Professional Documents
Culture Documents
Monetary Policy and Monetary Policy Instruments
Monetary Policy and Monetary Policy Instruments
Maputo, Mozambique
5 August 2009
The views expressed are those of the presenter and not necessarily those of the BIS
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Part I
- Role of the Central Bank & Monetary Policy framework/scope
- Short-term interest rates as operating target: implications
- Rules-based instruments: direct instruments
- advantages v/s disadvantages
- Reserve requirements
- Demand for reserves (required (RR), settlement & voluntary reserves)
- Features (RR ratios, eligible assets, maintenance periods, lagged accounting)
- Remuneration v/s non-remuneration
- Reserves averaging (description & use)
- Functions & main problems
- Conclusion to Part I
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Plan scenarios, set the policy rate and communicate with other market
players
Control liquidity & credit conditions (by using RRs, SFs & OMO)
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Operating Intermediate
Instruments Goal(s)
target(s) target(s)
Direct Financial stability
Base money Money supply
instruments
Market interest Inflation stability
Inflation rate
Indirect
rates Growth
instruments: Exchange rate
Exchange rate Full employment
Lending/deposit Etc
facilities etc Competitiveness
Reserve etc
requirements
Disc. Mon. op.
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They are:
Interest rate controls
Bank-to-bank credit ceilings
Statutory liquidity ratios (hold % of bank’s liabilities as govt securities)
Directed credits
Bank-to-bank rediscount quotas
Use of direct instruments – 1998 to 2004
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Easy to link with a monetary targeting policy (BUT monetary targeting relies on
strong & stable relationship over time between demand for money and supply of
money – not the case in reality)
Credit ceilings tend to ossify credit distribution & act as barrier to entry of
new players
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They are:
• reserve requirements
• Standing facilities
• discretionary monetary operations (OMOs, OMO-type
operations)
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Modernized clearing & payment systems (to avoid volatility in reserves supply)
Phase 2
• Characterised by reduction of reliance on RR for sterilisation
• Introduction of primary market issuance (eg, OMO-type operations)
• Foundation stone for development of securities secondary market
• Adequate collateral important as:
• CB has to protect itself from incurring losses on its credit operations
• Without collateral, CB counterparties cannot obtain liquidity
• Combination with freer interest rates to facilitate money market development
Phase 3
• Secondary market operations (OMO), use of standing facilities & further
refinements…
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Reserve money or
Base money or
Monetary Base
Reserve requirements
Required reserves (generally fixed by CB & binding (compulsory))
• Defined as requirement for a bank to hold minimum current account
balances with CB (usually a % of its unsecured cash deposits)
• Only INDIRECT influence of ∆ interest rates (i) on required reserves
• ↑ i => ↓ demand for deposits as economic activity slows down => ↓
the base used to calculate required reserves
• Enforcement thru penalty interest rate (usually the lending SF rate) or
restricted access to CB lending facilities
Better CB technical capacity & payment & settlement systems => ↓ free
reserves
Liquidity mgt problems & high overdraft penalties => ↑ free reserves
If not remunerated (opportunity cost) => banks keep minimum free reserves
Remunerated free reserves (usually at deposit SF rate, normally < policy rate)
=> ↓ opportunity cost => free reserves ↑
↑ free reserves => liquidity surplus => trigger CB to↑ policy rate
Free reserves usually high when CB’s balance sheet asset-driven (eg, when
govt borrows abroad and sells FX to CB; when CB makes net purchases of
FX to manage a fixed exchange rate regime and capital flows)
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Eligible assets?
• Include: usually, deposits with CB (demand, time, FC), vault cash
(debatable – estimation problems)
• Exclude: government securities & OMO eligible instruments =>to avoid ↓
efficiency of monetary policy thru increased complexity
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Carrying over excess reserve holdings into next MP => more smoothing,
esp. last day of MP (when O/N rate volatility is higher)
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Averaging acts as Buffer to stabilize cash flows & limit O/N int. rate volatility
Critique: By offering Greater flexibility => poorer liquidity mgt => prudential
issues
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“With averaging, before last day of MP” No averaging or “With averaging, last day of MP”
Unremunerated RR => Introduce a wedge bet. SFd and SFc to discourage over-
lending => ↓ too fast credit growth - not much used (tax => disintermediation)
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Conclusion to Part I
Rules-based instruments (=> disintermediation, distortions in the
allocation of bank resources and loss of effectiveness by the monetary
authorities) incompatible with today’s developed financial markets,
international trade and and liberalised capital markets.
Part II
- Liquidity supply & CB balance sheet
- Autonomous factors & importance of liquidity management
- Problems with liquidity surpluses
- Standing Facilities
- Definitions & uses
- Credit and deposit facilities
- Features (maturity, collaterization, eligible instruments)
- Corridor system & stigma
- Conclusion to Part II
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Supply of liquidity
Net supply of reserves or liquidity influenced by:
• Autonomous factors, ie, Uncontrollable changes to the CB’s balance
sheet NOT the result of its domestic liquidity operations
• Policy factors – its controllable domestic liquidity operations
Autonomous
A Central Bank’s Balance sheet liquidity position
Assets Liabilities = net sum of
Net foreign assets Currency autonomous factors
Net securities Bank reserves
• Required reserves = Net foreign assets +
• Outright
Credit to Government
• Under repo • Excess reserves
+ Other net assets
Lending to banks Government deposits
– Government
Credit to government Liquidity draining operations deposits – Currency
Other items net Capital and reserves
Net policy position (+ means inject, - means withdraw)
= Bank reserves – Autonomous liquidity position
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If liquidity level ∆ a lot => ST interest rate volatility ↑ => this impedes on devlt of
LT end of mkt => risk-aversion ↑ & banks reluctant to take positions
Both shortage & surplus liquidity => weak secondary market for securities
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CB carry out liquidity-draining by ↑ policy rate => -ve effect on credit growth
Market segmentation – big banks attract all deposits while small banks are
short of liquidity
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Bank rescue (LOLR) – the case with the recent financial crisis ?
• Crisis => ↑ demand for liquidity as:
• Banks want to ↑ precautionary reserves
• Banks are reluctant to lend to each other
• If CB bails out a bank =>↑ CB assets => surplus liquidity
• If CB makes losses => may endanger CB’s independence
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When SF rates low => SFs used as permanent LOLR facility (ie, => over-reliance)
• Over-reliance => moral hazard => danger to development of interbank
markets (CB’s SFs acts as rough substitute to interbank markets)
• Need for penalty rate & regulation
• However, Penalty rate may lead indirect stigma & discourage use when
appropriate (eg, the US at beginning of current financial crisis)
Help meet reserve deficiencies & avoid end-of-day overdrafts => limit
pressures on overnight rates
SFc > Market rates => market-ceiling rate for market rates
• if market rates threaten to rise above SFc, banks tend to borrow more
from SFc than from the market=> limit rise in market rates
High SFc = signal of tightening monetary policy
Use of SFc ↑:
• When current accounts are not monitored properly => banks don’t meet
their RR, esp on last day of MP due to liquidity forecasting errors
• With credit rationing, market segmentation, liquidity hoarding (during
crises); ECB (1st week Oct 08: daily avg use of SFc went from 0.5 bil
euros to 21 bil euros)
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SFd > O/N interest rate = signal of illiquid interbank market (less dev. countries)
Less widely used than SFc (esp in developed countries – more often
characterised by liquidity shortages)
When market-wide liquidity surplus => SFd ≈ policy rate
Frontloading (ECB since Aug 2007) => liquidity surplus at beginning of MP => ↑
use of SFd; ECB (1st week Oct 08: daily avg use of SFd went from 1.5 bil euros
to 43 bil euros)
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Maturity of SFs
• O/N in most countries – serves “safety-valve” function
• Recent trends (financial crisis): ↑ maturity to ↓ rollover risks in interbank
markets
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Soft ceiling: collateral needed for SFc => banks with non-eligible collateral
forced to borrow from the market => may cause market rates to ↑
=> (SFc < = O/N rate) – may pose problems during financial crises
Narrow corridor
• Use of SFd more attractive v/s interbank market for excess liquidity depositing
• Minimises interest rate volatility; best if stigma low or zero => ↓ need for
further fine-tuning operations
• Serves the rate-setting or rate-stabilising function
• Implies higher importance of RR averaging to contain rates within bounds
• Too narrow => ↓ incentive for banks to manage their liquidity via interbank
market & hamper its development
• Too narrow => moral hazard (no penalty) => over-reliance
• Necessary in financial crises with severely impaired interbank funding markets
Wide corridor
• Safety valve: prob (market rates under-/over-shooting SF rates) ↓
• Encourage banks to fund themselves via interbank market instead of CB
• More room for interest rate volatility => ↑ need of fine-tuning operations
• => Lower use of SF as spreads between SFc and market rates ↑
=> ↑ holdings of voluntary reserves
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Issuance of CB paper
• ↑ CB independence
• but in case of loss, may ultimately => ↓ CB independence
• Used when:
• separation needed bet. Monetary & fiscal policy goals
• CB more creditworthy than government or govt securities not available
• Coordination with Treasury needed to protect CB independence
• May be detrimental to development of active govt securities market
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Temporary operations (reversible and more flexible): best for fine-tuning & if CB
does not want to influence market price of specific asset
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Play crucial role in reallocation of liquidity among banks (during normal times)
Act as a safety net for smoothing interbank cashflows (in turbulent times)
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Auction techniques
All discretionary monetary operations are conducted via auctions
Standard tenders
• Regular; publicly announced by means of wire services; eg ECB’s MRO &
LTRO
Quick tenders
• Irregular; fine-tuning; little counterparties; may not be announced publicly in
advance
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Valuation markdown
• CB applies a reduction of the theoretical market value of the assets by
a certain % before applying any valuation haircut
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Conclusion to Part II
Today, most CBs use some sort of OMO and to a lesser extent SFs in the
conduct of monetary policy. Differences are more on type & maturity of
instruments used, collateral used and frequency of operations. These are
influenced by the regime, the economic structure & openness, degree of
development of primary and secondary markets for securities, credibility &
independence of the CB as well as its’ expertise in managing liquidity and
the accuracy of its’ liquidity forecasts.
The current financial crisis has shown that having highly developed &
liberalised interbank markets and being able to use all sorts of instruments of
monetary policy available do not guarantee success. Enforcement through
regulation and cooperation with government debt management policy are
crucial, together with the need for the CB to make good forecasts of
autonomous factors and take necessary measures early enough to counter
any adverse shocks…
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Part III
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Consequences:
• Many advanced economies CBs have used up the usual tools of mon pol
(like policy rate cuts (cut to almost 0 in US & UK)) – had to resort to
unconventional monetary policies to provide liquidity => huge ↑ in size of
balance sheets & ∆ in composition (=> ↑ risks of losses for CB)
• Government interventions to restore confidence in banking systems &
safeguard flows of credit have affected public finances & raised questions
on their sustainability => large ↑ in sovereign credit risk, fiscal debt &
deficits
Exit strategies (timing & scale), adequate legal & institutional frameworks,
disclosure of information by involved parties & differentiated resolution (to
minimize moral hazard) VITAL for success of interventions
• Success => direct effect on confidence & future credibility of policies
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Mounting writedowns & fears of downgrades => forced sale of assets in thin
markets => ↑ deleveraging & insolvency
LF => large ↑ in Libor-OIS spreads, writedowns & CDS spreads; big ↓ in equity prices
LF=> ↑ capital injections (esp. Q4 08 & Q1 09); ↑ govt share in Q4 08
Deteriorating credit quality => ↑ writedowns => ↑ deleveraging => ↓ credit growth
Domestic official support (=> ↑ Home bias) & FX swap market impairment =>
↓ cross-border funding => ↑ cross-border deleveraging affecting EMEs a lot
Concern over fiscal sustainability & tight lending conditions => CDS spreads still higher
than pre-crisis levels
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Volatility indicators
Significant ↓ in equity & exch rate volatility after all-time highs after LF
(Sep 08); levels almost back to pre-crisis levels
Bond volatility still high => effects of aggressive government intervention
(purchases of securities)
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Results:
• Improvement recently (lower spreads & volatility & ↑ asset prices)
• huge ↑ in CB’s balance sheet & ∆ in composition
• => greater risk exposure for CB => ↑ threats to CB independence
• => ↑ importance of more coordination with fiscal authorities
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In line with CB’s LOLR fn; diff on wider range & magnitude v/s trad. levels
Main goal: ↓ interbank market spreads to:
• Provide more term funding & Smooth distribution of reserves
FX swap lines = facilitate FC provision; main balance sheet expansion factor
Lending highly liquid securities against less liquid assets & doubtful collateral
=> ↑ credit & market risk for CB
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UMP => large ↑ in CB balance sheet (Fed’s & BoE’s assets almost X3, by end-08)
Reflection of aggressiveness of easing & nature of financial system
Liquidity injection X4 for BoE & more than tenfold for Fed
Highly volatile use of LT repos (from 0 to 100 %) – reflects high freq of LT fine-
tuning operations and their irregular nature
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Use of FC ↓ compared to
end-08, esp with BoE –
replaced by direct lending
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Improving signs…
TAF has helped in
easing money market
conditions…
Massive liquidity
injections => Funding
spreads now very low
at all maturities &
less volatile => sign
of improving funding
conditions
Bid-to-cover ratio ↓
=> urgent need to
borrow ↓
Stop-out rate no
longer > min. bid rate
– growing investor
confidence
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Problem: instead of
lending, banks ↑ use of
deposit facilities…
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Assumptions based on past experience may not be a good guide for the future
Lags & Durability of impact – is it going to last? How to unwind positions smoothly?
When to do so?
Success depends on design & magnitude of the measures but also on the
willingness and ability of creditors to lend & of borrowers to borrow
Liquidity-draining options:
• Sale of securities outright; reverse repos ;↑ attractivity of bank
reserves holdings; Issue CB bills
More important for exit: TIMING of exit & NOT the unwinding of
balance sheet size
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Deleveraging (=> sale of EME subsidiaries & net capital outflows (home
bias & higher regulatory capital charges due to currency risks) => ↓ FDI
& credit-rationing => ↑ refinancing problems & insolvency pressures
High external debt refinancing needs => EMEs very exposed to financial
distress
Financial markets take full toll in Q4 08 => large depreciations to support exports
Liquidity hoarding & fiscal stimulus sustainability uncertainty => ↑ sovereign
spreads
↓ equity prices & CDS spreads ↑ as confidence drops
Bond yields ∆ a lot as uncertainty grows over authorities’ actions
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Policy actions
↓ policy rates, RR and SFc↓ => expand liquidity provisioning
OMO: ↑ repos => inject liquidity; OMO-type: US$ swaps or outright sales of FC
to local banks to counter ↓ cross-border bank funding
Establishment of swap lines with advanced country CBs for some EME CBs
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Road ahead:
• More policy rate cuts & UMP (liquidity injection & credit flow support measures)
• more govt commitment to support banks & corporates (for liquidity and credit
needs), regulatory measures to facilitate creditor coordination
• Rely less on exports & promote domestic consumption/demand while avoiding
protectionist behaviors
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Like other EMEs, Africa exposed to spillover effects of financial crisis to real
economy & deleveraging from developed countries
Oil exporters & financially more developed countries hardest hit initially
Main concerns: Tightening of global credit => Capital & FDI inflow, tourism,
textiles & remittances revenues ↓; too thin domestic markets may not be able to
accommodate demand for credit =>↑ credit & liquidity risks
Last hour: Outlook slowing improving (recovery in commodity prices & growth
prospects + return of risk appetite =>resumption of foreign portfolio inflows) –
Africa will benefit from these with delays, though…
Risks remain: confidence still fragile, weak bank balance sheets, lower than
expected global growth, constrained international bank lending & questions on
fiscal sustainability of public sector support & exit strategies adopted in
developed countries that may have adverse effects on EMEs & Africa…
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SSA countries have fewer & less effective policy instruments: fiscal multipliers are
lower, financing constraints more binding, debt sustainability issues more
pressing, monetary policy options limited by currency arrangements
Countercyclical monetary policies:
1st half: high commodity prices => tightening of monetary policies
Since 2nd half: ↓ commodity prices => loosening of monetary policies
Exchange rate depreciations may ↑ export-competitiveness, but may ↑ inflation
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Less developed fin. markets => delayed crisis effects via ↓ commodity prices,
liquidity hoarding & capital repatriation by foreign banks & investors
↓ in commodity prices & demand and lower capital & FDI and remittances => ↓
trade flows => ↑ current account deficit & fiscal deficit & ↓ GDP
Tighter global funding conditions => spillover effects => ↓ money supply
Sovereign spreads back to pre-crisis levels after peaking around end-08
Conditions in equity markets improving, but still a long way to go
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Good liquidity management by the CB, both in calm & turbulent times –
good & timely forecasting + ability to carry out operations with the necessary
tools independently & to communicate clearly its intentions (esp on UMP &
exit strategies)
Need of close coordination between monetary & fiscal policies & the role of
govt support & UMP when conventional monetary policies reach their limits
CBs to understand better asset-price & credit boom formation & associated
risks & take necessary measures to counter them in a timely & smooth
manner
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Thank you….
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Supportive charts…
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