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Unformatted text preview: Module 4. Monetary Policy Learning Goals Understand the importance of Monetary Policy Know the Strategy that the Central Bank can follow and the one followed by the European Central Bank (ECB) Know the different instruments available to the Central Banks. Understand how these instruments are applied and the importance of the discretional, independent nature of the bank. Context You have passed the ECB selection process and will join the Frankfurt office next week. On your first day at work, you must give a presentation to your new bosses. To ensure you make a success of it you have decided to refresh your knowledge of Monetary Policy. Overview 1. Introduction 2. The Cornerstones of Monetary Policy 3. The Instruments of Monetary Policy 4. Auctions and guarantees 5. Settlement: Target2 6. Credibility Evaluation Read and discuss the article on adapting Monetary Policy. 1. Introduction The main aim of the ECB is to maintain price stability. The Governing Body of the ECB in 1998 established that: "Price stability shall be defined as a year‐on‐ year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Price stability is to be maintained over the medium term." In 2003 the Governing Body clarified that its objective was to maintain inflation rates below 2% in the medium term, but close to this value. The management of Monetary Policy is the way the ECB can achieve this aim. It does this independently of Governments, sometimes taking decisions that are not to leaders' liking. Within the management of Monetary Policy we include all actions which aim to fix, control and improve financial stability and therefore interest rates, inflation, etc. with the ultimate aim of promoting economic growth. Increasing the growth potential of the economy is in fact the task of other economic institutions, particularly those responsible for budget and structural policies. Nonetheless, they add that “without prejudice to the objective of price stability”, the ECB will also “support the general economic policies in the 1 Community with a view to contributing to the achievement of the objectives of the Community”, which include “a high level of employment and sustainable and non‐inflationary growth”. There are a series of benefits to be derived from financial and price stability. Price stability constitutes keeping the level of inflation within a range that allows for stable economic growth, so that there is neither excessive inflation or no inflation ‐ in other words, deflation. Wikipedia “In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money – allowing one to buy more goods with the same amount of money. This should not be confused with disinflation, a slow‐ down in the inflation rate (i.e. when inflation declines to lower levels). As inflation reduces the real value of money over time, conversely, deflation increases the real value of money – the functional currency (and monetary unit of account) in a national or regional economy.” Price stability provides a series of clear benefits. • It improves the decision criteria for company and consumer investment or spending, allowing them to calculate prices variations. This allows for more efficient allocation of resources and an increase of the potential productivity of the economy. Families' investment and savings decisions change according to interest rates and the economic climate. We will try to align these decisions with price stability • Price stability reduces “the inflation premium”. The inflation premium will be what investors demand in addition to the profitability of an investment. Thus price stability increases incentives to hold investments in nominal terms. TIPS “Treasury Inflation‐Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.” 2 The following table illustrates how the NCBs affect price stability and economic growth using interest rates. 2. The cornerstones of Monetary Policy1 The strategy of the ECB is based on two cornerstones of Monetary Policy, two complementary perspectives on influencing price changes. The first cornerstone ‐ economic analysis ‐ evaluates the short and medium‐ term determinants of price performance, focusing attention on actual activity and on the financial state of the economy. We analyse real economic indicators, the evolution of financial markets, exchange rate fluctuations and macroeconomic forecasts for the eurozone carried out by experts on the Eurosystem among others. 1 http://www.ecb.int/ecb/educational/movies/mopo/html/index.en.html 3 The second cornerstone ‐ monetary analysis ‐ takes a broader view, and takes advantage of the long‐term link between money and prices. Above all it is used to confirm, taking a medium to long‐term perspective, the short to medium‐ term indices from economic analysis. The evolution of a broad range of monetary indicators is taken into consideration, and a thorough evaluation of the loan and liquidity situation is carried out. 3. The instruments of Monetary Policy2 There are three main instruments of Monetary Policy: Open Market Operations, Banking reserve requirements and permanent loan and deposit facilities. Decisions on Monetary Policy are taken at European Central Bank (ECB) Board Meetings, and the National Central Banks of the countries that make up the eurozone put them into practice. The instruments 1. Open Market Operations Allow us to control interest rates, manage market liquidity and direct Monetary Policy. They are divided into four categories: a. Main refinancing operations These are temporary operations to inject liquidity on a regular basis. They are conducted weekly and with a one week repurchase agreement, implemented by the National Central Banks using standard auctions. They are the key source of financing for the loans system within the framework of the Eurosystem. b. Longer‐term refinancing operations These are temporary operations to inject liquidity on a monthly basis and with a three month repurchase agreement, implemented by the National Central Banks using standard tenders. Their aim is to provide additional longer‐term refinancing to counterparties. c. Fine‐tuning operations These are implemented on an ad hoc basis to manage market liquidity and soften the effects of unexpected fluctuations in market liquidity on interest rates. The National Central Banks normally carry out these operations through quick tenders or bilateral procedures. d. Structural operations These are carried out whenever the ECB wants to adjust the structural positions of the Eurosystem compared to the financial sector ‐ this may occur regularly or occasionally. 2 http://www.ecb.int/ecb/educational/movies/mopoinstr/html/index.en.html 4 They are implemented using the issue of government bonds or bills, temporary operations or ordinary operations. 2. Permanent facilities Their purpose is to provide and absorb liquidity and control overnight market interest rates. They are managed by the National Central Banks in a decentralised manner. The banks can request two types of permanent facilities: a. Permanent loan facility Allows entities to obtain overnight liquidity from the National Central Banks with assets as security. They must present sufficient assets as security, there are not usually credit limits or other restrictions, so that the entities can benefit from this facility. The interest rate for a loan facility is punitive (higher) b. Permanent deposit facility Allows the entities to place overnight deposits with the National Central Banks. The interest rate for the deposit facility is punitive (lower) 3. Holding minimal reserves Minimal reserves are a proportion of the bank's liabilities that must be held by financial bodies in reserves (deposits) with the Central Bank. Characteristics: a. They are calculated using monthly average b. The reserves earn interest at the rate of the main Eurosystem refinancing operations. 4. Auctions and guarantees. Open Market Operations are carried out via auctions. The auctions can be: 1. Fixed rate: the ECB specifies the rate and the entities bid for an amount. 2. Variable rate: The banks can submit up to ten bids with amount (minimum one million) and rates. Within variable rate tenders we can distinguish between a. American or multiple (variable) rate: bids are filled according to the rates submitted (from higher to lower). b. Dutch or single (variable) rate: bids are filled according to a single rate, the marginal rate (that used by the ECB) The loan is put in place using REPOS: temporary operations that consist of the sale of securities with a repurchase agreement. There are also repos to maturity, issue of government bonds or bills, etc. As there were different cultures regarding the guarantees accepted: two types of list of acceptable assets were created. 5 1. List one: Made up of instruments that meet some homogeneous conditions regarding quality, name, location, etc. Imposed by the ECB. 2. List two: Made up of the instruments proposed by each NCB. Whilst they do not comply with the characteristics of list one, they are of high enough quality and are deemed important for the national financial systems.3 In addition, any entity can use assets included in any of the lists of any NCB as security for Monetary Policy operations (cross‐border use of collateral) 5. TARGET24 The TARGET (Trans‐European Automated Real‐time Gross settlement Express Transfer System) is the European System of Central Banks (ESCB) system for large euro payments. It is a decentralised system, and is based on the interconnection of each country's payment systems. The main characteristic of TARGET is that it is a gross real‐time settlement system, so payments are settled individually (without waiting for clearing) and with immediate value, once they have been settled. To this end the payee must have a balance already in their account with the corresponding Central Bank, or else they provide the payee with the necessary credit, backed by suitable guarantees. 6. Credibility The credibility of the monetary authorities is a key aspect for building price stability, and therefore for the pricing mechanism itself. This credibility is built and conserved over time. The Central Banks must constantly monitor the general public's perception of its commitment to the maintenance of price stability, which will increase the probability that they really fulfil this objective. In this situation, where the Central Bank's intentions and the general public's perception are different, Monetary Policy becomes complex. Therefore, a clear, well‐defined objective and rigorous, continuous monitoring of this objective by the NCB, help the Central Bank consolidate its reputation. The credibility of the NCB is fundamental for different reasons: 1. It influences entities' expectations and the inflationary outlook. 2. It makes one‐off intervention more effective. 3. Independence and the coherence of the other economic policies are basic cornerstones to achieve credibility, but in addition the ECB must build a reputation with its initiatives. Requirements in order to achieve credibility: 1. Clear, consistent message (persistent message regarding price stability and no allusions to other aims when there are inflationary risks). Complete list: https://www.ecb.europa.eu/paym/coll/assets/html/list.en.html http://www.bde.es/webbde/en/sispago/sispagopm.html http://www.ecb.europa.eu/paym/t2/html/index.en.html 4 3 6 2. A unanimous opinion (controversies with the publication of the minutes of the Board). 3. Prudent decision‐making (smoothing). 7 ...
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- Spring '11