Major Challenges to Monetary Policy Effectiveness

1. Major Challenges to Monetary Policy Effectiveness Jaromir Hurnik Monetary Policy and Business Cycle May 2009

2. Outline • When is monetary policy effective? • Fiscal dominance • Global savings/investment imbalances • Asset prices • Monetary policy implementation • Zero interest rate bound and quantitative easing

3. When is monetary policy effective?

4. When is monetary policy effective? • Meets its ultimate objective of price stability with lowest social costs • Standard way of assessment: • Variance in inflation • Variance in GDP growth

5. Fiscal dominance

6. Fiscal dominance • Traditional view • Quantity theory • Directly financed government • Modern view • No direct financing of the government… • But fiscal dominance affects the economy through risk premium, the trend real interest rate, and exchange rate

7. Traditional view of fiscal dominance • Direct financing of the government leads ultimately to inflation • Direct financing = money printing • Quantity theory of money is a good approximation • Zimbabwe • Many (not as dramatic) examples among emerging economies during the 1990s • Is this the “quantitative easing”?

8. Modern view of fiscal dominance • Possible effects when public debt is large and/or increasing • Rise in country risk premium - increase in fears of default or expected inflation • Increase in the equilibrium interest rate • Pressure on the exchange rate • Central bank has to keep the nominal interest rate on average higher

9. Debt Sustainability Condition ps = primary budget surplus (percent of GDP) required to keep debt/GDP from rising r = interest rate on debt r = rGermany + country-specific spread g = growth rate of GDP

10. Spreads on governmental debt • Spreads over German rates reflect debt sustainability [CDS = credit default swap] Southern Europe & Austria CEE countries

11. Primary surplus scenarios Primary surplus required to avoid an unsustainable debt level Assumption: GDP grows at 4% Notation: d – Debt/GDP ratio r – interest rate (‘x’ axes)

12. Combating fiscal dominance • Presence of markets for public debt helps, but… • …market-based funding of the government can still undermine monetary policy • Large budget deficits crowd out the private sector • Access to funds • Higher borrowing cost • Eventual debt monetization • Fiscal discipline comes from policymakers

13. Global savings/investment imbalances

14. Global savings/investment imbalances • Alan Greenspan’s “conundrum” (2005 Testimony to the US Congress) • When the Federal Reserve started to increase the federal fund rate in 2004 the long-term bond rates did not increase but declined further • “ … long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields.”

15. Alan Greenspan’s “conundrum”

16. Bernanke’s “savings glut” (2005) • Asian countries (but not only them) moved from current account deficits to surpluses • Reaction to the Asian crises in 1997 • Accumulation of foreign reserves • Substantial decline in consumption/GDP ratios

17. Global imbalances are seen as the main cause of the recent bubble (Portes, 2009) • Inflow of capital to countries with the most developed financial markets • Capital flowing ‘uphill’ • Financial sector’s response • Search for yield • Financial engineering • Easy monetary conditions

18. Proposals to address global imbalances • Provide emerging market economies with credible insurance against sudden stops and… • Either market-based or IMF • …they may forego reserve accumulation • Develop domestic financial markets of developing countries

19. Asset prices

20. Asset Prices • Argument: If the central banks reacted to the sharply rising asset prices between 2003–07, the bubble on equity and real estate markets would not arise and we would not be where we are today • Should monetary policy respond to asset price booms? • If yes, than how?

21. “Reactive” school of thought • Changes in asset prices should influence monetary policy only insofar as they influence the forecasts for output and inflation • Central banks should only address the fallout from an eventual crisis • Formulated by Schwartz (1995); supported by the US Fed Bernanke or Kohn

22. “Proactive” school of thought • “Monetary policy should contribute, as best as it can, to achieving over time the highest sustainable path for the standard of living of society—recognizing that . . . low and stable . . . inflation is usually a key means . . . to serve this objective.” Mussa (2003)

23. “Proactive” school of thought • Low inflation is not a good guide for monetary policy when asset prices “misbehave” • No guidance on when and how asset prices should be taken into account when setting monetary policy • Include asset prices in the policy rule? • Or include them “on a discretionary basis”? • A part of the price index (Goodhart)?

24. Preconditions for proactive policy (Kohn, 2008) • Policymakers can identify bubbles: • in a timely fashion • with reasonable confidence • Monetary policy has high probability of checking some of the speculative activity • Expected improvement in economic performance from pricking the bubble is large enough

25. Skepticism about proactive policy • The recent experience made us more confident about detecting bubbles,… • …but it has not resolved the problem of doing so in a timely manner… • …or shown that small-to-modest policy actions will reliably and materially damp speculation

26. General consensus • Form views about the risks to macroeconomic and financial stability • Devise contingency plans • Strengthen prudential and supervisory policies • Both national and international (IMF, BIS,…)

27. Bubbles develop on the national level… Current account deficits in Baltic states and Bulgaria: A bubble or financial integration?

28. Monetary policy implementation

29. Monetary policy implementation • For years the central banks were able to keep the short-term money-market interest rates close to the key policy rate (the interest rate target) • In August 2007 short rate (e.g., 3-month LIBOR) for the US dollar denominated funds started to deviate significantly from the Fed target for funds

30. Decoupling of interest rates

31. Reasons for decoupling • Uncertainty among commercial banks about their solvency and financial stability • The banks were unsure about their counterparts ability to stay in business over a longer period

32. Central bank response • Central banks extended the money market operations to longer maturities (and more institutions) in order to narrow spreads between the market rates and key policy rates • It has not worked completely … • Borrowing and lending on the money market is uncollateralized • Fears of counterpart failures persist • Dealers make deliberately quotes at level nobody accepts

33. Czech money market October 15, CNB introduces new lending REPO operation September 15, Lehman Brothers bankruptcy

34. Situation in spring 2009 • Money market participants are less nervous… • …but high spreads between the market rates and the key policy rate persist • Applies to the US, Eurozone, and emerging economies interest rates • Eurozone: • Commercial banks borrow around euro 250 bn from the ECB at the key policy rate • The same day they deposit the money at the ECB, receiving paid the discount rate, which is 1 % point less

35. Zero interest rate bound (ZIRB)

36. Definition • Zero level of the nominal interest rate is a natural lower bound for conventional monetary policy actions • If the nominal interest rate is zero, the real interest rate is equal to minus expected inflation • r = i – pe • During long-lasting deflationary periods (pe<0) the real interest rate may be quite high

37. Impact of ZIRB on monetary policy • Constrains the stabilization role of monetary policy if nominal rates are low • Assume that an economy is in a deflationary downturn: • Output gap is -5% and inflation is 3% below the target • Policy rule [it = f1*(pt+1–pTARGET) + f2*(yt–yPOT)] suggests that the nominal interest rate should be negative

38. How real is the risk of ZIRB? • The importance of ZIRB for monetary transmission is exaggerated for small open economies • The central bank can • Purchase long-term government bonds to get long-term yields down • Purchase even private securities • Which eventually leads also to • Exchange rate depreciation… • …and via the exchange rate channel to inflation

39. Banking sector Central bank + Securities + Reserves + Reserves - Securities Quantitative easing • Operations where the central banks buys government or private debt in exchange for the newly issued base money (interest rate is close to zero) • Base money has the form of commercial bank reserves at the central bank

40. Quantitative easing… • …has immediate impact on the value of securities (and therefore on their yields) • Valuation effect • Valuation gain for debt holders (wealth effect)  bank balance sheets improve • The impact increases with the maturity of the paper • Price leverage • Long-term interest rates decline  central bank affects the long end of the yield curve • Works also with private debt

41. US FOMC statement in March 2009 • …the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term • Read: expected inflation below the Fed internal “target”

42. US FOMC March 2009 quantitative easing • The Fed will employ all available tools… • …maintain the target range for the federal funds rate at 0 to 1/4 %… • …increase the size of the Fed’s balance sheet by purchasing up to additional $750 bn of agency mortgage-backed securities, …, and to increase purchases of agency debt by $100 bn… • …purchase up to $300 bn of longer-term Treasury securities.. • … anticipates that the eligible collateral is likely to be expanded to include other financial assets

43. Effectiveness of quantitative easing at the Fed March 2009 FOMC meeting

44. Quantitative easing and monetary aggregates • Quantitative easing expands base money • Quantitative easing does not expand monetary aggregates  limited impact on credits and broad monetary aggregates • Δ reserves  Δcredits (Δ deposits) only if the were no free reserves to cover creation of new credits (deposits)… • …and the banks are willing to satisfy the demand for new credits

45. Quantitative easing and monetary aggregates • Note that the supply of reserves is not constrained (given the level of interest rates) even without the quantitative easing • When the short-term nominal interest rate serves as an operational target • The central bank adjusts supply of reserves to the demand for them (given the level of interest rates)

46. Base money increases…

47. …with marginal effect on monetary aggregates

48. Quantitative easing and inflation expectations • Decline in long-term interest rates and valuation gains of bond holders • Providing the “inflationary scare” (increase in pe) does not offset the “demand” effect of the easing • By early 2009 implicit measures of inflation expectations on the US bond market (across all maturities) increased only marginally to 2.5%

49. Quantitative easing and inflation expectations March 2009 FOMC meeting

50. What next? • Central banks must stay ready to change tack when signals of recovery and/or inflation occur • This may be in practice quite challenging • Do not change the tack to early • Inflation expectations must be firmly positive • Japan in August 2000  too early exit from easy monetary policy stance • Do not change the tack to late • High inflation • Reaction of financial market is uncertain