Monetary Policy & Interest Rates

Central Banks

What is a central bank?• Central banks began as banks to the government.• Today controls the level of liquidity by operating

the payment system.– Control the printing of notes/currency– Control the accounts used for interbank payments.

Base LiquidityCash

+ReserveAccounts

Used by banks toBack up deposits

MonetaryAggregates

Cash+

DepositAccounts

Money Supply The stock of the medium of exchange.

Types of Financial Assets

M1 Currency in Hands of the Public [C] + Demand Deposits [D]

M2 M1 + Savings Deposits + “Small” Time Deposits + [Liquid Money Market Instruments inc/ “Small” NCD’s]

M3 M2 + LTD [“Large” Time Deposits and NCD’s]

Money & Inflation: 1975-1994

Inflation & Money OECD Countries

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Average Money Growth

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Policy Framework

• Japan Objective: Bank of Japan Act Article 2 Currency and monetary control by the Bank of Japan shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy

• ECB Objective “The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”

Look forward to Inflation Targeting

HKMA Link KEY GOAL OF CENTRAL BANKS:

PRICE STABILITY

Great Inflation of the 70’s & 80’sCPI Inflation, % Annual Rate

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35

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OECD East Asia Subsaharan Africa Latin America

Troubles with Inflation

1. Unpredictable inflation generates risk for: - borrowers and lenders

- workers and employers

2. High inflation generates losses of purchasing power for people who hold money.

Money is a tool of liquidity, becomes less useful when subject to a high inflation tax.

• Hyperinflation: Inflation reaching growth of 50% per month.

CPI Inflation, Annual %

01000

200030004000

50006000

70008000

1979

1980

1981

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1983

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1992

Argentina Brazil Peru

Hyperinflation in China

ShanghaiPrice Index

Sep-45 100May-49 105000000000

Dynamics of Hyperinflation in China 1945-1949 TW Hu, 1970

194919471945

Monetary Policy Framework

• Goals – Overall objectives• Anchors – Benchmarks of Performance • Policy Instruments – Day-to-day operations• Transmission Mechanism – How central bank

activities affect the economy

Nominal Anchors

• Nominal Anchors act as the measure of currency value maintenance which orient the activities of the central bank.

• Exchange Rate Targets: Maintain value relative to another currency or basket of currencies.

• Inflation Targets: Maintain value relative to a basket of goods.

Importance of Nominal Anchors

• Commitment to nominal anchor can stabilize the value of money and implement low and stable inflation.

• Visible, credible commitment to nominal anchor implements low inflation expectations in financial markets and private sector.

Adjusting Interest Rates for Inflation

• Payoff on 1 year, 1 period loan is $1+i, but what is the purchasing power of the payoff?

• Convert the payoff into the prices prevailing in initial loan year by dividing the pay-off by the trajectory of prices.

• Inflation adjusted interest rate is sometime referred to as real interest rate.

11

11 Pt

t t t tt

t

ir r i g

PP

Monetary Policy and the Fisher Effect

In the long-run, real interest rate unaffected by monetary policy.

• High long term inflation path translates into high inflationary expectations.

• High inflationary expectations lead to high interest rates.

1[ ]Pt t ti r E g

Fisher Effect: OECD Economies Great Inflation of 1970’s

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Average Inflation 1970-1984

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Inflation Targeting

What is IT?

• Using price of goods as a nominal anchor.• Set specific numerical targets for future

inflation• Report regular forecasts of expected inflation

under current economic conditions. • Set interest rate policy to push future inflation

back into bounds.

Target the Forecasts• Monetary policy decisions must be made on

the basis of expected inflation because policy does not have immediate impact on inflation.

• Variety of approaches toward forecasting inflation including statistical and theoretical modeling.

• Stabilizing expected inflation stabilizes interest rates by limiting Fisher effect.

List of Inflation Targeting CountriesRose A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed

Operating Instruments

• On a day to day basis, most central banks will choose to set either interbank interest rates or exchange rates.– Central bank provides liquidity for interbank

payments and can determine interest rates in the interbank market.

– Central bank can also govern the degree of liquidity in forex market (which is mostly made up of banks).

RBI Report of the Working Group on Monetary Policy...

Policy Rates

Usually, price of liquidity issued at regular intervals by central bank

Money Market Rates

Interbank Rates

Treasury Bill Rates

Commercial Paper Rates

Negotiable CD Rates

Maturity 1 D

ay to 1 Year

Capital Market Rates

Government Bond Rates

Corporate Bond Rates

Lending Rates

Maturity A

bove 1 Year

PolicyRates

ExchangeRates

AssetPrices

(Stocks/RE)

Short-termRates

Long-termRates

ExternalDemand

DomesticDemand

Inflation&

GDP

Transmission Mechanism

Transmission Lags

• Monetary policy works by changing decision making of private individuals.

• Individual decision making is characterized by inertia.

• Effects of monetary policy not fully felt until a year.

Bank of England Estimates of Effect of Interest Rate

• Raising policy interest rates reduces liquidity in money markets and raises short-term rates.– Less liquidity for inventory or credit purchases.

• Raising money market rates attracts liquidity from stock, RE and bond markets reducing stock and RE prices and raising LT bond rates.– Higher LT rates reduces corporate investment and

reduced wealth hurts

• Raising money market rates attracts cash from other economies, leading to appreciation of domestic currency.– Expensive domestic currency makes net exports less

competitive.

Short-term Stabilization

• When short-term output is below trend, inflation tends to be decelerating. Stablilizing inflation can also stabilze the business cycle

Japan

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-8 -6 -4 -2 0 2 4 6

Output Gap

Infla

tion

Acc

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Inflation Acceleration =

Today LastYearInflation Inflation

Watching Central Banks

• Monetary policy and market expectations of monetary policy have strong impact on stock and bond markets.

Link

Link

Exchange Rate AnchorsMonetary Authorities

Fixed ExchangeRates

constantly maintain the external value of the currency.

Crawling Peg adjusts currency periodically in small amounts at a fixed rate or in response to changes in selective indicators.

Managed Floating attempt to influence the exchange rate without having a specific exchange rate path or target. Indicators for managing the rate are broadly judgmental.

De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks

I nflation targeting framework

Other

U.S. dollar (66) Composite (15)

Other (7)

_ (44)

_ (33)

Hong Kong SAR

BangladeshMongoliaSri LankaVietnamChina

Cambodia Singapore Indonesia MalaysiaLao P.D.R. Vanuatu Thailand PakistanMyanmar India

Korea JapanPhilippines

Exchange rate arrangement (Number of countries)

Monetary Policy Framework

Exchange rate anchor

Currency board arrangement (13)

Brunei

Other conventional fixed peg arrangement (68)

Managed floating with no pre-determined path for the exchange rate (44)

Crawling peg (8)

Independently floating (40)

Why Exchange Rate Stability?

Why Exchange Rate Anchor?• Easily measurable & visible benchmark for

maintaining value of the currency. • Stabilizes international trade and finance.

Why Exchange Rate Instrument?• Forex markets most liquid market in frontier

markets.

Link

• Fixed exchange rates stabilize both the value of the domestic currency relative to the anchor currency but also stabilizes the domestic interest relative to the interest rate of the anchor currency.

Money Market Rates

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%

Hong Kong USA

Exchange Rate MisalignmentOver-valuation/Undervaluation

of Currency• Exchange rate

misalignment: when price of currency differs from relative prices of goods making domestic goods relatively cheap/competitive or relatively expensive/uncompetitive

Overvalued/Uncompetitive

S <

Undervalued/Competitive

S >

j

ANC

PP

j

ANC

PP

Exchange rate misalignment tends to be resolved through either 1) exchange rate adjustment; or 2) inflation/deflation in domestic prices.

Currency Wars

• Developed economies believe that some Asian central banks are acting in FX markets to keep S high and undervalue currencies.

• Measuring proper valuation is difficult because it is hard to determine the proper price level.

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PPP conversion factor (GDP) to market exchange rate ra-tio

GDP per Capita (PPP, 2005)

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P/S

Short-term measures of competitiveness

• Unit labor costs – Total Labor Costs/Constant Dollar GDP

• ULC is cost of wages relative to real productivity.

• Unit of measure: Domestic Currency

Constant$t

t

t t t tt Constant$ Constant$ GDP

t t Labor Hours

Labor Costs Wage Rate × Labor Hours Wage RateULC = = =

GDP GDP