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 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 • inflationtargetting Note: legalaspects of central bank mandatewill be discussedduring the followingcourses

5. Expansionary vs. restrictive policy • 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) monetary policy – reduction of money supply • aiming to reduce inflation • cooling down overheated economy • higher interest rates = more expensive lending • „hawks”

6. 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 financelending reduction of the moneymultiplier • Currentvalues (as of 2.4.2013): • Poland: 3,5 % - 500.000 EUR per creditinstitution • euro area: 1% - 100.000 EUR per institution

7. 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.int/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.

8. Standing facilities • Central bank acts as „bank of banks” taking deposits and extending loans to commercial banks. • Central bank acts as „lender of last resort” providing liquidity to disstressed (but solvent) banks. • „standing” = can be used at the commercial banks’ initiative

9. Standing facilities - lending • primarycreditorregularshort-term lending (usuallyovernight) • Eurosystem: marginallendingfacility • Fed: discountwindow • NBP: lombard loans (kredyt lombardowy) • in usualconditionsinterestrate applied to central bank lendingsets a ceiling on interbankinterestrates • currentrates (2.4.2013): 1,50% (ECB), 4.75% (NBP) • to be distinguished from secondarylendingorliquiditysupport  seebelow, unconventionaltools

10. Standing facilities - deposits • overnight deposits with the central bank, available to commercial banks • 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 2.4.2013): 0,00% Corresponding NBP rate: 1,75%

11. Open market operations • 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 • 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)

12. Open market operations 2 • Other instruments used – collateralised loans, issuance of debt certificates by the central bank, swaps, fixed-term deposits • Difference in aims and regularity (Eurosystem examples): • main refinancing operations • long-term refinancing operations (LTRO, see also unconventional monetary policy) • fine-tuning operations (conducted on an ad hoc basis) • structural operations

13. Open market operations - example • From the ECB website Date: 28/03/2013 Action: Fine-tuningoperation Communication: [… T]he 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 2 April at 11.30 in order to collect one-week fixed-term deposits with settlement day on 3 April. A variable rate tender with a maximum bid rate of 0.75% will be applied and the ECB intends to absorb an amount of EUR 205.5 billion. […]. Fixed term deposits held with the Eurosystem are eligible as collateral for the Eurosystem's credit operations.The ECB intends to carry out another liquidity-absorbing operation next week.

14. Eligiblecollateral • Lending by central banksshould be based on adequatecollateral (assetssubmitted by commercialbanks as security). • Treasurybonds and othermarketableassets (e.g. creditclaims) areusuallyused as collateral. • Central banksmaintain a list of eligiblecollateral and updateit from time to time (example: http://www.ecb.int/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

15. 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

16. Central bank interestrates • Interest rates applied by central banks to 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 and between banks and the general public) and in the general economy via the transmission mechanism.

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

18. Assessment of the respectivemonetary policy tools • 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.

19. Transmissionmechanism • 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 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.

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

21. Transmissionmechanism 3 • Specific problems with transmission of expansive monetary policy in periods of recession. • „Zero interest rate policy” („ZIRP”)  further lowering of interest rates is not possible, as rates cannot be negative. • 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. • compared to „pushing on a string”

22. Unconventionaltools • 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 impossible (zero interest rates) • asset purchases - quantitative easing (QE) • open market operations – LTRO • liquidity support – e.g. Emergency Liquidity Assistance (acting as „lender of last resort”) • commitment to further actions

23. Quantitativeeasing • Central banks purchase large volume of assets (mostly Treasury bonds) from banks, creating new money to pay for them. • 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

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

25. 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

26. Commitment to furtheraction • 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.int/press/key/date/2012/html/sp120726.en.html • Understood as commitment to unlimited asset purchases. • Follow-up: launch of Outright Monetary Transactions on 6.9.2012 http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html

27. Will QE causeinflation? • 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.

28. Will QE causeinflation? 2 • 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 starts, 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 current expanded monetary base being used to finance lending.

29. 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

30. Communication - examples • „Monetary Policy Guidelines” – a yearlystrategydocument by the NBP http://www.nbp.pl/en/publikacje/o_polityce_pienieznej/zal2013a.pdf • ECB communicationchannelsexplained: http://www.ecb.int/mopo/strategy/comm/html/index.en.html

31. 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. 434-454 • ECB website http://www.ecb.int/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

32. 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

33. 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