Transcript The inflation target

Monetary Policy
Chapter 13, 14
Operating Instruments:
Target Interest Rates
• On a day to day basis,
central banks express
their policy in terms of a
single easily observed,
easily controlled financial
market price or quantity.
• In many economies,
central banks use the
interest rate in interbank
market as an operating
instrument
Fed
Federal Funds Rate
BoJ
Uncollateralized
Call Money Rate
ECB Main Refinancing
Rate
BoK Overnight Call Rate
UK
Official Bank Rate
Interbank Market
iIBR
S
i*
iTGT
D
Reserve Accounts
Open Market Practice
• On a daily basis, a central bank will provide
instructions to engage in open market
transactions that will adjust supply to keep
the interbank interest rate near the target rate.
• Example: If there is an excess demand for
reserves, the traders might engage in an
open market purchase of bills, increasing the
supply of reserves pushing down the rate
until it is near the target.
Interbank Market:
OMO to meet demand for reserves
S
iIBR
S'
i*
1
2
iTGT
D
Reserve Accounts
Keeping close to target
5.60
5.40
5.20
5.00
4.80
4.60
4.40
4.20
Market Rate
Target
http://research.stlouisfed.org/fred2/categories/118
2007-12-01
2007-11-01
2007-10-01
2007-09-01
2007-08-01
2007-07-01
2007-06-01
2007-05-01
2007-04-01
2007-03-01
2007-02-01
2007-01-01
4.00
Defensive Transactions
• An open market transaction to keep
interest rate near the target is referred to
as a defensive tranaction.
• If excess demand/supply for reserves is
felt to be temporary, OMO will be done
with a repo/reverse repo transaction.
• What is a repo transaction?
Why Interbank Rate as Instrument?
• Easy to observe
• (Mostly) easy to control since banks keep
reserves at the bank.
• Clear transmission to economy
Dynamic Transactions and Policy
Changes
• Central bankers shift monetary policy by
changing the interest rate target.
• In order to enact the change, the bank’s
traders are instructed to engage in
dynamic transactions.
– A dynamic purchase of bills will be
implemented to reduce interest rates.
– A dynamic sale of bills will be implemented to
increase interest rates.
Interbank Market: Policymakers
decide to increase target
iIBR
S'
S
2
iTGT'
iTGT
1
D
Reserve Accounts
Interbank Market:
Policymakers decide to reduce target
iIBR
S
S'
1
iTGT
2
iTGT'
D
Reserve Accounts
Fed Funds Rate & Money Market
Rates
• If iFF < iMM, banks can borrow money in
Fed Funds market and buy higher yielding
investments.
– Purchase of the limited number of these
instruments would push down rates.
• If iFF > iMM, banks would sell money
market instruments to fund lending in Fed
Funds market.
– Sale of these instruments would push up
interest rates.
Cutting Interest Rates will shift out the AD curve
P
AS
P**
2
P*
1
AD2
AD1
Y*
Y**
Y
Monetary Transmission
Mechanism
Money Market Rates
Interbank
Interest Rate
Economy
Policy Framework
• Fed Objective Humphrey Hawkins Act (1978): Fed
instructed by Congress to be “conducting the nation's
monetary policy .. in pursuit of maximum employment,
stable prices, and moderate long-term interest rates “
• 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.”
• 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
Why Price Stability?
1. High inflation generates high money
interest rates and taxes
2. Unpredictable inflation generates risk for
borrowers and lenders.
3. Stabilizing price level stabilizes output
when driven by demand shocks.
Demand Driven Recession
w/ Counter-cyclical monetary policy
YP
P
AS
1
P*
2. Monetary
Policy Cuts
Interest Rate
3
2
AD
AD’
Output Gap
1. Economy
goes into a
recession.
Fed detects
deflationary
pressure
Y
3. Demand
shifts back
returning
both price
and output
to LR level
Intermediate Target: Expected
Inflation
• Intermediate Target: How the central bank
measures the economy and the impact that it is
having on it.
• Since interest rates hit the economy with a lag,
measure the future path of inflation to judge
impact of monetary policy
• Problem: Expected inflation is not perfectly
measurable.
– Economic data and models
– Financial market info (TIPS spreads, yield spreads,
futures)
Policy Feedback: Taylor Principle
• Real interest rate impacts demand for goods
in economy.
• Real interest rate is rt = it - E[πt+1]
• When E[πt+1] rises, central bank should
increase it more than 1-for-1 to raise real
interest rate, limit demand and limit inflation.
• When E[πt+1] falls, central bank should reduce
it more than 1-for-1 to drop real interest rate,
raise demand and avoid deflation.
Taylor Rule
•
Economist named John Taylor argues
that US target interest rate is well
represented by a function of
1. current inflation
2. Inflation GAP: current inflation vs. target
inflation
3. Output Gap: % deviation of GDP from long
run path
•
Function: Inflation Target π* = .02
TGT
t
i
 .025   t 
1
 ( t   )  1 2  Output Gapt
*
2
The Taylor Rule Download
Inflation Targeting
• A growing number of central banks, beginning in
New Zealand in the 1980’s conduct monetary
policy under the framework of “inflation targeting”
• Bank states an explicit target for inflation and
publishes inflation forecasts under current
conditions. Policy is set in order to bring actual
inflation within a range around the target.
• Central bankers are judged by their ability to hit
target and repeated failures may result in
policymakers losing their jobs.
List of
Inflation
Targeting
Countries
Rose
A Stable International Monetary
System Emerges: Inflation
Targeting is
Bretton Woods, Reversed
Bank of England Target
•
•
•
The inflation target
The inflation target of 2% is expressed in terms of an annual rate of inflation
based on the Consumer Prices Index (CPI). The remit is not to achieve the
lowest possible inflation rate. Inflation below the target of 2% is judged to be
just as bad as inflation above the target. The inflation target is therefore
symmetrical.
If the target is missed by more than 1 percentage point on either side – i.e. if
the annual rate of CPI inflation is more than 3% or less than 1% – the
Governor of the Bank must write an open letter to the Chancellor explaining
the reasons why inflation has increased or fallen to such an extent and what
the Bank proposes to do to ensure inflation comes back to the target.
A target of 2% does not mean that inflation will be held at this rate
constantly. That would be neither possible nor desirable. Interest rates
would be changing all the time, and by large amounts, causing unnecessary
uncertainty and volatility in the economy. Even then it would not be possible
to keep inflation at 2% in each and every month. Instead, the MPC’s aim is
to set interest rates so that inflation can be brought back to target within a
reasonable time period without creating undue instability in the economy.
Chart 2 CPI inflation projection based on market interest rate
expectations and £175 billion asset purchases
Bank of England Inflation report
The fan chart depicts the probability of various outcomes for CPI inflation in the future. It has been conditioned on the assumption that the stock of purchased assets financed by the
issuance of central bank reserves reaches £175 billion and remains there throughout the forecast period. If economic circumstances identical to today’s were to prevail on 100
occasions, the MPC’s best collective judgement is that inflation in any particular quarter would lie within the darkest central band on only 10 of those occasions. The fan chart is
constructed so that outturns of inflation are also expected to lie within each pair of the lighter red areas on 10 occasions. In any particular quarter of the forecast period, inflation is
therefore expected to lie somewhere within the fan on 90 out of 100 occasions. The bands widen as the time horizon is extended, indicating the increasing uncertainty about
outcomes. See the box on pages 48–49 of the May 2002 Inflation Report for a fuller description of the fan chart and what it represents. The dashed line is drawn at the two-year point.
Japan and the Liquidity Trap
• BBC Story Download
• During the 1990’s and this decade Bank of
Japan reduced their nominal interest rate
ultimately implementing ZIRP – Zero
Interest Rate Policy
• Interest rate cannot be set at a rate below
zero because of the existence of an
alternative financial instrument that always
pays better than negative rates.
Money Market at ZIRP
MD
i
0
P
When nominal interest rate
reaches zero, demand for
money turns infinite since
money pays just as good
an interest rate as bonds.
M
P
Money Market at ZIRP
MD
i
i*
0
P
MS
P
M S'
P
1
2
The central bank can shift
out the money supply and
even push the real interest
rate negative as long as
expected inflation is
positive.
M
P
Money Market at ZIRP
i
Once the real
interest rate
drops to the
negative of
expected
i*
inflation,
people will be
willing to hold
all additional
money
created andi**
the real
interest rate
0
will not drop
MD
P
MS
P
M S'
P
M S''
M S'''
P
P
1
2
3
4
M
P
ZIRP: Japan
JP: Call Rate: Uncollaterized: Overnight
% pa
10
9
8
7
6
5
4
3
2
1
0
Jul-1985
Jul-1988
Jul-1991
Jul-1994
Jul-1997
Jul-2000
Jul-2003
Jul-2006
Post-2008 Environment
• Deep business cycle recession
• Shaky financial sector
Recession Worsening
Zero Lower Bound
• Recession environment suggest expected
deflation
• Taylor rule suggests negative interest
rates but…
• Interest rates can’t decline below zero,
since no one would lend reserves (which
pay at least zero interest) and accept a
negative return.
Big differential between interest rate
suggested by Taylor rule and zero.
ZIRP: Japan
JP: Call Rate: Uncollaterized: Overnight
% pa
10
9
8
7
6
5
4
3
2
1
0
Jul-1985
Jul-1988
Jul-1991
Jul-1994
Jul-1997
Jul-2000
Jul-2003
Jul-2006
Large Scale Expansion in Monetary
Base
Monetary Base
€2,000,000
€1,800,000
€1,600,000
€1,400,000
€1,200,000
ECB (Million Euro)
€1,000,000
Bank of England (Million
Pound)
€800,000
Federal Reserve Board
(US$ Million)
€600,000
€400,000
€200,000
M
Se
p-
04
ar
-0
Se 5
p05
M
ar
-0
Se 6
p06
M
ar
-0
Se 7
p07
M
ar
-0
Se 8
p08
M
ar
-0
9
€0
Final Question
• Can Fed Withdraw Funds when expected
inflation no longer low?
– Maybe, Japan has done it before.
– But will financial firm profits disappear without
easy funding? Can Fed accept that?
Learning Outcomes
• Use the model of the bank reserves market to
qualitatively derive and describe the impact of
defensive and dynamic transactions on
interbank rate and quantity of reserves.
• Use the model of the money market and AS-AD
to qualitatively derive and describe the impact of
monetary policy transactions on the economy.
• Use the Taylor principle to qualitatively describe
and the Taylor rule to quantitatively describe the
impact of economic conditions