Transcript Central bank interest rates

Dr Marek Porzycki
1.
2.
3.
4.
5.
6.
7.
Basic function and purposes
Approaches – restrictive vs. expansionary
Monetary policy tools
Transmission mechanism
Unconventional tools applied during current
crisis
Communication of monetary policy
Sources and reading
Steering the money supply
- direct
influence on the monetary
base (M0)
- indirect impact on monetary
aggregates (M1 and above) via
the transmission mechanism
price stability objective
 price stability vs other goals of monetary policy
- economic growth
- high employment
- stability on financial markets
 Poland: since 1999 the direct inflation target strategy has
been applied in the implementation of monetary policy. The
Monetary Policy Council defines the inflation target and then
adjusts the NBP basic interest rates in order to maximise the
probability of achieving the target. Since the beginning of
2004, NBP has pursued a continuous inflation target at the
level of 2.5% with a permissible fluctuation band of +/- 1
percentage point.
Note: legal aspects of central bank mandate will be discussed
during the following courses



-
Expansionary (loose) monetary policy – expansion
of money supply
aiming at higher inflation (or at least accepting it)
stimulating economic growth
lower interest rates = cheaper lending
„doves”
Restrictive (tight, contractionary) monetary policy –
money supply expands more slowly than usual or
even shrinks
aiming to reduce inflation
cooling down overheated economy
higher interest rates = more expensive lending
„hawks”



Reserve requirements (minimum reserves)
- the proportion of total deposits that banks
must hold as reserve with the central bank.
Standing facilities
- aim to provide and absorb liquidity of
banks, signal the general monetary policy
stance and influence market interest rates.
Open market operations (OMO)
- buying or selling assets (usually
government bonds) on the open market from
commercial banks and financial institutions


a specified fraction of deposits kept with a
commercial bank to be set aside in the central
bank as mandatory reserve
deposits set aside as reserve cannot be used to
finance lending - aims:
◦ limiting excess bank liquidity, putting upper limit on the
money multiplier
◦ smoothing out the impact of movements in banking sector
liquidity on interbank interest rates

-
-
Current values (as of 18.10.2016):
Poland: 3,5 % minus 500.000 EUR per credit
institution
euro area: 1% minus100.000 EUR per institution



Starting from 18.01.2012, the ECB has
lowered the reserve requirement from
previous 2% to 1% as one of measures
intended to support bank lending (
expansionary monetary policy)
press release:
http://www.ecb.europa.eu/press/pr/date/20
11/html/pr111208_1.en.html
However, this move did not reach its intended
goal, as commercial banks preferred to
deposit excess reserves at the ECB using the
deposit facility.




SF are aimed at providing and absorbing overnight
liquidity, signal the general stance of monetary
policy and influence overnight market interest rates
Central bank acts as „bank of banks” taking deposits
and extending loans to commercial banks.
„standing” = can be used on the commercial banks’
initiative
Credit-deposit operations serve to limit fluctuations
of the shortest (especially overnight) interbank
market rates;
primary credit or regular short-term lending (usually
overnight)
- Eurosystem: marginal lending facility, banks obtain
overnight liquidity from the NCBs against eligible assets
- Fed: discount window
- NBP: lombard loans (kredyt lombardowy) extended to banks
against Treasury securities as collateral in order to cover
their short-term liquidity shortfalls.
 in usual conditions interest rate applied to central bank
lending sets a ceiling on interbank interest rates
 current rates (18.10.2016): 0,25% (ECB), 2.50% (NBP)
 to be distinguished from secondary lending or liquidity
support
 see below, unconventional tools






short-term (overnight) deposits with the central bank,
available to commercial banks
Time deposits at the central bank allow commercial banks
to manage their surplus liquidity, preventing short-term
interbank market interest rates from falling below the
deposit rate.
Interest rate on overnight deposits sets floor to interbank
lending rates, as the deposit facility allows banks to „park”
any amount of money at the central bank at the deposit
rate
Deposit rate is the lowest of central bank interest rates.
Current ECB interest rate on deposit facility (as of
18.10.2016): -0,40% ( negative interest rate)
Corresponding NBP rate: +0,50%


Aim: to encourage banks to boost lending to each other, to
consumers, and to businesses, in turn boosting the broader economy,
while discouraging hoarding liquidity
◦ instead of earning interest on money deposited with the central
bank, banks are charged by the central bank to park their cash with
it
But: the consequences may be unwelcome:
◦ banks can pass on to customers the costs they incur for depositing
money with the central bank
◦ negative return on parking funds with the central bank might
encourage banks to invest in riskier assets to secure a return,
potentially driving new asset bubbles
◦ banks are likely to increase their purchases of government bonds 
government borrowing costs are artificially low  banks and
governments could find themselves so intertwined and
interdependent that they drag each other - and the economy –
down; crowding out effect may occur
◦ Experience in Sweden and Denmark (no noticeable change in the
interest rates charged by banks for bank loans)







initiated by the central bank
Basic form: purchases or sales of assets (mostly Treasury
bonds) from financial institutions
Purchases of assets  expansion of monetary base,
providing liquidity
Sales of assets  shrinking of monetary base, absorbing
liquidity
Dynamic vs. defensive open market operations
◦ Defensive OMO: in response to or in anticipation of
other market events
Repos (repurchase agreements) and reverse repos –
purchases/sales reversed on a specified time, subject to
specified interest rate
Outright transactions (purchase/sale without an
agreement to reverse the transaction)

Other instruments used – collateralised loans, issuance
of debt certificates by the central bank, swaps, fixedterm deposits
◦ NBP: issue of own-debt securities (7-day NBP money market
bills), whose minimum yield (interest rate) equals the
reference rate adopted by the Monetary Policy Council.

Difference in aims and regularity (Eurosystem examples):
◦ main refinancing operations: liquidity-providing transactions
with a weekly frequency and a maturity of normally one week
◦ long-term refinancing operations (LTRO and TLTRO –
transactions wih maturities of, respectively, up to 3 months
and up to 4 years, see also unconventional monetary policy)
◦ fine-tuning operations (conducted on an ad hoc basis in order
to smooth the effects on interest rates caused by unexpected
liquidity fluctuations in the market)
◦ structural operations, e.g. the issuance of debt certificates
From the ECB website
Date: 06/06/2014
Action: Fine-tuning operation
Communication:

As announced by the Governing Council on 10 May 2010, the
ECB conducts specific operations in order to re-absorb the
liquidity injected through the Securities Markets Programme
(SMP). In this regard, the ECB will carry out a quick tender on 10
June 2014 at 11.30 in order to collect one-week fixed-term
deposits with settlement day on 11 June 2014. A variable rate
tender with a maximum bid rate of 0.15% will be applied and
the ECB intends to absorb an amount of EUR 162.5 billion. (…).





Lending by central banks should be based on adequate
collateral (assets submitted by commercial banks as security).
Treasury bonds and other marketable assets (e.g. credit
claims) are usually used as collateral.
Lombard loans extended by the Polish NBP: collateral consists
of Treasury securities and the amount of loan may not exceed
80% of their nominal value
Central banks maintain a list of eligible collateral and update
it from time to time (example:
http://www.ecb.europa.eu/paym/coll/assets/html/list.en.html)
Risky collateral, e.g. bonds with lower credit risk rating, may
be eligible under certain circumstances but valuation haircuts
may be applied to reflect higher risk.
Example: use of Greek sovereign bonds as collateral for
Eurosystem monetary policy operations



-
Institutions allowed to contract with the central
bank within the monetary policy framework.
Broadly: commercial banks and similar
institutions.
Eurosystem eligibility criteria – eligible
institutions should be:
subject to minimum reserve requirement
in financially sound condition
subject to financial supervision by competent
authorities
fulfilling operational criteria


-

Interest rates applied by central banks to the
respective monetary policy instruments
Announced by the central banks and changed in
reaction to monetary policy needs:
rate increase – tightening the monetary policy, aimed
at reduction of the money supply
rate decrease – easing the monetary policy, aimed at
expansion of the money supply
Influence on conditions on the money market
(interbank market and transactions between
banks and the general public) and in the general
economy via the transmission mechanism.
Examples:
 ECB
http://www.ecb.europa.eu/stats/monetary/rat
es/html/index.en.html
 NBP
http://www.nbp.pl/ („Stopy procentowe NBP”)
http://www.nbp.pl/homen.aspx?f=/en/dzienn
e/stopy.htm




Reserve requirements - useful as a limit of
possible money creation but not suitable for
rapid changes in answer to changing
conditions on the market.
Standing facilities – useful to influence
interest rates on the market but not suitable
for reacting to daily fluctuations.
Open market operations – more flexible,
initiated by the central bank at any time and
with any volume needed. Easily reversible.




combination of the monetary policy and the fiscal
policy, as two channels influencing growth and
employment
They are generally determined, respectively, by the
central bank and the government
Monetary and fiscal policies affect each other, and the
right policy mix is supposed to achieve desirable
macroeconomic outcomes such as price stability,
credit availability, economic growth and financial
stability
An example of a policy mix would be tight
monetary policy combined with easy fiscal policy.




Function of „bank of banks”  central banks deal
directly only with commercial banks but not with the
general public.
Proper functioning of the monetary policy requires
transmission of measures taken by the central bank
through commercial banks to the real economy.
Transmission channels include credit and deposit
businesses of the commercial banks, asset prices,
currency exchange rates and indirectly also wage and
price-setting resulting from supply and demand of
goods, services and labour.
Transmission mechanism is affected by events beyond
control of the central bank, such as global economic
developments, commodity prices, political events etc.

Source: ECB,
http://www.ecb.europa.eu/mopo/intro/transmission/html/index.en.html


Specific problems with transmission of expansive
monetary policy in periods of recession.
„Zero interest rate policy” („ZIRP”) and negative interest
rates.
◦ ZIRP: the central bank maintains a 0% nominal interest rate.
◦ central bank is no longer able to reduce nominal interest rates

Liquidity trap: injections of cash into the private
banking system by a central bank fail to decrease
interest rates and hence make monetary policy
ineffective
◦ A liquidity trap is caused when people hoard cash because
they expect an adverse event such as deflation, insufficient
aggregate demand, or war.
◦ Japan: the economy fell into a period of prolonged stagnation
despite near-zero interest rates


Expanding the monetary base does not increase
money supply as long as banks do not start credit
expansion.
Monetary policy alone is not able to kick-start
economic growth.
◦ Central banks can encourage money creation, but they
cannot force commercial banks to extend credit
◦ money cannot be pushed from the central bank to
borrowers if they do not wish to borrow

compared to „pushing on a string”
◦ monetary policy is asymmetric  it is easier to
tighten it, stopping an expansion, than to ease it in
order to stop a contraction






crisis-related, extremely expansive monetary policy
in order to stimulate economic growth
applied when interest rate cuts have failed to
stimulate monetary expansion („pushing on a string”)
and further cuts are next to impossible (zero or
negative interest rates)
asset purchases - quantitative easing (QE)
Long term open market operations (LTRO) and
targeted long term open market operations (TLTRO)
liquidity support – e.g. Emergency Liquidity
Assistance (acting as „lender of last resort”)
commitment to further actions


Central banks purchase large volume of financial assets
(mostly Treasury bonds) from banks, creating new money to
pay for them.
Direct effects of QE:
◦ Raising the prices of those financial assets and lowering their
yield while simultaneously increasing the monetary base[



As banks buy Treasury bonds in order to re-sell them to the
central bank, QE is sometimes considered to circumvent the
prohibition on monetary financing (lending by the central
bank to the Treasury). Purchases of Treasury bonds by the
central bank are legal if occuring on the secondary market,
but prohibited on primary market (directly from the
Treasury).
Result: large expansion of the monetary base (M0)
first applied in Japan since 2001, then by several central
banks after 2007
started in January 2015, intended to last at least until March
2017, in any case until the inflation is considered to move
towards the inflation target (below but close to 2%)
 average monthly asset purchases amounting to €60 bn/€80 bn
 assets purchased include bonds issued by euro area central
governments, agencies and European institutions, in addition to
private sector assets
 justified by the need to „address the risks of a too prolonged
period of low inflation”  i.e. the ECB’s price stability mandate
 monetary stimulus to the economy also mentioned
See more:
http://www.ecb.europa.eu/press/pr/date/2015/html/pr150122
_1.en.html (initial announcement)
http://www.ecb.europa.eu/mopo/implement/omt/html/index.en.h
tml (general information)

secondary lending or liquidity support
 Central bank acts as „lender of last resort”
providing liquidity to disstressed (but solvent)
banks.
- Eurosystem: Emergency Liquidity Assistance (ELA)
 providing liquidity to solvent banks facing
temporary liquidity problems (e.g. withdrawal of
deposits, lack of access to interbank lending).
 function: preventing bank runs.
 Not applicable to insolvent banks which should be
subject to bank resolution tools or insolvency
proceedings.




On 21.3.2013 the ECB announced that Emergency
Liquidity Assisstance to Cypriot banks would be
continued only until 25.3, unless a programme to
ensure their solvency is put in place.
http://www.ecb.int/press/pr/date/2013/html/pr130
321.en.html
On 25.3 a bailout deal was reached between Cyprus
and the Eurogroup (Eurozone finance ministers).
On 25.3 the ECB decided to continue providing ELA to
Cypriot banks, based on the assumption that the
bailout maintained their solvency.
http://www.ecb.int/press/pr/date/2013/html/pr130
325.en.html






Function: sending signals to the markets
Example: speech by Mario Draghi, President of the
ECB, on 26.7.2012 „Within our mandate, the ECB is
ready to do whatever it takes to preserve the euro.
And believe me, it will be enough.”
http://www.ecb.europa.eu/press/key/date/2012/ht
ml/sp120726.en.html
Understood as commitment to unlimited asset
purchases.
Follow-up: launch of Outright Monetary Transactions
on 6.9.2012 (never actually used)
http://www.ecb.europa.eu/press/pr/date/2012/html
/pr120906_1.en.html




Does QE mean „printing money”?
QE and other forms of unconventional monetary
policy result in a large expansion of central banks’
balance sheets  expansion of monetary base (M0)
However, inflation results from the increase of total
money supply, including not only M0 but mostly
money created by commercial banks (M1, M2).
As banks mostly deposited additional funds
obtained from QE as deposits in the central banks
(excess reserves), lending expansion did not occur
and there was no increase in total money supply.




As long as commercial banks do not start credit
expansion using the expanded monetary base,
overall money supply remains low and inflation
does not result.
Once credit expansion exceeds a certain degree,
central banks would need to restrict monetary
policy, including shrinking the monetary base in
order to avoid inflation („exit strategy”).
Too early tightening of the monetary policy could
push the economy into deep recession.
In case of a too late tightening, inflation can result
from expanded monetary base being used to
finance lending.






In order to be efficient, monetary policy
needs to be predictable.
explaining monetary policy in detail to the
general public
publishing long-term strategies and policies
declaring „approaches” in monetary policy
regular meetings of the rate-setting bodies,
followed by press conferences
publication of minutes of discussion of the
rate-setting bodies


„Monetary Policy Guidelines” – a yearly
strategy document by the NBP
http://www.nbp.pl/polityka_pieniezna/doku
menty/zalozenia/zalozenia_pp_2016.pdf
ECB press releases:
http://www.ecb.europa.eu/press/pr/date/20
16/html/index.en.html





F. Mishkin, The Economics of Money, Banking, and
Financial Markets, Pearson, 10th ed. 2013
monetary policy tools, p. 418-431
price stability and other goals: Chapter 17, p. 434-461
ECB website
http://www.ecb.europa.eu/mopo/html/index.en.html (see
menu on the left side of the website)
NBP website
http://www.nbp.pl/homen.aspx?f=/en/onbp/informacje/p
olityka_pieniezna.html
Fed website
http://www.federalreserve.gov/monetarypolicy/default.ht
m
For Polish readers: A. Sławiński (red.), Polityka pieniężna,
Warszawa 2011



most comprehensive and detailed description
of the Eurosystem monetary policy
set in the ECB Guideline (EU) 2015/510 of 19
December 2014 on the implementation of the
Eurosystem monetary policy
framework (ECB/2014/60)
http://www.ecb.europa.eu/ecb/legal/1002/1
014/html/index-tabs.en.html

Try yourself in monetary policy – €CONOMIA
- The Monetary Policy Game on the ECB
website:
http://www.ecb.europa.eu/ecb/educational/e
conomia/html/index.en.html