Monetary policy

Monetary policy has become the preferred policy instrument that is used in the pursuit of economic stability. It is implemented for regulatory purposes by open market operations in support of discount rate rate changes made in response to the degree of capacity utilisation in the economy. It has also been used for the purpose of expanding the money supply as a temporary expedient to counter the threat of deflation - a practice termed quantitative easing (and popularly known as "printing money"). The practice of routinely targeting of monetary policy on the money supply in order to counter inflationary tendencies has generally fallen into disuse, however.

Proposals to use monetary policy instruments to prevent the destabilising buildup of speculative asset-price bubbles, have generally been rejected as impracticable.

The monetary policy consensus

The Deputy Governor of the Bank of England has traced the evolution of monetary policy from the early post-war years when it was assigned only a marginal stabilisation role in favour of what was then thought of as the Keynesian use of fiscal policy - through the unsuccessful attempts in the 1980s to target the money supply, that he attributes to monetarism - to the current consensus, which he classifies as "the neo-classical synthesis" or as "new Keynesian". That "new consensus" gives monetary policy the central stabilisation role, and - with rare exceptions - assigns a marginal role to fiscal policy. It adopts the classical contention of long-run neutrality of money and the sensitivity of expectations to the policy regime, together with the Keynesian theory's contention that market rigidities result in a short-term trade-off between economic activity and inflation . The magnitude of that tradeoff (termed the sacrifice ratio) depends primarily upon labour market price flexibility. The existence of a trade-off can reduce the credibility and effectiveness of monetary policy if it is believed that policy action will subsequently be relaxed when the regulatory authority comes under political pressure to avoid any further reduction in economic activity (a problem that is termed time inconsistency).

Regulatory policy

Policy objectives and their implementation

It is now generally accepted practice for the state's role in monetary policy to be confined to the stipulation of objectives, leaving the implementation of policy entirely in the hands of the central bank. This has been referred to as "indirect implementation" because it involves action designed to influence the conduct of the banks rather than the imposition of instructions concerning their conduct. Conventional "free market" arguments have been advanced in favour of that option and it can also be argued that it increases the credibility of policy action by reducing the risk of time inconsistency in face of pressure to relax an unpopular measure.

The remits of the major central banks differ mainly in respect of the relative weights to be given to their main objectives. The remit of the United States Federal Reserve Board is "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates" . The remit given to the European Central Bank, on the other hand, assigns overriding importance to price stability by requiring it "without prejudice to the objective of price stability" to "support the general economic policies in the Community" including a "high level of employment" and "sustainable and non-inflationary growth". . The British Government's 1997 remit to the Bank of England also gives priority to the control of inflation by requiring it to "deliver price stability" ..."and without prejudice to that objective to support the Government's policies including its objectives for growth and employment" .

Choice of the target discount rate is usually guided by empirical data concerning the relation between interest rates, the inflation rate and the output gap such as is embodied in the "Taylor Rule". Since it takes about a year for interest rate changes to affect output and about two years to affect inflation, the decision depends upon judgements concerning the future of the economy. The authorities make use of economic forecasting models to assist those judgements, but they usually take account also of a range of factors including inflationary expectations (as indicated by the differences between the prices of fixed-interest and index-linked bonds) and the state of the housing market. Having taken the decision, the central bank normally announces its intended discount rate and supports the announcement by open market operations, including temporary loans of money by repurchase operations and the buying or selling of securities. The techniques employed differ only in detail as between the major central banks .

In most countries, discount rate decisions are taken by committees of leading bankers or of experts chosen for that purpose. In the United States they are taken by "Federal Open Market Committee, in the Eurozone the decisions are taken by the European Central Bank Governing Council., and in Britain they are taken by the Bank of England's Monetary Policy Committee . In the United States and Britain, each decision is followed after an interval by the publication of an account of the reasons for taking it.

The monetary transmission mechanism

The term "monetary transmission mechanism" refers to the ways in which discount rate changes contribute to policy objectives.

The Bank of England has identified the expected effects of an increase in its discount rate on the British economy as

• a general increase in short-term interest rates;
• a rise in the exchange rate as the interest rate increase raises the relative returns on domestic assets, making imported goods cheaper;
• a reduction in consumer spending because it stimulates saving and discourages borrowing;
• an increase in mortgage rates, leaving householders with less to spend;
• a fall in house prices as the mortgage rate raises the cost of buying a house, which reduces homeowners' opportunities to finance their purchases by extending their mortgages

(the last two effects are, of course, peculiar to countries in which flexible mortgage rates are customary)

The Bank estimates the full effect on prices price inflation to take up to about two years and the maximum effect on output to take up to about one year (the output effect is generally expected to be transitory).

An account of the monetary transmission mechanism issued by the European Central Bank states that changes to its discount rate are expected to:

• affect banks and money-market interest rates;
• influence expectations of future inflation, which promotes price stability by reducing people's motives to raise their prices for fear of higher inflation or reduce them for fear of deflation;
• affect asset prices for comparable reasons;
• affect saving and investment decisions since higher interest rates make it less attractive to take out loans for financing consumption or investment;
• have have an impact on aggregate demand via the value of collateral that allows borrowers to get more loans and/or to reduce the risk premia demanded by lenders/banks, and by creating tighter or looser conditions in the labour and intermediate product markets;
• affect the supply of credit as higher interest rates increase the risk that borrowers may default on repayment of loans, and banks cut back on loans to households and firms.

The Federal Reserve Board has issued a statement on similar lines .

Quantitative easing

The effectiveness of discount rate reductions in countering recessions is limited by the fact that negative rates are not feasible and that liquidity trap effects tend increasingly to rob them of impact as they fall below 1 per cent. The only remaining monetary policy instrument is then a major increase in the money supply, brought about by some form of quantitative easing.

Monetary policy techniques that can be roughly categorised as quantitative easing include:

• "credit easing" - direct lending to the private sector (as practised in 2009 by the Federal Reserve Board's Open Market Committee).
• the purchase of government securities from the non-bank sector (as practised in 2009 by the Bank of England ).
• very large-scale open market operations (as practised in 2009 by the European Central Bank and 2001-6 and 2009 by the Bank of Japan).

The principal effects of central banks' purchases of securities from private sector are:

• bank lending tends to rise in response to the extra money that becomes available from asset sales to the central bank, leading to a multiple expansion of the money supply; and,
• the prices of other assets tend to be driven up as the private sector seeks to replace the bonds purchased by the central bank, reducing the cost of non-bank finance .

The unusual persistence of the 1990s recession in Japan has been taken to indicate that the quantitative easing actions by the Bank of Japan were ineffective, but some econometric studies suggest that without it, the recession would have been deeper . Several central banking authorities have expressed confidence in the effectiveness of its application to the recession of 2009, but it may be some time before econometric analyses become available.

Proposals for asset-price regulation

An article by staff economists in the IMF World Economic Outlook of May 2000 proposed the use of monetary policy to prevent large asset price swings from undermining the stability of the financial sector. They recommended a tightening of monetary policy under three circumstances:-

• when there are signs of serious overvaluation of several different assets and, in particular, when both stock prices and property prices rise well above historical trends;
• when asset price inflation is accompanied by rapid credit and money growth;
• when there are marked falls in savings ratios and private sector balances, and large rises in investment ratios and external current account deficits.

But in a 2002 speech, Federal Reserve Governor Ben Bernanke opposed the use of monetary policy to target the asset markets, arguing that it would be "neither desirable nor feasible" for the Fesderal Reserve to act as an "arbiter of security speculation or values" ; and in a 2005 lecture, Jean-Claude Trichet, the President of the European Central Bank, argued that not all bubbles threaten financial stability, and that if policy-makers attempted to eliminate all risk from the financial system, they either fail or they would "hamper the appropriate functioning of a market economy".

It is clear from their speeches that Ben Bernanke and Jean-Claude Trichet were more concerned about the practical aspects of the proposal than with free-market ideology, and Bernanke himself subsequently failed to recognise the house price bubble the bursting of which led to the crash of 2008

Dissenting views

The founder of the Chicago School, Milton Friedman was opposed to the discretionary use of monetary policy in response to cyclical developments, and his collaborator, Anna Schwartz has registered her objections to the policy of quantitative easing