Conducting monetary policy
How does a central bank go about changing monetary
policy? The basic approach is simply to change the size
of the money supply. This is usually done through open
market operations, in which short-term government debt
is exchanged with the private sector. If the Fed, for example,
buys or borrows treasury bills from commercial banks, the
central bank will add cash to the accounts, called reserves,
that banks are required keep with it. That expands the
money supply. By contrast, if the Fed sells or lends treasury
securities to banks, the payment it receives in exchange will
reduce the money supply.
While many central banks have experimented over the
years with explicit targets for money growth, such targets
have become much less common, because the correlation
between money and prices is harder to gauge than it once
was. Many central banks have switched to inflation as their
target—
either alone or with a possibly implicit goal for
growth and/or employment.
When a central bank speaks publicly about monetary
policy, it usually focuses on the interest rates it would
like to see, rather than on any specific amount of money
(although the desired interest rates may need to be
achieved through changes in the money supply). Central
banks tend to focus on one policy rate—generally a shortterm, often overnight, rate that banks charge one another
to borrow funds. When the central bank puts money into
the system by buying or borrowing securities, colloquially
called loosening policy, the rate declines. It usually rises
when the central bank tightens by soaking up reserves.
The
central bank expects that changes in the policy rate will
feed through to all the other interest rates that are relevant
in the economy.
Transmission mechanisms
Changing monetary policy has important effects on aggregate demand, and thus on both output and prices. There
are a number of ways in which policy actions get transmitted to the real economy (Ireland, 2008).
The one people traditionally focus on is the interest rate
channel. If the central bank tightens, for example, borrowing costs rise, consumers are less likely to buy things they
would normally finance—such as houses or cars—and
businesses are less likely to invest in new equipment, software, or buildings. This reduced level of economic activity would be consistent with lower inflation because lower
demand usually means lower prices.
But this is not the end of the story. A rise in interest
rates also tends to reduce the net worth of businesses
and individuals—the so-called balance sheet channel—
making it tougher for them to qualify for loans at any
interest rate, thus reducing spending and price pressures.
A rate hike also makes banks less profitable in general and
thus less willing to lend—the bank lending channel. High
rates normally lead to an appreciation of the currency, as
foreign investors seek higher returns and increase their
demand for the currency. Through the exchange rate
channel, exports are reduced as they become more expensive, and imports rise as they become cheaper. In turn,
GDP shrinks.
Monetary policy has an important additional effect on
inflation through expectations—the self-fulfilling component of inflation. Many wage and price contracts are
agreed to in advance, based on projections of inflation.
If policymakers hike interest rates and communicate that
further hikes are coming, this may convince the public that
policymakers are serious about keeping inflation under
control. Long-term contracts will then build in more modest wage and price increases over time, which in turn will
keep actual inflation low.
When rates can go no lower
During the past two years, central banks worldwide have
cut policy rates sharply—in some cases to zero—exhausting the potential for cuts. Nonetheless, they have found unconventional ways to continue easing policy.
One approach has been to purchase large quantities
of financial instruments from the market. This so-called
quantitative easing increases the size of the central bank’s
balance sheet and injects new cash into the economy.
Banks get additional reserves (the deposits they maintain
at the central bank) and the money supply grows.
A closely related option, credit easing, may also expand
the size of the central bank’s balance sheet, but the focus is
more on the composition of that balance sheet—that is, the
types of assets acquired. In the current crisis, many specific
credit markets became blocked, and the result was that the
interest rate channel did not work.
Central banks responded
by targeting those problem markets directly. For instance,
the Fed set up a special facility to buy commercial paper
(very short-term corporate debt) to ensure that businesses
had continued access to working capital. It also bought
mortgage-backed securities to sustain housing finance.
Some argue that credit easing moves monetary policy too
close to industrial policy, with the central bank ensuring the
flow of finance to particular parts of the market. But quantitative easing is no less controversial. It entails purchasing
a more neutral asset like government debt, but it moves the
central bank toward financing the government’s fiscal deficit, possibly calling its independence into question.
Now that the global economy appears to be recovering,
the main concern has shifted to charting an exit strategy:
how can central banks unwind their extraordinary interventions and tighten policy, to ensure that inflation does
not become a problem down the road?
Koshy Mathai is the IMF’s Resident Representative in Sri
Lanka
