Monetary policy

Monetary policy is the process by which the monetary authority manages the money supply, and the chief mechanism is through interest rates. You may hear in the news that “the Bank of England has cut interest rates” – this topic will help you understand the models and assumptions that guide their decisions. You can consider this chapter to be a basic training guide for central bankers. This topic will cover a lot of ground but tries to give you a relatively simple, usable framework to relate monetary economics to monetary policy decisions.

We often hear that central banks are “independent”, and while this is an important trend it is often overstated. In reality all major central banks are owned by the government and operate under licence. The government grants the central bank its powers – it decides what target they should hit and what tools they have at their disposal. Therefore it’s important to stress that central banks only have operational independence. They only have the freedom to decide how best to hit their assigned target with the tools they’ve been authorized to use. Indeed different central banks have slightly different goals.

The US Federal Reserve (or “Fed”) has a “dual” mandate of delivering both low inflation and low unemployment.

It used to be the case that the monetary authority would attempt to deliver numerous objectives and be given a fairly large amount of scope in terms of how they went about doing so. But there is a dismal track record of failure. Generally speaking the use of “discretion” became superseded by the adherence to publicly known “rules”. Since we do not have confidence in policymakers’ ability to fine-tune the economy we only grant them the ability to act within the constraints of clear frameworks. Also, such rules reduce uncertainty about what actions central bankers may take, and therefore help manage expectations.

Central bank tools and targets

We can list some of the more famous monetary policy rules.

A money growth rule was advocated by Milton Friedman, the father of modern monetarism, and it is simply the logical appli- cation of the quantity theory. If inflation is caused by increases in the money supply, and you want low and moderate growth in output, the implication is to increase the monetary base by a low and moderate amount. Friedman suggested 2% per year. That’s it. No policy committees, no discussions, no judgement. You could even program a computer to ensure that the monetary base grew at 2% per year and this would deliver as close to monetary stability as we can hope for: M = 2%

The central bank is committed to using the interest rate to keep inflation within a publicly known range.

One way of doing this is by using some sort of benchmark, such as a Taylor Rule. Instead of using the monetary base as the tool of monetary pol-icy, some economists advocate the use of interest rates. John Taylor pioneered a rule that allows policymakers to plug in real data and see what the optimum interest rate should be. A simple version is:

Taylor rule = 1 + (1.5 × inflation) (1 × unemployment gap)

Imagine that the economy is growing at 3%, and there is an inflation target of 2%. We can use the quantity theory to show that the equivalent NGDP target would be 5%. Therefore a policy option would be to adjust M in response to changes in V such that P + Y = 5%. One advantage that NGDP targets have over an inflation target is that this allows productivity improvements to manifest themselves as lower prices. Another advantage is that it allows prices to rise when there is a negative real shock. If there is a natural disaster, for example, prices should rise because they should reflect real scarcities.

Despite listing the above as rules there is a lot of discretion involved in how they are implemented. Ideally, a rule will be so clear that it doesn’t matter who – if anyone – is implementing it. It used to be the case that central banks would try to influence a range of macroeconomic variables, but from the 1990s there was a trend to focus purely on price stability. This is partly as an attempt to limit the scope of what they’re trying to accomplish (and thus make it more likely that they’ll succeed), and partly because economists feel that if price stability occurs then the rest (strong GDP, low unemployment, stable value of the currency) will fall into place.

The evidence of recent decades, both from the United States and other countries, supports the conclusion that an environment of price stability promotes maximum sustainable growth in employment and output and a more stable real economy

Ben Bernanke, 2006

Policymakers therefore tend to focus on fighting inflation, and we can view inflation in three ways (see DeLong 2022, p. 184):

  1. As a tax – it means that your cash is worth less when you spend it than when you received it.
  2. As a rearrangement – people who borrow money gain while those who lend money lose.
  3. A source of confusion – it messes up the economic calculations that we make because our accounts will include prices from different dates with different purchasing power.

If interest rates go up it becomes more attractive to save, mortgages become more costly, and therefore people will reduce their consumption. It also becomes harder for firms to finance their capital projects and so investment falls. Therefore there’s a negative relationship between interest rates and total spending. Similarly if interest rates are cut we would expect people to consume more (they will choose to save less) and businesses will borrow more for investment spending. Again, there’s a negative relationship between interest rates and total spending.

If the economy is reasonably close to full employment then increases in aggregate demand will bid up prices, while falls in aggregate demand will cause prices to fall. We therefore have a very crude framework for policy decisions:

  • If inflation is >2% the economy is overheating so you increase interest rates, reduce spending, and reduce aggregate demand
  • If inflation is <2% the economy is slowing down so you cut interest rates to boost spending, and boost aggregate demand.
  • If inflation is =2% it is on target and interest rates are about right.

This sounds very simplistic, and you might expect that central bankers have complicated models to predict by exactly how much they need to change interest rates to get a given change in inflation. But economists are pretty bad at making forecasts, and therefore some prefer to rely on what we know about the past rather than what we don’t know about the future. In addition what we do know about the way interest rate changes feed through into the economy is that they have “long and variable lags”. Central bankers will tend to be quite conservative and make changes at discrete intervals, before waiting to see what the impact is. The rule of thumb is that any change in interest rates will show up in inflation and output around 18 months later, and you need a 1% cut in interest rates to increase CPI by 0.5%. Therefore lots of tweaking and fine-tuning will create chaos. Policymakers often prefer to act cautiously and wait to see what the impact of a raise or cut is before acting further.

This is a good explanation of current Fed policy:

The main policy rate that central banks influence is a short- term risk-free rate. The idea is that this acts a benchmark for other interest rates, and we can sketch out a rudimentary transmission mechanism:

  1. Short-term risk-free rate – i.e. a policy rate, or (central) Bank Rate, that bridges banks with the central bank
  2. Money market rates – i.e. an interbank rate, such as LIBOR, that bridges banks with other banks
  3. Rates on bank loans and deposits – i.e. a prime rate, or base rate, that bridges banks and their customers
  4. Financial asset prices

There are essentially two ways for the central bank to affect the short-term risk free rate.

Through supply

Recollect that the monetary base comprises (i) reserve balances and (ii) currency. The central bank can create as many bank reserves as it wishes, and thus hit any level of the monetary base it desires. Obviously the broader the measure of the money supply being used, the less control the central bank has. One of the lessons of the Great Depression is that it is possible for a central bank to attempt to increase the money supply (by increasing the monetary base), only for it to be offset (rather than amplified) by a contraction in bank lending and other components of the broad money supply. In other words, the bridge of intermediation can collapse.

Central banks alter the amount of reserves through the pro- cess of open market operations (OMO). This involves the buying of securities or the lending against collateral using newly created money. If the central bank wishes to increase the monetary base by £10bn, they simply buy £10bn worth of financial assets (such as government bonds) and credit the accounts of the purchaser. The recipient of the money will then spend it and it works its way through the financial system. If the central bank wishes to decrease the monetary base, they can sell off some of their existing assets and retire the money they receive. Some people find it odd to imagine a central bank destroying money, but every day there are new bank notes being printed to replace old ones. All they need to do is ensure that slightly fewer new ones are released. When it comes to electronic accounts it is even easier.

Through demand

Here the aim is not really to hit a particular quantity of reserves, but to focus on price. And in this context the “price” of reserves is the short-term risk-free interest rate. Central banks influence the demand for reserves through operational standing facilities, which are not as complicated as they sound. Here’s how it has traditionally worked in the UK:

  • Commercial banks choose a target amount of reserves that they wish to hold.
  • They receive Bank Rate on those reserves.
    • If they have more reserves they can use a deposit facility within the Bank of England, which earns a rate below Bank Rate.
    • If they have fewer reserves they can borrow from the Bank of England at a rate above Bank Rate (details of this are published a month later so that there’s no negative publicity).

From around 1997 to 2007 the system of inflation targeting seemed to be working. CPI was being kept fairly close to target, GDP was growing and the currency was stable. And then the financial crisis occurred.

Most of us – I was one – thought we had at last found the holy grail. Now we know it was a mirage

Martin Wolf

Emergency monetary policy

Thus far we’ve said that if the central bank wants to increase aggregate demand they will cut interest rates. So what if interest rates have been cut so much they can’t go any lower? This is the conventional explanation for why fiscal policy is necessary, and we will look at this in the next chapter. But before we do, I want to stress that it is a myth that the short-term risk-free rate is the only tool of monetary policy. If you look at the transmission mechanism mentioned previously, we can think of other ways for the central bank to influence the economy.

This is where the central bank targets the quantity of assets bought rather than the price (i.e. the interest rate).

There are two main ways in which QE is supposed to work. The first is the liquidity channel. If banks have more money they should increase their lending to consumers and this directly increases the broad money supply. The second is the yield channel. When the central bank buys assets this bids up their price and therefore reduces the yield. Sellers that receive the new money will substitute into other assets that have relatively higher yields (e.g. company shares or bonds). This bids up those prices as well reducing yields across the entire market. As we know there is an inverse relationship between interest rates and aggregate demand, so this should boost economic activity. If the transmission mechanism breaks down, the central bank moves its focus from stage 1 to stages 3 and 4. Instead of looking at interest rates to see whether monetary policy is easy or not, you must also look at the size of the central bank balance sheet.

The reason QE is controversial is because the central bank is financing government debt. The reason they focus on government debt is because this is the “risk-free” benchmark, and relatively neutral. Imagine the controversy if the Bank of England directly facilitated the debt of individual firms. How would they choose which ones to buy without being accused of favouritism and corruption? But hyperinflation is always down to one arm of the government financing the debt of the other. In theory this isn’t the case in the UK or US, because the central bank is not allowed to directly purchase government debt. But note the profit opportunity being presented to commercial banks. You know that the government is issuing lots of debt, and you know that the central bank is committed to purchasing lots of it. All you need to do is buy from one and sell to the other. Whether or not you use the proceeds to grant more loans to your customers, or whether you simply park it in your reserve account that generates a risk-free return, is up to you.

In December 2012 the Federal Reserve adopted a policy of forward guidance. This can be viewed as an attempt to target expectations. They make a commitment to keep interest rates at a low level until a specified threshold is met. For example, until unemployment falls below 6.5%. One of the problems with this is that there are conceivable scenarios where you’d want to increase interest rates despite unemployment being above the threshold. In response to this the central bank will incorporate various “knockouts”. For example forward guidance is abandoned if inflation rises above 2.5%, or financial market stability is threatened. But the fact that these can be somewhat ambiguous demonstrates that forward guidance is a discretionary (rather than rule-bound) policy.

As briefly discussed, some central banks have also adopted a negative deposit rate. Sweden adopted one in July 2009 and the ECB followed in 2014. By charging interest on reserve balances the central bank is incentivizing commercial banks to reduce their reserve assets and increase their lending.

Finally, helicopter money is when the central bank prints money and gives it to people directly. This will unambiguously increase the money supply and boost AD.

Everybody accepts that the government has an incentive to inflate, and therefore it is difficult for them to credibly commit not to do so. If the market expects low inflation, then a burst of inflation will temporarily boost employment (and indeed monetize debt). So policymakers are in a game – they have an incentive to renege on promises as soon as they are trusted, and this would prevent trust from developing in the first place. This is known as the time inconsistency problem. The key issue in monetary policy is how can governments credibly commit to a low inflation environment?

In conclusion, there are some generally accepted points about monetary theory that are worth holding dear. Firstly, inflation is a monetary phenomenon – the root cause is excessive money creation. Secondly, money is not neutral; therefore monetary growth can affect real variables and cause misallocations of capital. Monetary stability is crucial for a prosperous society.

In each instance we are simply using money to measure the value of something else. Money doesn’t have a “price” of its own.

Because money is traded on all markets and on none specifically its own,
and because it has no specific price of its own to come under specific pressure,
an imbalance between its supply and demand has far-reaching consequences.

Leland Yeager

If there is a problem in the market for shoes, then it is the price mechanism that will adjust to find equilibrium. It won’t adjust immediately, and we would expect to see harmful spillovers into the market for leather, or shoe polish, etc. But it won’t cause a system-wide problem. Money on the other hand is one half of all economic exchanges. If there is an imbalance between the demand for and supply of money, there is no single market that can adjust. Every market in the economy will be affected.

  • The EconTalk podcast, and the episodes with Milton Friedman on Money (August 28th 2006), Allan Meltzer on Inflation (Feb 23rd 2009), and Charles Calomiris on the Financial Crisis (Oct 26, 2009), are particularly relevant for this session.
  • I also recommend the episode of Macro Musings called Scott Sumner on The Money Illusion (October 2021)
  • This episode from Conversations with Tyler, Mark Carney on Central Banking (May 2021) does a nice job of setting the objectives of a central banker, in a modern economy, related to issues such as climate change and digital currencies. It provides an engaging awareness of some of the differences between major central banks.
  • The Macro Musings episode with Jens van ‘t Klooster on Recent ECB Policy (May 2022) discusses the recent change in the ECB’s remit, how ECB actions differ from the Federal Reserve, and does a really nice job of whether the 1990s model of central banks is outdated and needs to evolve due to changing circumstances and priorities (such as climate change and elevated sovereign debt).