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Navigating Monetary Policy: Credit Freeze and Market Dysfunctions - Insights for Central Banks

This document discusses the challenges central banks face in implementing monetary policy amid credit freezes and dysfunctional markets. Jorgen Elmeskov from OECD highlights two key observations: it is feasible to set interest rates independently of liquidity and influence asset prices through the composition of central bank assets. However, these strategies pose potential issues, such as the decoupling of interest rates from liquidity. Proper management of excess reserves is crucial to avoid adverse economic impacts and maintain financial stability.

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Navigating Monetary Policy: Credit Freeze and Market Dysfunctions - Insights for Central Banks

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  1. Reserve Bank of India Research Conference 2010Session I: Credit Freeze, Dysfunctional Markets and Monetary Policy Transmission Uncertainty / Policy Options for the Central Banks- discussion Jorgen Elmeskov OECD

  2. Two observations on feasibility • It is feasible... • ...to set interest rates independently of the quantity of liquidity... • ...and to influence asset prices through the composition of central bank assets... • ...but it may also raise a number of problems • ...that will have to be addressed in the context of exit

  3. 1. Decoupling of interest rates and liquidity • Raising interest rates when excess reserves are large will require hikes in the interest rate on deposits which tends to become the main determinant of overnight rates • This will again tend to suppress activity in the money market • And leaving in place large amounts of excess reserves increases the risk that they will spill over into money and credit • These effects suggest that liquidity should be mopped up as financial sector conditions improve

  4. 1. Decoupling of interest rates and liquidity • Mopping up should be more or less automatic as temporary extensions of traditional liquidity instruments are reversed • Though three footnotes apply to the reversal of such schemes • It may be desirable to leave some extensions in place • In the near term price-based discouragement of use may be preferable to discontinuation • There may be a need to smooth liquidity • Where liquidity has been boosted by purchasing long-dated assets mopping up will require action • Selling back assets may not be simple • So other instruments may have to be used • Long-term deposits, reverse repos, issuance of central bank bills

  5. 2. Effects of central bank asset holdings • Some central banks have bought large amounts of long-dated assets • They expose the central bank to interest rate and, at least in principle, credit risk • And continued holding of these assets may lead to economic distortions • But selling back assets may not be so simple • Political pressure could arise • Substantial losses could be realised which could be politically awkward and might dent credibility

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