Monetary Law and Monetary Policy 4. Monetary policy – instruments and policies

1. Monetary Law and Monetary Policy4. Monetary policy – instruments and policies Dr Marek Porzycki/ Dr hab. Krzysztof Oplustil Chair for Economic Policy

2. Overview • 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

3. Basic function of monetary policy Steering the moneysupply • direct influence on the monetarybase (M0) • indirectimpact on monetaryaggregates (M1 and above) via the transmissionmechanism

4. Inflationtargetting and itsalternatives • pricestabilityobjective • pricestability vs othergoals of monetary policy • economicgrowth • high employment • stability on financialmarkets • Poland: since 1999 the direct inflation target strategy has been utilised in the implementation of monetary policy. 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 discussedduring the followingcourses

5. Expansionary vs. restrictive policy • Expansionary(loose) monetarypolicy – expansion of moneysupply • aimingathigherinflation(oratleastacceptingit) • stimulatingeconomic growth • lowerinterestrates = cheaperlending • „doves” • Restrictive (tight, contractionary) monetarypolicy –moneysupplyexpandsmoreslowlythanusualorevenshrinks • aiming to reduceinflation • cooling down overheatedeconomy • higherinterestrates = moreexpensivelending • „hawks”

6. Instruments of monetarypolicy • Reserverequirements (minimum reserves) - the proportion of total assets that banks must hold in 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 sellingassets (usually government bonds) on the open marketfrom commercial banks and financial institutions

7. Reserverequirement • aspecifiedfraction of depositskept with a commercial bank to be set aside in the central bank as mandatoryreserve • deposits set aside as reservecannot be used to finance lending - aims: • limiting excess bank liquidity, puttingupper limit on themoneymultiplier • smoothing out the impact of movements in banking sector liquidity on interbank interest rates • Currentvalues (as of 21.10.2014): • Poland: 3,5 % - 500.000 EUR per creditinstitution • euro area: 1% - 100.000 EUR per institution

8. Reserverequirement - example • 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/2011/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.

9. Standing facilities (Credit-deposit operations) • SFareaimed 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” takingdepositsand extendingloansto commercial banks. • Central bank acts as „lender of last resort” providingliquidityto disstressed (but solvent) banks. • „standing” = can be used on the commercial banks’ initiative • Credit-deposit operationsserve to limit fluctuations of the shortest (especially overnight) interbank market rates;

10. Standing facilities - lending • primarycreditorregularshort-term lending (usuallyovernight) • Eurosystem: marginallendingfacility, banks obtain overnight liquidity from the NCBs against eligible assets • Fed: discountwindow • NBP: lombard loans (kredyt lombardowy) extended to banks against Treasury securities as collateralin order to cover theirshort-term liquidity shortfalls. • in usualconditionsinterestrate applied to central bank lendingsets a ceilingon interbankinterestrates • currentrates (27.10.2014): 0,30% (ECB), 3.00% (NBP) • to be distinguished from secondarylendingorliquiditysupport  seebelow, unconventionaltools

11. Standing facilities - deposits • short-term (overnight) depositswiththe central bank, available to commercial banks • Time deposits at the central bank allow commercial banks to manage theirsurplus liquidity, preventing short-term interbank market interest rates from falling below the deposit rate. • Interestrate on overnightdepositssetsfloorto interbanklendingrates, as thedepositfacilityallows banks to „park” anyamount of moneyatthe central bank atthedepositrate • Depositrateisthelowest of central bank interestrates. CurrentECBinterestrate on depositfacility (as of 27.10.2014): -0,20% ( negativeinterestrate) • Corresponding NBP rate: 1,00%

12. Digression: Negativeinterestrate • Aim:to encourage banks to lend to more to each other, to consumers, and to businesses, in turn boosting the broader economy,whilecreatingdisincentive to hoardingliquidity • instead of earning interest on money depositedinthe central bank, banks are charged by the central bank to park their cash with it • But: theconsequencesmay be unwelcome: • banks canpass 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 effectmayoccur • ExperienceinSweden and Denmark (no noticeable change in the interest rates charged by banks for bank loans)

13. Open market operations • initiated by the central bank • Basic form: purchasesorsales of assets (mostlyTreasurybonds) from financial institutions • Purchases of assets expansion of monetarybase, providingliquidity • Sales of assets  shrinking of monetarybase, absorbingliquidity • Dynamicvs. defensiveopen market operations • DefensiveOMO: in response to or in anticipation of other market events • Repos (repurchaseagreements) and reverserepos – purchases/salesreversed on a specified time, subject to specifiedinterestrate • Outrighttransactions (purchase/sale without an agreement to reversethetransaction)

14. Open market operations 2 • Other instruments used – collateralisedloans, issuance of debtcertificates by the central bank, swaps, fixed-termdeposits • Polish NBP: issue of own-debt securities (7-day NBPmoney market bills), whose minimum yield equals the reference rate adopted by the Monetary Policy Council. • Differenceinaims and regularity (Eurosystemexamples): • mainrefinancing operations: liquidity-providing transactions with a weekly frequency and a maturity of normally one week • long-term refinancing operations (LTRO, transactions with a monthly frequency and a maturity of normally three months; seealsounconventionalmonetarypolicy) • fine-tuning operations (conducted on an ad hoc basisin 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

15. Open market operations - example • From the ECB website Date: 06/06/2014 Action: Fine-tuningoperation 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. (…).

16. Eligiblecollateral • Lending by central banksshould be based on adequatecollateral (assetssubmitted by commercialbanks as security). • Treasurybonds and othermarketableassets (e.g. credit claims) areusuallyused as collateral. • Lombard loansextended by thePolish 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 eligiblecollateral and updateit from time to time (example: http://www.ecb.europa.eu/paym/coll/assets/html/list.en.html) • Riskycollateral, e.g. bonds with lowercreditrisk rating, may be eligibleundercertaincircumstances but valuationhaircutsmay be applied to reflecthigherrisk. Example: use of Greek sovereignbonds as collateral for Eurosystem monetary policy operations

17. Eligiblecounterparties • 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

18. Central bank interestrates • Interestrates applied by central banks to respectivemonetarypolicy instruments • Announced by the central banks and changedinreaction to monetarypolicyneeds: • rateincrease – tighteningthemonetarypolicy, aimedatreduction of themoneysupply • ratedecrease – easingthemonetarypolicy, aimedatexpansion of themoneysupply • Influence on conditions on themoney market (interbank and between banks and the general public) and inthe general economyvia thetransmissionmechanism.

19. Central bank interestrates • Examples: • ECB http://www.ecb.europa.eu/home/html/index.en.html („Keyfiguresat a glance”) http://www.ecb.europa.eu/stats/monetary/rates/html/index.en.html • NBP http://www.nbp.pl/ („Stopy procentowe NBP”) http://www.nbp.pl/home.aspx?f=/dzienne/stopy.htm

20. Assessment of the respectivemonetary policy tools • Reserverequirements- useful as a limit of possiblemoneycreation but not suitable for rapidchangesinanswer to changingconditions on the market. • Standing facilities – useful to influence interestrates on the market but not suitable for reacting to dailyfluctuations. • Open market operations – moreflexible, initiated by the central bank atany time and withanyvolumeneeded. Easilyreversible.

21. Policy mix • combination of the monetary policy and the fiscal policy of a country • these two channels influence growth and employment, and are generally determined by the central bank and the government respectively • 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.

22. Transmissionmechanism • Function of „bank of banks” central banks dealdirectlyonlywith commercial banks but not withthe general public. • Properfunctioning of themonetarypolicyrequirestransmission of measurestaken by the central bank through commercial banks to theeconomy. • Transmissionchannelsinclude credit and depositbusinesses of the commercial banks, assetprices, currencyexchangerates and indirectlyalsowage and price-settingresultingfromsupply and demand of goods, services and labour. • Transmissionmechanismisaffected by eventsbeyondcontrol of the central bank, such as global economicdevelopments, commodityprices, politicalevents etc.

23. Transmissionmechanism 2 • Source: ECB, http://www.ecb.europa.eu/mopo/intro/transmission/html/index.en.html

24. Transmissionmechanism 3 • Specificproblemswithtransmission of expansivemonetarypolicyinperiods of recession. • „Zero interestratepolicy” („ZIRP”) and negativeinterestrates. • 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: economy fell into a period of prolonged stagnation despite near-zero interest rates

25. Transmissionmechanism 4 • Expandingthemonetarybasedoes not increasemoneysupply as long as banks do not start credit expansion. • Monetarypolicyaloneis not able to kick-starteconomic growth. • Central banks canencourage money creation, but theycannot 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 being easier to stop an expansion than to end a severe contraction.” (R.G. Sandilans)

26. Unconventionaltools • crisis-related, extremelyexpansivemonetarypolicyin order to stimulateeconomic growth • applied wheninterestratecutshavefailed to stimulatemonetaryexpansion („pushing on a string”) and furthercutsareimpossible (zero interestrates) • assetpurchases - quantitativeeasing (QE) • Long term open market operations – LTRO • liquiditysupport – e.g. EmergencyLiquidityAssistance (acting as „lender of last resort”) • commitment to furtheractions

27. Quantitativeeasing • Central banks purchaselargevolume of financial assets (mostlyTreasurybonds) from banks, creatingnewmoney to pay for them. • Directeffects of QE: • Raisingthe prices of those financial assets and lowering their yield while simultaneously increasing the monetary base[ • As banks buy Treasurybondsin order to re-sellthem to the central bank, QEissometimesconsidered to circumventtheprohibition on monetaryfinancing (lending by the central bank to theTreasury). Purchases of Treasurybonds by the central bank are legal ifoccuring on thesecondary market, but prohibited on primary market (directlyfromtheTreasury). • Result: largeexpansion of themonetarybase (M0) • first applied in Japan since 2001, then by several central banks after 2007

28. Liquiditysupport • secondarylendingorliquiditysupport - Eurosystem: EmergencyLiquidity Assistance (ELA) • providingliquidity to solvent banks facingtemporaryliquidityproblems (e.g. withdrawal of deposits, lack of access to interbanklending). • function: preventing bank runs. • Not applicable to insolventbankswhichshould be subject to bank resolution toolsorinsolvencyproceedings.

29. Liquiditysupport – recentexample • 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/pr130321.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/pr130325.en.html

30. Commitment to furtheraction • Function: sendingsignals to themarkets • Example: speech by Mario Draghi, President of theECB, 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/html/sp120726.en.html • Understood as commitment to unlimitedassetpurchases. • Follow-up: launch of OutrightMonetaryTransactions on 6.9.2012 (neveractuallyused) • http://www.ecb.europa.eu/press/pr/date/2012/html/pr120906_1.en.html

31. Will QE causeinflation? • DoesQEmean „printing money”? • QE and otherforms of unconventionalmonetarypolicyresultin a largeexpansion of central banks’ balancesheets expansion of monetarybase (M0) • However, inflationresultsfromtheincrease of totalmoneysupply, including not only M0 but mostlymoneycreated by commercial banks (M1, M2). • As banks mostlydepositedadditionalfundsobtainedfromQE as depositsinthe central banks (excessreserves), lendingexpansiondid not occur and there was no increaseintotalmoneysupply.

32. Will QE causeinflation? 2 • As long as commercial banks do not start credit expansionusingtheexpandedmonetarybase, overallmoneysupplyremainslow and inflationdoes not result. • Once credit expansionstarts, central banks wouldneed to restrictmonetarypolicy, includingshrinkingthemonetarybasein order to avoidinflation („exitstrategy”). • Tooearlytighteningof themonetarypolicycouldpushtheeconomyintodeeprecession. • In case of a toolatetightening, inflationcanresultfromcurrentexpandedmonetarybasebeingused to finance lending.

33. Communication with the public and managingexpectations • 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

34. Communication - examples • „Monetary Policy Guidelines” – a yearlystrategydocument by the NBP http://www.nbp.pl/polityka_pieniezna/dokumenty/zalozenia/zalozenia_pp_2015.pdf • ECB communicationchannelsexplained: http://www.ecb.europa.eu/mopo/strategy/comm/html/index.en.html

35. Additionalreading and reference materials • 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 • NBP website http://www.nbp.pl/homen.aspx?f=/en/onbp/informacje/polityka_pieniezna.html • Fed website http://www.federalreserve.gov/monetarypolicy/default.htm • For Polish readers: A. Sławiński (red.), Polityka pieniężna, Warszawa 2011

36. ECB General Documentation • most comprehensive and detailed description of the Eurosystem monetary policy • „The implementation of monetary policy in the euro area. General documentation on Eurosystem monetary policy instruments and procedures” – set in annex to the ECB Guideline of 20.9.2011 on monetary policy instruments and procedures of the Eurosystem (recast) (ECB/2011/14) • http://www.ecb.int/ecb/legal/pdf/02011o0014-20130103-en.pdf

37. Currentinterest • „Monetary policy in a prolonged period of low inflation”, speech by Mario Draghi, President of the ECB, at the ECB Forum on Central Banking,Sintra, 26 May 2014 • http://www.ecb.europa.eu/press/key/date/2014/html/sp140526.en.html

38. On a lighternote… • Try yourself in monetary policy – €CONOMIA - The Monetary Policy Game on the ECB website: http://www.ecb.europa.eu/ecb/educational/economia/html/index.en.html