CENTRAL BANKING AND MONETARY

POLICYSection 4

MONETARY POLICY FRAMEWORK

Intermediate Target/Nominal Anchor

Economic Indicator toGuide Expected

Value of Currency.

Operating TargetsFinancial Market

Indicator Directly Influenced by Tools

Tools/InstrumentsDirect powers of the

Central bank.

Policy Feedback

Policy Goal

TransmissionMechanism

WHAT IS THE ROLE OF THE CENTRAL BANK?Banker to the Government

Manages F/X and other reserves.

Major financier of the government.

Banker to Banks

Hold liquid deposits of commercial banks

Operate interbank payment system

Provide S/T financing

Implement Monetary PolicyRegulate Financial System

BALANCE SHEETS OF THE EXCHANGE FUND

Hong Kong Exchange Fund Balance Sheet (Millions HK$)Assets $3,032,818 Liabilites $2,395,310HK Dollar $227,855 Certificates of Indebtedness $327,372Foreign Currency $2,804,963 Fiscal Reserves Account $773,862

Coins in Circulation $10,575Exchange Fund Bills & Notes $782,605Balances of Banking System $164,093Placement by Banks & Other FI $50,734Placement by HK Statutory Body $214,911Others $71,158

Accumulated Earnings $637,508

Bank of Government

Bank of Bankers

BALANCE SHEETS OF THE BANK OF JAPAN

Bank of Japan (Billions of Yen)Assets LiabilitiesGold ¥441.2 Banknotes Issued 93,081.7¥ Cash ¥211.1 Current Deposits 178,135.9¥ Govt Securities ¥250,439.4 Other Deposits 1,153.9¥ Commercial Papers ¥2,215.3 Deposits of Government 10,127.0¥ Corporate Bonds ¥3,222.9 Others 10,978.1¥ Stocks ¥5,374.6Loans and Discount (LD) ¥31,708.3 Total Liabilities 293,476.6¥ Foreign Currency Assets ¥6,032.8Deposit with Agencies ¥1.2Other Accounts ¥564.3Total Assets ¥300,212 Net Worth ¥6,735.10

Bank of GovernmentBank of Bankers

01-Jan-1

0

01-Mar-1

0

01-May-1

0

01-Jul-1

0

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0

01-Nov-1

0

01-Jan-1

1

01-Mar-1

1

01-May-1

1

01-Jul-1

1

01-Sep-1

1

01-Nov-1

1

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2

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2

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2

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2

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2

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2

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3

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3

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3

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3

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4

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4

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4

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Share of Gov't Debt Held By BoJ

CENTRAL BANK OBJECTIVES Price Stability

Business Cycle Stability

Financial Stability

Exchange Rate Stability

8

Genberg, H and D He (2009): “Monetary and financial cooperation among central banks in East Asia and the Pacific”, in R Rajan, S Thangavelu and R Parinduri (eds), Exchange Rate, Monetary and Financial Issues and Policies in Asia, World Scientific Publishing Co, pp 247 – 70

9

More Goals

Mongolia Price stability and exchange rate stability

“The main objective of Bank of Mongolia is to sustain stability of national currency tugrug” and this statement can be interpreted in two manners. For instance, stability of tugrug in the external market refers to the stability of exchange rate of tugrug in foreign currencies, whereas stability of tugrug in domestic market refers to the stability of Consumer Price Index.

Sri Lanka Economic and price stability

One of the core objectives of the Central Bank of Sri Lanka is economic and price stability… Economic and price stability is a situation where there are no wide fluctuations in the general price level in an economy which helps to achieve sustainable economic growth.

Nepal Price and Balance of payments stabilityKey objectives of the Bank are to achieve price and balance of payments stability, manage liquidity and ensure financial stability, develop a sound payments system, and promote financial services. 

Afghanistan Price StabilityAs enshrined in DAB law (Article 2, Para.1), the primary objective of DAB is to achieve and to maintain domestic price stability

Brunei Exchange Rate StabilityThe country’s monetary discipline of having a currency board system has ensured the full convertibility of base money with the exchange rate pegged at par to the Singapore Dollar.

Myanmar Macroeconomic StabilityThe main objective of monetary policy in Myanmar is to maintain macroeconomic stability in the economy while promoting domestic savings.

Cambodia Price Stabilitydetermine and direct the monetary policy aimed at maintaining price stability".

Vietnam Economic and price stability

to control inflation, stabilize macro-economy, support economic growth at a reasonable level, and ensure the liquidity of credit institutions.

BUSINESS CYCLE STABILITY Modern economies are beset by volatility in economic output and employment.

Does the pursuit of price stability come at the expense of business cycle stability or are the two goals complementary. Always?

1992

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3.000

4.000

5.000

6.000

7.000

8.000

9.000

Unemployment Rate %

China, P.R.: Hong Kong Korea, Republic of Singapore

FINANCIAL STABILITY

Financial Market Stability Financial markets and institutions play an important role in moving funds from savers to borrowers. Stock Market Stability Real Estate Market Stability

In recent years, bubbles and busts have beset markets. Interest Rate Stability: Businesses and consumers that rely on credit prefer a

predictable exchange rate.

9. FINANCIAL INSTABILITY

Economist Guide to Global Housing Markets

INCREASED FINANCIALIZATION IN DEVELOPED COUNTRIES

IMF World Economic Outlook 2008 Chapter 3

THE COST OF CLEANING UP AFTER FINANCIAL CRISES IS VERY HIGH.

CHALLENGES TO MONETARY POLICY EFFECTIVENESS 15

Link

EXCHANGE RATE STABILITY Hong Kong’s monetary policy emphasizes exchange rate stability.

Monetary Policy in Hong Kong Convertibility Undertaking: An undertaking by the Central bank to

convert domestic currency into foreign currency at a fixed exchange rate.

Linked Exchange Rate System: Since October 17, 1983, Hong Kong has a convertibility undertaking with the US dollar.

Why?

Monetary Policy Framework

Intermediate Target/Nominal Anchor

Economic Indicator toGuide Expected

Value of Currency.

Operating TargetsFinancial Market

Indicator Directly Influenced by Tools

Tools/InstrumentsDirect powers of the

Central bank.

Policy Feedback

Policy Goal

TransmissionMechanism

CHAPTER 16

Interbank Rate as the Operating Target

INTERBANK MARKET

In conducting payments, banks may face a shortfall of reserves and be forced to borrow reserves from other banks or the central bank at the interbank rate.

Demand: Each bank would like to keep a certain amount on reserve at any time to meet their own liquidity needs. Tradeoff for keeping stock of reserves is you cannot lend them to others. If the interbank rate IBR is high, they will want to lend their own balances to other banks and hold small reserves in their own account.

Supply: Central bank controls the supply of reserves.

INTERBANK MARKET: BASICS

S

D

iIBR

Reserve Accounts

i*

EQUILIBRIUM

Excess Supply: If iIBR > i* , banks will have funds in reserve accounts in excess of that required to meet their own liquidity needs. They will offer funds at competitive rates pushing rates down.

Excess Demand: If iIBR < i*, banks will tend to hold on to reserves rather than lend them at unattractive rates. Banks facing shortfalls must offer better rates

CRITERION FOR OPERATING TARGETS

1. Controllable

2. Observable

3. Linked to Goals

Operating Targets are set by central banks to guide day to day operations.

23

WHY SHORT-TERM RATES AS OPERATING TARGET?

1. Controllable: Central bank controls liquidity conditions in certain market

2. Easily Observable: changes send clear signal of changes in policy

3. Helps to Achieve GoalsA. Financial Stability: avoid fluctuating interest ratesB. Predictable Effects: transmission mechanism from changes in

interest rate to economy are relatively well understood

Back

OPERATING TARGET: POLICY INTEREST RATE

Many countries will target the interbank rate. This is done in two ways.

1. Explicit Policy Target for Interbank Interest Rate US Fed: Fed Funds Rate; Bank of Japan: Uncollateralized Call Money Rate Reserve Bank of Australia: Cash Rate

2. Explicit Policy Instrument Rate for (some) Central Bank Operations

Set in order to guide interbank rate to identical target level.

Bank of Korea: Base Rate (7-Day) → Interbank Call Rate ECB: Main Refinancing Rate (14-Day Repo) → Euribor Bank of Thailand Policy Rate → O/N Bibor Bank Negara Malaysia Overnight Policy Rate→ O/N Interbank Rate

POLICY INSTRUMENTS

Defined (in general) as a policy lever directly under the control of policy makers.

1. Open Market OperationsA. Under some frameworks can include the policy rate.

2. Standing Facilities

3. Reserve Requirements

POLICY RATE

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Policy Rate: Month End: Base Rate: Bank of Korea

TOOLS: OPEN MARKET OPERATIONS

Open Market Purchase: Central bank buys short-term government bills from commercial banks. Credits counter-parties with additional funds in reserve accounts.

Open Market Sale: Central bank sells bills to commercial banks. Debits counterparties reserve accounts.

Sets supply of reserves

OMO’s usually implemented with repo operations.

REPURCHASE AGREEMENTS:

Repo Central bank purchases quantity of government securities from commercial bank.

Central bank simultaneously contracts to sell securities back to the bank at some future date (typically 1 to 13 days) at a slightly higher price.

Equivalent to perfectly collateralized loan with interest

Reverse Repo Central bank sells quantity of government securities to commercial bank.

Central bank simultaneously contracts to buy securities from the bank at some future date (typically 1 to 13 days) at a slightly higher price.

Equivalent to perfectly collateralized deposit with interest

CENTRAL BANK BALANCE SHEETS

Assets Liabilities

Monetary Liabilities• Currency• Reserves

Non-monetary Liabilities• Long-term “Stabilization Bonds• Government Fiscal Reserves

• Government Bills

• Foreign Reserves

• Unconventional Assets

T-ACCOUNTS

T-Accounts are a handy tool for examining the effects that any transaction has on balance sheets.

A bank transaction will change both liabilities and assets (and possibly net worth). The total change in liabilities plus net worth must always equal the total change in assets.

OPEN MARKET PURCHASE: CENTRAL BANK PURCHASES $100 OF T-BILLS FROM BANK A

CB credits the reserve accounts of Bank A which increases its liabilities and takes possession of an equal value of securities as assets.

Bank A gets an extra amount of reserves and loses an equal amount of securities.

Assets Liabilities

+100 T-Bills + 100 Reserves

Assets Liabilities

+100 Reserves-100 T-Bills

CB Balance Sheet

Bank A Balance Sheet

TOOLS: STANDING FACILITIES

Loan Facility: Commercial banks can borrow reserves overnight at a loan facility rate.

Deposit Facility: Commercial banks can deposit reserves overnight at a deposit facility rate.

These opportunities keep interbank rate within narrow band of the policy rate.

32

For historical reasons, standing facilities are called the discount window.

INTERBANK MARKET: BASICS

S

D

iIBR

Reserve Accounts

iTGT

iLF

iDF

Central bank supplies reserves elastically when IBR = LF Rate

Commercial banks willing to hold reserves elastically when IBR = DF Rate

FACILITY: SUPPLY AND DEMAND If the interbank rate rises above the lending facility rate, then banks can borrow as much as they want from the central bank through the discount window. Supply becomes perfectly elastic at iLF.

If the interbank rate rises above the deposit facility rate, banks can lend as much to the central bank as they want through the window. Demand for reserves is perfectly elastic at iDF.

BANGKOK MONEY MARKET

0.8

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I II III IV I II III IV I II III IV I II III IV

2012 2013 2014 2015

POLICYLENDINGDEPOSITMinium ObservedMaximum Observed O/N BIBOR

IMPLEMENTING THE OPERATING

TARGET

POLICY RATE IMPLEMENTATION Monetary policy committee announces

policy rate.

At regular intervals, central bank holds a reverse auction, offering to “lend”* banks as much reserves as they want to hold at policy rate.Ex. Bank of Korea has weekly repo operations with 7 day rp agreements

Banks take up enough to fill demand.

* Engage in a repurchase agreement

MAIN REFINANCING OPERATION

S

D

iIBR

Reserve Accounts

iP

iLF

iSF

MRO

FINE TUNING OPERATIONS

On a day-to-day, minute-to-minute basis the willingness of banks to hold reserves will change creating intra-refinancing period volatility in the market interbank rate for reserves.

Standing facility creates a corridor for fluctuations in the interbank rate but this is only a backstop.

Ex. Bank of Korea Lending facility is policy rate +100 bps Deposit facility is policy rate -100bs.

Central bank conducts ad hoc OMSs to match fluctuations in demand for reserves with supply in order to stabilize interbank rate (ex. BoK stabilizes overnight call money rate) near policy rate. In USA & Japan, all OMO’s are ad hoc.

INCREASE IN DEMAND FOR RESERVES MATCHED BY FINE TUNING OMO PURCHASE TO KEEP INTERBANK RATE FROM RISING.

S

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BOK MONETARY POLICY REPORT

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Volatile Interbank Market

CN: Shanghai Interbank Offered Rate (SHIBOR): Overnight

CN: Nominal Lending Rate: Within 1 Year (Including 1 Year)

OPERATING TARGET IN EUROLAND

The Governing Council (Monetary Policy committee) decides a rate of interest for these repos, the main financing rate, as the policy interest rate.

Every week, the ECB engages in 1-week repurchase agreements with banks in member countries at policy rate providing reserves in exchange for securities.

Auctions are decentralized and done through NCBs

In between periods, The ECB intermittently conducts fine-tuning operations to make sure , the interbank interest rate called EURIBOR, stays near the target.

OUTRIGHT VS REPO

Repo Operations – Many demand fluctuations are temporary. When demand shifts for reasons that policymakers think are likely to be reversed in the near future, they are likely to implement the supply adjustments with repo operations that are temporary by construction.

Outright Operation – If policymakers have reason to believe that shifts in demand are likely to be permanent, they may accommodate the market by a purchase or sale of bills without an accompanying repurchase agreement. This will change the supply of liquidity on an indefinite basis.

OPEN MARKET OPERATIONSELIGIBLE SECURITIES U.S. Fed only uses T-bills and T-bonds for repurchase

ECB and BoJ use some private securities including collateralized bonds and high quality commercial paper.

Bank of Korea uses Monetary Stabilization Bonds (i.e. BoK paper)

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Policy Rate: Month End: Main Refinancing Operations Key Interest Rate: Month End: Deposit Facility

Key Interest Rate: Month End: Marginal Lending Facility Euro Interbank Offered Rate (EURIBOR): 1 Week

Euro Index Average (EONIA): Overnight

WHAT SHIFTS THE DEMAND FOR RESERVES?

Demand for Broad Money – When households want to hold liquid assets, they hold liquid bank deposits. When bank deposits go up, demand for bank reserves go up.

Reserve Requirements – When regulations require banks to hold a high share of reserves relative to deposits, demand for reserves goes up.

Liquidity Risk – When the financial institutions want to hold liquidity, demand for liquidity goes up.

DEFENSIVE VS DYNAMIC

DEFENSIVE TRANSACTIONS – Open Market Operations in which the central bank matches the changes in supply to meet changes in demand in order to maintain a target interest rate.

DYNAMIC TRANSACTIONS – Open Market Operations in which the central bank changes the supply of reserves relative to demand in order to actively change the policy target.

CHANGING THE TARGET After a decision has been made to change the target, the central bank’s traders kick into action and conduct active open market operations.To lower the target interest rate, the central bank will conduct open market purchases, making reserves more plentiful and reducing the cost of borrowing them.

To raise the target interest rate, the central bank will conduct open market sales, making reserves less plentiful and raising the cost of borrowing them.

DYNAMIC OPEN MARKET PURCHASEBASIC ECONOMICS

SiIBR

Reserve Accounts

S´

D

i*1

The interbank market is in equilibrium with supply matching demandThe central bank engages in an open market purchase increasing the supply of reserves. The interbank

market has an excess supply of reserves creating downward pressure on rates. The

market reaches a new equilibrium only when rates full sufficiently that banks will hold them rather than lend.

2i**

Excess Supply

ADJUSTING POLICY RATES: PRACTICE At the main refinancing operation/regularly scheduled repo, policy makers announce a new rate for the operation (along with new standing facility rates.

The commercial banks take up as many reserves as they need at the new rate. With demand equaling supply at the new rate, the market finds equilibrium at the same rate.

CUTTING POLICY RATES: PRACTICE

S

D

iIBR

Reserve Accounts

iP

iLF

iDF

MRO

New Policy Rate and Corridor Announced

At Refinancing Operation, Banks take up more reserves at lower rates.

Since demand for reserves is satisfied, equilibrium in interbank market at the policy rate.

i*=

CUTTING POLICY RATES: OM PURCHASE

S

D

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INTERBANK RATES AND THE MONEY MARKET

Money market: Debt markets w/ maturity less than 1 year: CP, T-bills, NCDs, repos.

Interbank rates steer rates in the broader money market through arbitrage.

If iIB < iMM, borrow in interbank market, lend in money market;

if iIB > iMM, then reverse.

54

MONEY MARKET

Market for debt instruments with initial maturity less than 1 year Treasury Bills Commercial Paper: Corporate debt NCD’s

KOREAN MONEY MARKET

2004

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0101

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8

Call Money RateKIBOR 1 week6 Month KIBOR1 Year Treasury3 Month NCD3 Month Commercial Paper

Source: CEIC Database

MONETARY TRANSMISSION MECHANISM

Interbank Interest Rate

Money Market Rates

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TERM STRUCTURE Chapter 6: The Risk and Term Structure of Interest Rates

TERM STRUCTURE OF INTEREST RATES

Bonds of different maturities typically have different interest rates.

Typically, bonds of longer maturity pay higher yields over their lifetime.

Segmented Market Theory: Long-term bonds have greater interest rate risk and less liquidity. This explains why long-term bonds have greater yields on average.

AVERAGE YIELD CURVE: KOREA YIELD CURVE

1Year 3 Year 5 Year 10 Year0

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Korea Govt Bond Yield to Maturity

EXPECTATIONS THEORY

Assumption: Portfolio holders are indifferent between long and short-term bonds.

Yield to maturity over the life of a long-term bond must be equal to average yields on repeated rollovers of short-term bond holdings during the same period.

Consider two strategies which should have the same expected pay-off. Starting with $1.

1. Buy a two year discount bond and hold it for two years. Payoff:

2. Buy a 1 year bond. After 1 year, invest pay-off in another 1 year bond. Payoff:

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Arbitrage between markets implies equal returns on equal assets.

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In general, if the pay-off for investing in an n period bond should be the same as the pay-off from rolling over 1 year bonds for n periods:

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PREFERRED HABITAT THEORY

Bonds have some differences in risk and liquidity characteristics. Regardless, they are close substitutes and the expectation theory well describes the connection between bonds of different yields.

Yields of bonds of period n are represented as the

The maturity premium hn tends to increase in n.

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Yield Curve

Base Rate: Bank of Korea Treasury Bond Yield: 5 Yr Maturity

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Yield Curve

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% p

er

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FORECASTING WITH THE TERM STRUCTURE

If the expectations theory holds, long-term interest rates can be used to infer market expectations of future interest rates.

Steep yield curve indicates low short-term rates and high future interest rates.

Inverted yield curve indicates high short-term rates and low future interest rates.

INTEREST RATES: PUZZLES & PROBLEMS

The Zero Lower Bound

ZERO LOWER BOUND One constraint on using the interbank interest rate as an operating target: nominal interest rates cannot go below zero.

As inflation drops, the central bank can purchase government securities to lower interest rates only up to the lower bound.

Once, that point has been reached banks will no longer lend out their excess reserves preferring to keep them rather than accept a negative interest rate.

A bank that sets a ZIRP, zero interest rate policy must also target a level of reserves

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ECB Main Refinancing Operations Policy Rate Japan Call Rate: Uncollateralized : Overnight

US Fed Funds Rate

ZERO LOWER BOUND -THEORY

SBR

DBR

iIBR

Reserves

i*

SBR′

i**

SBR′ ′

i***

SBR′ ′ ′ SBR′ ′ ′ ′

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When nominal interest rate reaches zero, demand for money turns infinite since money pays just as good an interest rate as bonds.

LIQUIDITY EXPANSION

PROBLEM

How to raise interest rates without changing the liquidating $2.4 trillion worth of bonds.

S

D

iIBR

Reserve Accounts

iDF

i*

FED currently sets a low 25 basis point deposit facility

Banks willing to hold excess reserves at iDF rather than lend them for lessWhen FED

raises rates, they will raise iDF

iDF’

Quota

Uncompensated Reserves

Reserves beyond the quota will not receive interest, so banks have an incentive to lend them out

but impose quota on excess reserves

will form the effective liquidity in interbank market

S’

Equilibrium in Interbank Market where effective supply equals demand

In the future, the FED will manage both the quota and the supply of uncompensated reserves until situation is normalized.

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SWITZERLAND SETS DEEP NEGATIVE RATE

CHALLENGES TO MONETARY POLICY EFFECTIVENESS 76Link

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Swiss Money Market

Policy Rate: Month End: Overnight Average Rate: SARON Call Money Rate: Swiss National Bank

PUZZLE: WHY CAN INTEREST RATES BE PERSISTENTLY NEGATIVE?

Commercial banks may be willing to hold reserves that pay negative interest since:(1)Reserves may be more convenient than

paper currency in making payments.(2)Currency may have large holding costs

US$1Million US$1Trillion

CENTRAL BANK SETS NEGATIVE DEPOSIT FACILITY

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iIBR

Reserve Accounts

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iLF

iDF

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i*