Central bank monetary policy

Money and Capital Markets

14C h a p t e r

Eighth Edition

Financial Institutions and Instruments in a Global Marketplace

Peter S. Rose

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

The Tools and Goals of Central Bank Monetary Policy

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Learning Objectives

To understand how the policy tools available to central banks work in carrying out a nation’s money and credit policies.

To explore the strengths and weaknesses of the various monetary policy tools.

To learn how the Federal Reserve System controls U.S. credit and interest rate levels.

To see how central bank policy actions affect a nation’s economic goals.


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Introduction

Central banks are given the task of regulating the money and credit system in order to achieve the economic goals of full employment, a stable price level, sustainable economic growth, and a stable balance-of-payments position with the rest of the world.

Although these objectives are not easy to achieve and often conflict, the central bank has powerful policy tools at its disposal.


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General versus Selective Credit Controls

General credit controls affect the entire banking and financial system.Examples: reserve requirements, the discount

rate, open market operations Selective credit controls affect specific groups

or sectors of the financial system.Examples: moral suasion, margin

requirements on the purchase of listed securities


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Reserve Requirements

In the U.S., all depository financial institutions (including nonmembers) are required to conform to the deposit reserve requirements set by the Fed.

Changes in reserve requirements are a very potent, though little-used tool.

Indeed, reserve requirements have recently been reduced in the U.S., and eliminated in Canada, New Zealand, and the U.K.


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Current Levels of Reserve Requirementsfor Depository Institutions in the U.S.

Source: Board of Governors of the Federal Reserve System, October 2001


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An increase in deposit reserve requirements decreases the deposit and money multipliers,

slowing the growth of money, deposits and loans reduces the amount of excess legal reserves -

institutions deficient in required legal reserves will have to sell securities, cut back on loans, or borrow reserves

increases interest rates, particularly in the money market, as depository institutions scramble to cover any reserve deficiencies


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The Discount Rate

The discount rate is the annual percentage interest charge levied against those institutions choosing to borrow reserves from the discount window of the Federal Reserve bank in its region.

Frequent borrowing is discouraged and may be penalized with a higher interest rate.


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The Discount Rate

An increase in the discount rate reduces the volume of loans from the discount

window (cost effect) makes borrowing from the Fed less attractive

(substitution effect) signals that the Fed is pushing for tighter credit

conditions (announcement effect), and market participants may respond by curtailing their spending plans or by accelerating their borrowings (to secure the credit they need before interest rates move even higher - negative psychological effect)


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The Discount Rate

Since the middle of 1999, the Fed’s discount rate has followed the Federal funds interest rate.

Typically, the discount rate has been set half-a-point lower than the Federal funds rate, so as to turn the discount rate and the discount window into a passive tool in the conduct of U.S. monetary policy.

The Discount Rate

Source: http://www.frbdiscountwindow.org/, April 2002Note: Intended federal funds rate effective 12/11/2001 = 1.75%

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Open Market Operations

Open market operations in the U.S. consist of the buying and selling of U.S. government and other securities by the Federal Reserve System to affect the quantity and growth of legal reserves, and ultimately, general credit conditions.

Open market operations are a most flexible policy tool, suitable for fine-tuning the financial markets.


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The open market tool has two major effects. When the Fed is purchasing securities, the

additional demand for the securities in the market tends to increase their prices and lower their yields, so interest rates decline.

A Federal Reserve purchase of government securities increases the reserves of the banking system and expands its ability to make loans and create deposits, thereby increasing the growth of money and credit.


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Types of Federal Reserve Open Market Transactions

Outright or Straight Open Market Transaction(permanent change in the level of reserves held by

depository institutions)

FederalReserve

bankFed buys securities

Dealer

Dealer’s bank

Securities

Reserves

FederalReserve

bankFed sells securities

Dealer

Dealer’s bank

Securities

Reserves


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RP or Reverse RP Transaction(temporary change in the level of reserves held by


RP: Fed buys securities temporarily

FederalReserve

bank

Dealer

Dealer’s bank

Securities

Reserves

Later on:Reserves

Securities returned

Reverse RP: Fed sells securities temporarily

FederalReserve

bank

Dealer

Dealer’s bank

Securities

Reserves

Later on:Reserves

Securities returned


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Run-Off Transaction(permanent reduction in the level of reserves held by


FederalReserve

bankSells more securities to raise more cash

Pays cashTreasury

Maturing Treasury securities

Dealer

Dealer’sbank

Orders bank to pay for the new securities

Reserves


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Agency Transaction (Type A)(no change in the total level of reserves held by all


FederalReserve

customer

Places order for securities through a Federal Reserve bank

which then contacts dealer

Delivers securitiesDealer

Dealer’sbank

Orders payment to dealer

ReservesCustomer’s

bank


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Agency Transaction (Type B)(permanent reduction in the level of reserves held by


FederalReserve

customer

Places order for securities

Securities delivered from Fed’s own portfolio

FederalReserve

bank

Orders payment to Fed

ReservesCustomer’sbank


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Defensive open market operations are technical adjustments in market conditions to preserve the status quo and to maintain the present pattern of interest rates and credit availability.

In contrast, dynamic open market operations are designed to upset the status quo and to change interest rates and credit conditions to a level the Fed believes to be more consistent with its economic goals.


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Selective Credit Controls Used by the Fed

Moral suasion refers to the use of “arm-twisting” or “jawboning” by central bank officials to encourage lending institutions and the public to conform with the spirit of its policies.


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Selective Credit Controls Used by the Fed

Margin requirements on the purchase of stocks and convertible bonds and on short sales of securities limit the amount of credit that can be used as collateral for a loan.

Since 1974, the U.S. margin requirement on stocks, convertible bonds, and short sales has been 50% of the market value of the securities.


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Interest Rate Targeting

In recent years, the Federal Reserve has given increasing weight to targeting the cost and availability of credit in the money market (in particular, the daily average interest rate on federal funds transactions).

The Fed achieves its target through open market operations that impact primarily the nonborrowed reserves (and hence the total reserves) available to the banking system.


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Interest Rate Targeting

D’When the

demand for reserves S’

The Fed supplies

more reserves

Such that the

federal funds rate is maintained at the desired level

E’

Federal Funds

Interest Rate (%)

Supply of Reserves ($)

D S

E


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Monetary Policy Targets

Operating Targets(borrowed & nonborrowed reserves)

Instrumental Targets(the federal funds rate & the growth of total reserves)

Intermediate Targets(money & credit growth & long-term interest rates)

Final Targets(low unemployment & inflation, sustainable economic growth,

& a stable international balance-of-payments position)


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The Federal Reserve and Economic Goals

The Goal of Controlling Inflation Inflation creates undesirable distortions in the

allocation of scarce resources. In the 1990s, several central banks (such as

New Zealand, Canada, and U.K.) began setting target inflation rates or rate ranges.

The U.S. has not set an explicit inflation rate target – it pursues price stability and full employment simultaneously.


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The Goal of Full Employment The Employment Act of 1946 committed the

U.S. government to minimizing unemployment as a major national goal.


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The Goal of Sustainable Economic Growth The Federal Reserve has declared that one of

its most important long-term goals is to keep the economy growing at a relatively steady and stable rate – that is, a rate high enough to absorb increases in the labor force and prevent the unemployment rate from rising but slow enough to avoid runaway inflation.


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Equilibrium in the U.S. Balance of Payments and Protecting the Dollar

In the international sector, the Fed pursues two interrelated goals:protecting the value of the dollar in foreign

currency markets, and achieving an equilibrium position in the

U.S. balance of payments.


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The Trade-offs Among Economic Goals

Economic goals conflict. For example, controlling inflation and stabilizing

the U.S. international payments situation (sizable trade deficits) usually require the Fed to slow down the economy through restricted money supply growth and higher interest rates.

However, this policy threatens to generate more unemployment and subdue economic growth.


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The Trade-offs Among Economic Goals

However, there is growing research evidence that full employment and price stability (the absence of serious inflation) are compatible with each other in the longer term.

This definition of sustainable long-run full employment is often referred to by economists as the NAIRU – the non-accelerating inflation rate of unemployment.


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The Limitations of Monetary Policy

Central banks cannot completely control financial conditions or the money supply. Changes in the economy feed back on the money

supply and the financial markets. The structure of the economy is changing due to

deregulation, internationalization, technological developments, etc., such that changes in domestic interest rates are probably not as potent a factor affecting the economy as they were a decade ago.


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Money and Capital Markets in Cyberspace

Most central banks maintain comprehensive websites, including information on what tools they normally use to carry out their money and credit policy. Visit, for example, http://www.federalreserve.gov/ http://www.bankofcanada.ca/en/ http://www.bankofengland.co.uk/ http://www.rbnz.govt.nz/ http://www.bis.org/cbanks.htm

http://www.federalreserve.gov/

http://www.bankofcanada.ca/en/

http://www.bankofengland.co.uk/

http://www.rbnz.govt.nz/

http://www.bis.org/cbanks.htm


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Chapter Review

Introduction General versus Selective Credit Controls General Credit Controls of the Fed

Reserve Requirements The Discount Rate Open Market Operations

Selective Credit Controls Used by the Fed Moral Suasion by Central Bank Officials Margin Requirements


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Chapter Review

Interest Rate Targeting The Federal Funds Rate

The Federal Reserve and Economic Goals The Goal of Controlling Inflation The Goal of Full Employment The Goal of Sustainable Economic Growth Equilibrium in the U.S. Balance of Payments and

Protecting the Dollar


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Chapter Review

The Trade-offs Among Economic Goals The Limitations of Monetary Policy

Central bank monetary policy

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