Transcript | 6. lecture:Tools of monetary policy to combat the recession (Vladimír Vaňo) - University for modern Slovakia

Helicopter Ben versus the ONLY NEEDLE IN THE COMPASS

• For the powder with which the American central bank proceeded to exceptional expansionary monetary policy during the previous recession, its head Ben Bernanke earned the designation of “helicopter Ben” associated with a metaphor about how he eases monetary policy with a rate like tossing the liquidity from a helicopter.
• At first sight such a metaphor seems to be in conflict with the re-emphasis of the ECB President Jean-Claude Trichet, who often repeated that “the only needle in the compass of the ECB when deciding on interest rates is a stable inflation.”
• Exceptional anti-crisis measures of monetary policy in times of economic weakness and the slowdown in inflation is, however, an emergency measure for the prevention of deflation, a general decline in consumer prices.
• Exceptional expansionary monetary policy in times of recession, therefore, does not contradict with the role of the central bank as the guardian of price stability in a time of strong growth.

Prevention of dead - end deflation: the liquidity trap of Japan

• As we will see in more detail in the next lecture, a deflationary environment is usually not only associated with economic stagnation, as was Japan also shown during the last decade.
• Against deflation commonly available instruments are useless.
• Japan’s situation in terms of monetary policy is also referred to as a liquidity trap, when a combination of stagnation and deflation cannot be reversed with the easing of monetary policy.
• That’s why, to prevent a repeat of the Japanese scenario, the U.S. central bank joined the campaign of exceptional expansionary monetary policy.
• As has been said already, one should be careful to distinguish between high liquidity money that can be influenced by central bank directly by liquidity recharge, and the money supply (M2 in the USA and M3 in the euro area), driven by private sector demand for credit, and that affects inflation.
• Available instruments of monetary policy can cope with a faster than wanted inflation better (decreasing the demand and higher loan interest) than with deflation (when demand for loans in an environment of falling prices that cannot be supported even with a recordly low interest rates).
• Exceptional measures of monetary policy during the severest post-war recession were just emergency actions, so that the U.S. (or euro area) did not repeat the scenario of deflation and a prolonged economic stagnation of Japan.

The objective of monetary policy: inflation is stable, but no decrease in consumer prices (deflation)

• “Take away the punch bowl when the best fun begins,” according to a former U.S. Fed chief Alan Greenspan, is that the primary task of central banks.
• The role of monetary policy is to manage the money supply, so in order to prevent unhealthy and unsustainable growth (so-called overheating), but also to avoid excessively rapid growth of consumer prices.
• Since its establishment are the three roles of the U.S. Fed’s monetary policy maintaining a stable inflation, support of sustainable growth, and employment.

Best result: if the central bank aims at a single target

• Post-war experience with monetary policy have led scholars to the conclusion that the central banks work is most effective when it does not aim at several targets at once, but only one target: the stable development of prices.
• Academic theories of monetary policy, but also practical experience with the fact that monetary policy is the best contribution to economic prosperity, if it puts maintaining a stable inflation as primary objective, led in recent decades more and more central banks to the introduction of inflation targeting, i.e. the efforts to maintain a specific and well-known level of inflation.
• Our European Central Bank is working also in the inflation targeting regime: its primary goal of monetary policy is to maintain stable inflation close to the inflation target.
• The ECB aims to keeping inflation as measured by consumer price index HICP below, but close to 2%.

Monetary policy during recession: avoid deflation, which can be caused by a weak growth

• The so-defined goal - not the lowest possible inflation, but price growth below, but close to 2% - reminds that the objective of monetary policy is not a zero growth in consumer prices, and absolutely not their decline - a general deflation.
• The objective of monetary policy is the environment with stable and predictable inflation.
• Narrow definition of the ECB monetary policy role (stable inflation) does not mean that the central bank has not responded to the economic downturn and recession, either. And especially if the downturn in economic activity is so serious that it constitutes a risk of decline in consumer prices, i.e. deflation.

High inflation: high interest rates as a brake to credit expansion and growth (the economy and prices)

• Practical experience with the fact that increasing the basic rate is an effective tool to cool down the unhealthy growth, as well as excessively high inflation have not only the USA (chart attached), but also the euro area.
• An increase in the basic rates and expensive loans contribute to the weakening demand for them, thus slowing down the growth of private sector investment. Slower growth in investment and employment helps to weaken consumer demand, hence the pressure for rapid price growth.
• From another point of view an increase in key interest rates means, that for the financial sector it is worth more to keep the most liquid money in higher interest bearing accounts of the central bank, therefore out of the economy. Higher interest thus contributes to slower growth of the most liquid money in the financial sector. It also limits its ability to raise total money supply with credit expansion growth, which affects inflation.
• Increasing the basic interest rates, which slows down credit growth, investments, and the consumer prices is also known as “tightening of monetary policy.”

After exhausting the instruments of qualitative monetary policy the quantitative ones follow

• In times of economic weakness, loss of employment, and demand the central banks conversely start with "easing of monetary policy" to avoid deflation.
• It starts with reducing key interest rates: cheaper loans boost companies’ demand. They can use them for investments with lower returns, which had been unworthy in times of high interest rates. From another point of view, lower interest rate on the most liquid money lying "dormant" in the central bank, outside the economic cycle, motivates banking industry to seek better use for them in the loan process.
• The decline in economic activity and profitability, hence higher business risk, but also a decline in employment and hence higher credit risk of households, during the recession lead to a tightening of conditions for the assessment of new loans. Therefore, neither expansionary monetary policy, nor higher volume of the most liquid money mean immediate massive increase in lending activity.
• Moreover, the decline in economic activity leads to reduced utilisation of existing industrial capacities, thus discouraging companies from new investments financed by new loans. Higher unemployment and insecurity in the labour market like the demand for new loans discourages households.
• This tightening of credit conditions on the supply side, but also more cautious interest in new loans on the demand side leads to the fact that in times of recession usually the most liquid money growth rate in the financial system exceeds the growth rate of total money supply (included are charts from the U.S. and euro area).

When there is nowhere to go down with interest

• When central banks run out of available space for the reduction of the interest (so-called quality control tool of monetary policy), and deemed necessary to ease monetary policy further, they extend to the so-called "Quantitative Easing" of monetary policy.
• In quantitative easing of monetary policy central bank complements most liquid money to financial sector by purchasing the first-rate assets from its balance.
• By definition, the least risky assets are government bonds. In the case of the U.S. therefore a quantitative monetary easing is a form of purchase of federal government bonds from the balance of the banking sector, i.e. on the secondary market.
• Federal government bonds are in quantitative easing of monetary policy just an instrument for transactions in which the central bank at near-zero interest supplements the most liquid money, in order to encourage lending activity.
• In quantitative easing of monetary policy, therefore, it never comes to the purchase of government bonds directly by the central bank from the issuer, i.e. the government (the Treasury). Operations of quantitative monetary easing are not made on the primary market (when the state issues bonds for the first time to private investors).
• In addition, the transfer of government bonds from the portfolios of the private investors to the portfolio of central bank does not change the government's commitment to pay within the due date the principal amount (and the interest on ongoing basis).
• At a time when bonds in the portfolio of central bank reach their maturity date (the issuer pays the principal amount of the bonds), the most liquid money issued in quantitative release return from the circulation back to the central bank. Before the maturity date the central bank can “draw them back” e.g. by resale of the government bonds on the secondary market.
• Whether how and when the most liquid money available in the financial system are reflected in revival of growth in total money supply depends mainly on the development of loan demand.
• Following the revival of private sectors’ demand for loans (as it occurred at the beginning of this year), the central bank once again approaches to a contracting of monetary policy, by sale of premature government bonds purchased in the quantitative release, or by rising key interest rates. Both of these operations contribute to slower growth of the most liquid money in the financial system.

The scope of effectiveness of monetary policy

• Between making monetary policy decisions and their full impact on the real economy there is a textbook example of relatively long time delay, 9-18 months.
• This is a result of the fact that the monetary policy decisions affect the real economy only indirectly (by affecting the most liquid money that can later influence the demand for loans and credit expansion process, which decides on the amount of total money supply in the economy).
• When the central banks decide to change the setting of monetary policy, in addition to the current situation they shall therefore consider in particular the prospects for the foreseeable future.
• Therefore, when deciding on monetary policy, central banks are considering the present trend and especially the risks of future development of inflation and economic growth.

Taylor rule

• Also the inflation targeting regime is contributing to increased transparency of monetary policy that operates in such a decisions mode that affect the future development, which is in the current time although predictable, but still uncertain.
• From a credible anti-inflation policy can therefore be expected that it tends to rather raise interest when inflation exceeds the inflation target, on the contrary, rather tend to reduce the interest when inflation slows below the inflation target (the attached chart).
• At a glance simple but quite powerful theoretical tool for assessing the adequacy of the monetary policy is the Taylor rule.
• Taylor rule assumes that changes in interest rates depend on:
  • how the real economic growth rate deviates from sustainable rate of its potential growth, but also on how far the actual inflation rate differs from the inflation target.
  • In other words, even crossing the inflation target does not automatically lead the central bank to an increase in interest, if it occurs during the deceleration of growth (which later will also contribute to slower inflation). On the other hand, if in the period of relatively satisfactory inflation the economic growth exceeds its long-term sustainable potential level, for the central bank this would be conversely a signal for tightening monetary policy as a precautionary response to the imminent risk of inflation increased by demand.
  • Application of Taylor rules in the U.S. and the euro area shows that this theoretical tool helps to explain recent changes in the later decisions of central banks (chart attached).

Monetary policy and the yield curve

• The key interest rate, which directly sets the central bank rate is the usually the shortest maturities:
  • overnight rate of Fed in the U.S. (currently 0.25%),
  • a 7-day refinancing rate of the ECB (1.50%) in the euro area (plus overnight rate for deposits - 0.75% - and for overnight loans - 2.25%).
  • Interest rates on longer maturities are formed by the supply and demand on monetary or bond market.
  • The shape of the yield curve (longer maturities interest) is a statement about what is the current view of the money and bond market for the future direction of key central bank rates. It is therefore the opinion on the future pace of economic growth and inflation.
  • The shape of the yield curve is one of the signalling tools of financial market’s view of future prospects:
    • At the time of growth, the yield curve is rising up: longer maturities bear higher interest than the shorter ones. Market expects faster growth in the future, faster inflation and hence a gradual increase in key interest rates.
    • On the contrary, in times of recession there is a flattening or even inversion of the yield curve (longer maturities bear smaller interest than the shortest): Descending yield curve reflects market expectations that the slowdown is approaching in the future growth, lower inflation, and thus, a gradual reduction in the shortest central bank rates.
    • The difference between the key rate, which is directly affected by the central bank, and in between, as the money and bond market forms the price of longer maturity money, refutes the popular misunderstanding about the relationship between accommodative monetary policy and low-interest long-term investment loans (such as mortgages).
    • The attached graph illustrates that even when the Fed's key interest rate was extremely low on long-term loans, the rates on long-term loans was a few percentage points higher.

Monetary policy in small and open economies

• The experience of Slovakia until 2008, but also the experience of neighbouring economies in the past three years illustrates that the management of monetary policy in small and open economies is more complex and not always affected by domestic fundamental factors only.
• In particular, events in global financial markets and investor mistrust towards domestic assets may result, like in Hungary, in the fact that even in times of weak economic growth the monetary policy is forced to keep the interest rates higher than it would be needed by the private sector weakened by recession.

The role of the exchange rate in the management of monetary policy of a small and open economy

• At the time of turmoil on world markets, there is an increased aversion of investors towards assets with higher risk, including the assets of the so-called emerging markets.
• As in the summer of 2011, or in the autumn of 2008, the turmoil in global markets was accompanied by the pressure on weakening of exchange rates of Central European currencies.
• Weaker exchange rates for small economies mean increased exchange cost in imports.
• (Note: The turmoil in world markets is associated with the weakening of the local real economy, thus the external demand for exports of Central European countries. A weaker exchange rate in an environment of declining external demand, as it was in 2009, does not guarantee higher exports).
• Increased exchange cost in imports is reflected to higher consumer prices (so-called imported inflation).
• A higher price growth does not allow central bank of a small open country to promote economy by lower interest rates.
• In addition, the central bank in order to avoid disproportionate further weakening of the exchange rate and more expensive imports may even reach for the stabilizing increase of interest (example Hungary and Romania). Higher interest rates, particularly increased difference of interest rate for the reference world currencies, encourages foreign investors to buy the domestic currency which bears higher interest rate (for lower-bearing loan in the reference currency) and helps thus to stabilize the exchange rate, which is under the depreciative pressure.
• As the neighbours in the region were convinced, own monetary policy in a time of global turmoil can be accompanied by a not most comfortable combination of recession, higher inflation, and higher interest rates. The reason is the fluctuations that are not always just a consequence of the condition of domestic fundamentals.

The impossible trinity: inflation targeting, a stable exchange rate, free capital movement

• The management of monetary policy in a small economy is complicated by relationships between the free capital movement, the level of interest rates of central bank seeking inflation targeting, and exchange rate.
• The so-called Trilemma theory says that for a small economy it is particularly difficult to achieve all three objectives:
  • guarantee the free capital movement,
  • at the same time keep monetary policy in the inflation targeting mode,
  • maintain a stable exchange rate (which would not be a problem neither for exporters, nor conversely for import prices).
  • Why are such the three factors, labelled as "impossible":
    • If the central bank seeks to strictly maintain inflation at its target, it may at the time of stronger growth and higher inflation lead to the need of raising the interest rates. Higher interest rates are a magnet for inflows of speculative capital, which leads to a strengthening of the local currency, often in inadequate extent which damages the export industry. The resulting slowdown puts the central bank of small economy to the dilemma between inflation and the growth.
    • Weakening of the exchange rate, such as during the global turmoil, leads by more expensive imports to accelerating inflation. Both of these factors force the central bank to increase interest rates, although the state of the domestic economy would rather call for the need of cheaper loans.
    • Strong economic growth, accompanying improvement of trade balance and capital inflow lead to a strengthening of local currency. If its range for the domestic export industry is inadequate, the central bank seeks to relieve speculative pressure on exchange rates by lower interest. This, however, in the domestic economy leads to cheaper loans to the extent which in the medium term can lead to unhealthy trends in demand, accelerating price growth, etc.

Conclusion:

• Monetary policy in times of recession is not a panacea. It seeks in particular to avoid an impasse deflation, accompanied by deflation and against which monetary policy is useless (Japan).
• Monetary policy seeks to create conditions for the earliest recovery of economic growth and job creation.
• A driving force of economic expansion, loan funded investments, and employment is private sector and entrepreneurship.
• The management of monetary policy in small and open economies may be in times of recession much more complex and influenced not only by the needs of the domestic economy.