c) [...]... with periodic “pre-emptive strikes” by monetary policy against threat of inflation • Monetary policy has long lags • Cannot wait to respond until inflation has begun • Needs to be forward-looking and pre-emptive Advantages and Disadvantages to the U.S Approach • Does not rely on a stable money-inflation relationship • Discourages overly expansionary monetary policy • Lack of transparency • Uncertainty... financial markets, doubt among How a Central Bank Executes Monetary Policy How a Central Bank Executes Monetary Policy By: OpenStaxCollege The most important function of the Federal Reserve is to conduct the nation’s monetary policy Article I, Section of the U.S Constitution gives Congress the power “to coin money” and “to regulate the value thereof.” As part of the 1913 legislation that created the Federal Reserve, Congress delegated these powers to the Fed Monetary policy involves managing interest rates and credit conditions, which influences the level of economic activity, as described in more detail below A central bank has three traditional tools to implement monetary policy in the economy: • Open market operations • Changing reserve requirements • Changing the discount rate In discussing how these three tools work, it is useful to think of the central bank as a “bank for banks”—that is, each private-sector bank has its own account at the central bank We will discuss each of these monetary policy tools in the sections below Open Market Operations The most commonly used tool of monetary policy in the U.S is open market operations Open market operations take place when the central bank sells or buys U.S Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates The specific interest rate targeted in open market operations is the federal funds rate The name is a bit of a misnomer since the federal funds rate is the interest rate charged by commercial banks making overnight loans to other banks As such, it is a very short term interest rate, but one that reflects credit conditions in financial markets very well The Federal Open Market Committee (FOMC) makes the decisions regarding these open market operations The FOMC is made up of the seven members of the Federal Reserve’s Board of Governors It also includes five voting members who are drawn, on a rotating basis, from the regional Federal Reserve Banks The New York district 1/7 How a Central Bank Executes Monetary Policy president is a permanent voting member of the FOMC and the other four spots are filled on a rotating, annual basis, from the other 11 districts The FOMC typically meets every six weeks, but it can meet more frequently if necessary The FOMC tries to act by consensus; however, the chairman of the Federal Reserve has traditionally played a very powerful role in defining and shaping that consensus For the Federal Reserve, and for most central banks, open market operations have, over the last few decades, been the most commonly used tool of monetary policy Visit this website for the Federal Reserve to learn more about current monetary policy To understand how open market operations affect the money supply, consider the balance sheet of Happy Bank, displayed in [link] [link] (a) shows that Happy Bank starts with $460 million in assets, divided among reserves, bonds and loans, and $400 million in liabilities in the form of deposits, with a net worth of $60 million When the central bank purchases $20 million in bonds from Happy Bank, the bond holdings of Happy Bank fall by $20 million and the bank’s reserves rise by $20 million, as shown in [link] (b) However, Happy Bank only wants to hold $40 million in reserves (the quantity of reserves that it started with in [link]) (a), so the bank decides to loan out the extra $20 million in reserves and its loans rise by $20 million, as shown in [link] (c) The open market operation by the central bank causes Happy Bank to make loans instead of holding its assets in the form of government bonds, which expands the money supply As the new loans are deposited in banks throughout the economy, these banks will, in turn, loan out some of the deposits they receive, triggering the money multiplier discussed in Money and Banking 2/7 How a Central Bank Executes Monetary Policy Where did the Federal Reserve get the $20 million that it used to purchase the bonds? A central bank has the power to create money In practical terms, the Federal Reserve would write a check to Happy Bank, so that Happy Bank can have that money credited to its bank account at the Federal Reserve In truth, the Federal Reserve created the money to purchase the bonds out of thin air—or with a few clicks on some computer keys Open market operations can also reduce the quantity of money and loans in an economy [link] (a) shows the balance sheet of Happy Bank before the central bank sells bonds in the open market When Happy Bank purchases $30 million in bonds, Happy Bank sends $30 million of its reserves to the central bank, but now holds an additional $30 million in bonds, as shown in [link] (b) However, Happy Bank wants to hold $40 million in reserves, as in [link] (a), so it will adjust down the quantity of its loans by $30 million, to bring its reserves back to the desired level, as shown in [link] (c) In practical terms, a bank can easily reduce its quantity of loans At any given time, a bank is receiving payments on loans that it made ...ISSN 1607148-4 9 771607 148006 OCCASIONAL PAPER SERIES NO 62 / JUNE 2007 INFLATION-LINKED BONDS FROM A CENTRAL BANK PERSPECTIVE by Juan Angel Garcia and Adrian van Rixtel OCCASIONAL PAPER SERIES NO 62 / JUNE 2007 This paper can be downloaded without charge from http://www.ecb.int or from the Social Science Research Network electronic library at http://ssrn.com/abstract_id=977352. INFLATION-LINKED BONDS FROM A CENTRAL BANK PERSPECTIVE by Juan Angel Garcia 1,2 and Adrian van Rixtel 1,2 In 2007 all ECB publications feature a motif taken from the €20 banknote. 1 The authors would like to thank Jürgen Stark, Philippe Moutot, Francesco Drudi and Manfred Kremer for providing useful comments at various stages of the project as well as an anonymous referee for helpful suggestions. Arnaud Mares provided very useful input to an earlier draft of this paper. We are also very grateful to Hervé Cros, BNP Paribas, for kindly supplying some data. The views expressed in this paper are those of the authors and do not necessarily refl ect those of the European Central Bank. 2 Capital markets and Financial Structure Division, Directorate Monetary Policy, European Central Bank. Adrian van Rixtel is currently on leave at the Banco de España, Madrid. © European Central Bank, 2007 Address Kaiserstrasse 29 60311 Frankfurt am Main Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main Germany Telephone +49 69 1344 0 Website http://www.ecb.int Fax +49 69 1344 6000 Telex 411 144 ecb d All rights reserved. Any reproduction, publication or reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the author(s). The views expressed in this paper do not necessarily reflect those of the European Central Bank. ISSN 1607-1484 (print) ISSN 1725-6534 (online) 3 ECB Occasional Paper No 62 June 2007 CONTENTS CONTENTS ABSTRACT 4 1 INTRODUCTION AND SUMMARY 5 2 THE DEVELOPMENT OF INFLATION-LINKED BOND MARKETS 7 2.1 Major inflation-linked bond markets 7 2.2 The development of the euro area sovereign inflation-linked bond market 8 3 THE ISSUANCE OF INFLATION-LINKED BONDS: CONCEPTUAL CONSIDERATIONS 12 3.1 Considerations of issuers 12 3.2 Considerations for investors 13 3.3 Costs and benefits from a social welfare perspective 14 3.3.1 Portfolio diversification and market completeness 14 3.3.2 Incentives to savings 15 3.3.3 Distributional arguments 15 3.4 The role of inflation-linked bonds in matching pension liabilities 16 3.5 The potential for private issuance of inflation-linked bonds 17 3.6 The choice of the reference index 19 3.7 Inflation-linked bonds, debt indexation and the maintenance of price stability 20 4 EXTRACTING INFORMATION FROM INFLATION-LINKED BONDS FOR MONETARY POLICY PURPOSES 23 4.1 Break-even inflation rates as indicators of inflation expectations 23 4.2 Inflation-linked bond yields as measures of real interest rate and growth prospects 34 5 CONCLUDING REMARKS 36 REFERENCES 37 EUROPEAN CENTRAL BANK OCCASIONAL PAPER SERIES 45 4 ECB Occasional Paper No 62 June 2007 ABSTRACT Inflation-linked bond markets have experienced significant growth in recent years. This growth is somewhat surprising, for inflation-linked bonds cannot be considered a financial innovation and their development has taken place in a period of historically low global inflation and inflation expectations. In this context, the purpose of this paper is twofold. First, it provides a selective survey of the key arguments for and against the issuance of inflation-linked debt, and some of the factors that help to understand their recent growth. Second, it illustrates IMF Staff Papers Vol. 45, No. 4 (December 1998) © 1998 International Monetary Fund Anticipation and Surprises in Central Bank Interest Rate Policy The Case of the Bundesbank DANIEL C. HARDY* Market reaction to a change in official interest rates will depend on the extent to which the change is anticipated, and on how it is interpreted as a signal of future policy. In this paper, a technique is developed to separate the anticipated and unanticipated components of such changes, and applied to estimate the response of euro–deutsche mark interest rates to adjust- ments in the Bundesbank’s Lombard and discount rates. [JEL E43, E47] G OVERNMENT OFFICIALS, financial market participants, and agents in the economy at large attach importance to official central bank interest rates. What are termed official rates typically comprise the rates applied at one or more central bank standing facilities and in some cases at which the central bank operates a regular tender. In most industrialized countries, as in a number of developing countries, the central bank determines these rates both to define the range within which it manages short-term interbank rates through on-going open market operations, and to signal its medium-term policy stance (see Borio, 1997, for a recent survey). A change in official rates can thus affect expectations that are reflected in longer-term interest rates and other financial market prices, and hence initiate the monetary pol- icy transmission process. It is therefore important that policymakers be able to predict the market response to such changes. Yet market participants have an incentive to anticipate policy shifts, and insofar as they succeed, market prices should largely adjust in advance of the implementation of a 647 *Daniel C. Hardy is a Senior Economist in the Middle Eastern Department. He thanks R. Flood, H. Herrmann, O. Issing, J. Reckwert, S. Schich, K H. Tödter, J. Zettelmeyer, and participants at a seminar at the Deutsche Bundesbank for their helpful comments. change. Therefore, predicting the market response to changes in official rates requires that these changes be decomposed into their anticipated and unanticipated components. Such a decomposition may reveal what aspects of a change in official rates influence expectations over different time hori- zons, and whether the central bank can achieve different ends depending on the nature and degree of forewarning that has been given of the change. These considerations were the motivation for this paper. A number of past studies have looked at the impact effect of changes in offi- cial interest rates by the U.S. Federal Reserve (for instance, Lombra and Torto, 1977; Thornton, 1986 and 1994; Cook and Hahn, 1988 and 1989; and Radecki and Reinhart, 1994), the Bank of England (Dale, 1993), the Bank of Canada (Paquet and Pérez, 1995), and recently the Deutsche Bundesbank (Nautz, 1995; Hardy, 1996). In most such studies the change in money market rates on the days surrounding a change in an official rate is simply regressed on the change itself. However, changes in market rates ought largely to reflect changes in expectations, based presumably on new information, so it is impor- tant to distinguish between the anticipated and unanticipated actions by the central bank. These studies also usually limit their focus to the relatively rare instances when central bank rates were actually changed and neglect occa- sions when a change was thought possible but did not materialize. One common approach to identifying anticipated WORKING PAPER SERIES NO 868/FEBRUARY2008 PURDAH ON THE RATIONALE FOR CENTRAL BANK SILENCE AROUND POLICY MEETINGS byMichael Ehrmann and Marcel Fratzscher WORKING PAPER SERIES NO 868 / FEBRUARY 2008 In 2008 all ECB publications feature a motif taken from the 10 banknote. PURDAH ON THE RATIONALE FOR CENTRAL BANK SILENCE AROUND POLICY MEETINGS 1 Michael Ehrmann and Marcel Fratzscher 2 This paper can be downloaded without charge from http://www.ecb.europa.eu or from the Social Science Research Network electronic library at http://ssrn.com/abstract_id=1090543. 1 This paper is forthcoming in the Journal of Money, Credit, and Banking. We would like to thank Terhi Jokipii and Björn Kraaz for excellent research assistance, Niels Bünemann for some information about the purdah practices of central banks and Magnus Andersson, Alan Blinder, Alex Cukierman and Bernhard Winkler as well as seminar participants at the ECB for comments. This paper presents the authors’ personal opinions and does not necessarily refl ect the views of the European Central Bank. 2 Both authors: European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany; e-mail: Michael.Ehrmann@ecb.int, Marcel.Fratzscher@ecb.int © European Central Bank, 2008 Address Kaiserstrasse 29 60311 Frankfurt am Main, Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main, Germany Telephone +49 69 1344 0 Website http://www.ecb.europa.eu Fax +49 69 1344 6000 All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the author(s). The views expressed in this paper do not necessarily refl ect those of the European Central Bank. The statement of purpose for the ECB Working Paper Series is available from the ECB website, http://www.ecb. europa.eu/pub/scientifi c/wps/date/html/ index.en.html ISSN 1561-0810 (print) ISSN 1725-2806 (online) 3 ECB Working Paper Series No 868 February 2008 Abstract 4 Non-technical summary 5 1 Introduction 6 2 Institutional Design of the Purdah Period 8 3 Measuring Communication 10 4 Purdah communication and fi nancial market reactions 11 5 Conclusions 15 References 16 Appendix A: Quotes from FOMC transcripts 18 Appendix B: Measuring central bank communication 20 Appendix C: Quotes of statements by FOMC members reported during the purdah 21 Tables and fi gures 30 European Central Bank Working Paper Series 35 CONTENTS 4 ECB Working Paper Series No 868 February 2008 Abstract Despite substantial differences in monetary policy and communication strategies, many central banks share the practice of purdah, a self-imposed guideline of abstaining from communication around policy meetings or other important events. This practice is remarkable, as it seems to contradict the virtue of transparency by requiring central banks to withhold information precisely when it is sought after intensely. However, imposing such a limit to communication has often been justified on grounds that such communication may LOGO Can central bank’s monetary policy be described by a linear (augmented) Taylor rule or by a monetary rule? GVHD: GS.TS TRẦN NGỌC THƠ SVTH : NHÓM 12-K23 COMPANY LOGO www.themegallery.com SUMMARY Why study? 1 Literature reviews 4 Hypothesises and Prediction 3 Theories 2 Research methods 5 Conclusion 6 COMPANY LOGO www.themegallery.com Why study? Should central banks obey a linear (augmente) Taylor rule or nonlinear rule? a Need to modeling to test which rule the best is How to conduct monetary policy? COMPANY LOGO www.themegallery.com STUDY OBJECTIVES the roles of a forward- looking version of the Taylor rule in the conduct of monetary policy Objectives The role of asset prices or financial variables in the conduct of monetary policy Comparing a linear Taylor rule with a nonlinear rule COMPANY LOGO www.themegallery.com RESEARCH QUESTION  whether central banks’ monetary policy can indeed be described by a linear Taylor rule or, instead, by a nonlinear rule?  whether that rule can be augmented with a financial conditions index containing information from some asset prices and financial variables? COMPANY LOGO www.themegallery.com Theories Taylor rule Monetary policy Rational Expectation Forward looking Taylor rule Asset prices vs Financial variables COMPANY LOGO www.themegallery.com Developing hypothesises  The relation between the interest rate, inflation and the output gap is described by A forward-looking Taylor Rule  The interest rate is not adjusted immediately to its desired level but is concerned about interest rate smoothing.  The central bank can have asymmetric preferences that it might assign different weights to expected negative and positive inflation and output gaps in its loss function COMPANY LOGO www.themegallery.com Prediction  The central bank increases the real rate in response to higher inflation, which exerts a stabilizing effect on inflation; on the other hand  In situations in which output is below its potential a decrease in the interest rate will have a stabilizing effect on the economy.  The interest rate is adjusted to desired rate gradually  The central banks’ monetary policy can indeed be described better by a non-linear Taylor rule COMPANY LOGO www.themegallery.com INTRODUCTION  Taylor Rule (1993), of the linear alge- braic interest rate rule that specifies how the Federal Reserve (Fed) of the United States (US) adjusts its Federal Funds target rate to current inflation and output gap.  Extension : Clarida et al. (1998,2000), who suggested the use of a forward-looking version of the Taylor rule where central banks target expected inflation and out- put gap instead of past or current values of these variables COMPANY LOGO www.themegallery.com INTRODUCTION  Important extension is related to the inclusion of asset prices and financial variables in the rule. ASSET PRICES ? [...]... the nonlinear smooth transition regression model 1 The ECB’s monetary policy is better described by a nonlinear monetary rule than by a linear Taylor rule 2 The results also show that the ECB – contrary to the other central banks – con- tinues to consider the information contained in the financial index even after nonlinearities are controlled for 3 we find weak evidence to reject the linear model for the... COMPANY LOGO www.themegallery.com A BRIEF REVIEW OF LITERATURE  Clarida et al (1998,2000) suggest the use of a forward-looking version of the Tay- lor rule where central banks target expected inflation and output gap instead of past or current values of these variables  Fourc¸ ans and Vranceanu (2004) and Sauer and Sturm (2007) also stress the importance of considering a forward-looking Taylor rule. .. of a linear reaction function Kajuth (forthcoming) shows that monetary policy should also react to house prices due to their effects on consumption The issue of financial stability is also ... lend out If banks are allowed to hold a smaller amount in reserves, they will have a greater amount of money available to lend out 4/7 How a Central Bank Executes Monetary Policy At the end of... bank run The interest rate banks pay for such loans is called the discount rate (They are so named because loans are made against the bank s outstanding loans “at a discount” of their face value.)... Money and Banking takes effect And what 3/7 How a Central Bank Executes Monetary Policy about all those bonds? How they affect the money supply? Read the following Clear It Up feature for the answer