Monetary Policy

Monetary Policy is another demand management policy that can be used to influence aggregate demand, inflation and employment (also national income).

In an advanced economy, money performs three key functions:

• A means of exchange – money is used for purchasing goods and services;
• A unit of measurement – money measures and compares prices, incomes and profit; and
• A store of value – money can be saved and thus used for future transactions

An important role for the government is to ensure the stability of the financial system.

• In most countries this was the original reason for the creation of the central bank.
• In Australia, the central bank is the Reserve Bank of Australia (RBA)
• In the United Kingdom it is known as the Bank of England and the central bank is called the Federal Reserve (The Fed) in the United States.

The RBA’s Objectives:

• The stability of the currency of Australia (Internal and External)
• The maintenance of full employment in Australia; and
• The economic prosperity and welfare of the people of Australia.

Stability of Currency: Since 1992, the RBA has followed the objective of keeping consumer price inflation between 2 and 3 percent, on average, over the course of the business cycle.

‘Economic prosperity and welfare’ can be taken to mean the achievement of rising living standards in the long term (economic growth), along with the management of the business cycle through monetary policy.

‘Full employment’ can be taken to mean achieving the ‘natural’ rate of unemployment, which is currently thought to be about 4 percent of the workforce.

• At this level cyclical would be closer to zero, but there would be some frictional and structural unemployment

Reserve Bank is independent!

• Independence prevents manipulation of interest rates for political ends and keeps monetary policy focused on RBA goals.

Interest rates represent the price of credit - payment from borrowers to lenders for the use of funds.

• A household taking out a loan at 7 percent interest rate per annum will pay $7 in interest for every $100 borrowed.
• Likewise, interest rates represent the return for saving surplus funds.
• Interest rates can also be thought of as the opportunity cost of money, in the sense that holding money forfeits the return that could have been earned by depositing the money in an interest-bearing account.
• The interest rate in a particular market is the price that equates the demand and supply of funds.
• Savers determine the supply of funds while borrowers determine the demand for funds.

Because a large proportion of transactions in our economy rely on credit and borrowing, changes in interest rates can have a significant effect on the level of spending and economic activity

• If you aren’t borrowing money, you’re saving money

The real interest rate is the nominal rate minus the rate of inflation.

• For example, if the nominal interest rate is 7 percent and the expected inflation rate is 2 percent then the real interest rate would be 5 percent

The RBA adopted an ‘inflation-targeting’ focus in 1993, after previous approaches to monetary policy had not delivered acceptable price stability and macroeconomic outcomes.

Inflation is regarded as a risk to the economy because it:

• Erodes real income (spending power);
  • Banks will want to protect themselves from the lessening of purchasing power in the future due to inflation
• Leads to higher interest rates, creating a disincentive to private sector (I) borrowing and spending.
• Decreases a country’s international competitiveness;
• Increases uncertainty
• Encourages investment in non-productive assets; and
  • Divert cash into value holding assets
• Undermines the value of the currency.

The headline rate can be adjusted to estimate an ‘underlying’ or ‘core’ rate of inflation.

• Core is underlying minus food and energy which are volatile

The natural rate does gradually change over time due to changes in the structure of the labour market and changes in government policy.

In conventional monetary policy, The Interbank Overnight Cash rate (Cash Rate) is the main policy tool.

Commercial banks have accounts with the central bank like how we have accounts with the commercial banks.

Monetary Policy: Stances

Stances

• In general terms, an UPWARD CASH RATE MOVEMENT over a period of time is described as a ‘CONTRACTIONARY’ monetary policy stance, (Tight monetary policy)
• A DOWNWARD MOVEMENT is an ‘EXPANSIONARY’ stance. (Loose monetary policy)

A stance is not necessarily just labelled by whether rates are rising or falling.

• A bench mark that is sometimes used to help understand the monetary policy stance at any point in time is the neutral rate.
• The ‘neutral rate’ is the real policy rate that is neither expansionary nor contractionary

The term ‘real policy rate’ refers to the nominal cash rate adjusted for inflation – the current cash rate minus the underlying inflation rate in the last quarter.

It is useful for assessing the stance of monetary policy at any point, but there is no direct way of observing or calculating the rate.

• Reserve Bank research papers estimated a neutral rate between 3 and 4 percent over the period 1990 – 2007, after which it has declined steadily and may have been around 0.5 percent at the start of 2020 due to the long period of slow growth after the GFC.
• At the time of writing (late 2022), the neutral rate would have risen somewhat because inflation is rising.

The Transmission Mechanism

The Transmission Mechanism

• Changing interest rates flow through to aggregate demand because they influence:
  • Incentive for decisions to save, borrow or invest - saving & Investment channel
  • The cash flow of households and firms - cash flow channel
  • Asset prices and perceived wealth; and - wealth channel
  • The exchange rate - exchange rate channel

Savings / Investment Channel

• Changes in interest rates have important effects on households’ decision to save or borrow, and firms’ decisions to invest.
• Rising interest rates increase the incentive to save because higher rates deliver higher interest payments.
• Higher rates also increase the opportunity cost of spending – if it chooses to spend, a household forgoes the opportunity to save surplus funds in an interest –earning deposit.
• Businesses often borrow to invest, so a rise in interest rates will reduce the demand for business loans because of a lower potential return on investment.

Cash Flow Channel (“Money in your pocket”)

• Another way to understand the transmission is to understand how higher rates affect cash flow of households and firms.
• Households that are ‘net savers’ will benefit from higher interest payments, whereas ‘net borrowers’ will have to meet larger monthly repayments on their loans.
• Most firms are net borrowers, so rate increases leave less free cash to pay expenses, expand production or increase employment.

Wealth Channel (Key Point: Wealth Effect)

• Rising interest rates make the ownership of alternative financial assets such as shares and property seem less attractive because the relative returns of those assets declines.
• If asset prices decline, or rise at a slower rate, so does the ‘on paper’ wealth of households with property holdings and /or share portfolios.
• The perception of falling wealth tends to lead to fall in household discretionary spending (a negative wealth effect), and could reduce the equity households can offer when approaching a bank for a loan.

Exchange Rate Channel

• Changes in interest rates impact on exchange rates, because financial capital is highly mobile.
• If Australian rates are above overseas rates, capital inflow will increase demand for the currency and lead to an appreciation of the AUD.
• Other things being equal, a higher dollar will reduce aggregate demand because:
  • The competitiveness of exports in overseas markets suffers as overseas residents pay more for the products they buy; (X)
  • Imports become cheaper for Australian household; (M)
  • Import-competing firms in Australia have to compete with those cheaper imports.

Strengths

Flexibility

• RBA meets 8 times a year, so monetary policy is relatively flexible compared to fiscal.
• Interest rate decisions can be made without authorisation of parliament, which also adds to policy flexibility

Independence

• As an independent authority, Reserve Bank monetary policy decisions are independent of political bias.

Monetary policy is more effective in the control of high levels of aggregate demand and inflation than it is during the contraction or recession phase of the business cycle

A contractionary stance tends to have a greater impact than an easy monetary policy because higher interest rates have a more direct effect on household and business decisions than do lower interest rates.

Interest Rate - Exchange Rate Relationship (Positive)

• A cut in interest rates, for example, will lead to a fall in capital inflow
• This will reduce the demand for the currency and lead to a depreciation
• Net exports will be stimulated as prices fall in overseas markets , and imports should fall as prices rise. (?) – Improve this statement.
• Thus an expansionary monetary policy (reducing interest rates) will not only increase consumption and investment but also increase net exports.

Weaknesses

Both Fiscal and Monetary Policy suffer from time lags:

• The recognition lag – the time taken to recognise trends;
• The decision lag – the time taken to make policy decisions; and
• The action or effect lag – the time taken for policy decisions to have an effect on aggregate demand and the economy

The recognition and decision lags are short for monetary policy because the RBA Board meets monthly and its decisions are informed by recent data and expectations.

The effect lag is thought to be quite long, because the transmission chain from the policy to the impact on aggregate demand is indirect – through other interest rates and then the cost of borrowing , cash flow, asset price and exchange rate channels.

Not Effective in a Contraction:

• Monetary policy seems less effective in a contraction or trough – low interest rates don’t seem sufficient to stimulate private spending when economic conditions are pessimistic.
• Two of the four transmission mechanism channels are responsible for this weakness
• Businesses don’t necessarily react to lower costs of borrowing if they are not confident about economic prospects when aggregate demand is low - this explanation is relevant in the Australian case in recent years.
• Likewise, asset prices are influenced by many factors apart from the interest rate, especially expected future income that can be earned from an asset - this is influenced by confidence about the future

No Target

• Unlike fiscal policy, monetary policy cannot be used selectively to target particular groups or sectors in the economy.
• The reserve Bank cannot raise interest rates in Western Australia to curb a booming economy, yet leave them unchanged in the rest of Australia. (States’ differing performance)

Unconventional Monetary Policy

Conventional is the normal policy -> changing the interest rates

Unconventional monetary policy occurs when tools other than changing a policy interest rate are used. These tools include:

• forward guidance
• asset purchases
• term funding facilities
• adjustments to market operations
• negative interest rates.

Forward Guidance

• Forward guidance relates to the central bank’s communication of the ‘stance’ of monetary policy.
• It lets market participants and the general public know what the future path of the policy interest rate, and potentially other aspects of monetary policy, is likely to be.
• Forward guidance can be:
  • time-based; or
  • based on the state of the economy.
  • Under ‘time-based guidance’, the central bank commits to a stance of monetary policy until a specific point in time (e.g. it will not increase interest rates until a certain date).
  • Under ‘state-based guidance’, the central bank commits to a stance of monetary policy until a specific set of economic conditions are met (e.g. it will not increase interest rates until inflation or unemployment reach certain levels).
• A primary motivation for their forward guidance was to reinforce the central bank’s commitment to low interest rates, which helps reduce the interest rates people can expect in the future. (influence expectations)

Asset Prices

• Asset purchases involve the outright purchase of assets by the central bank from the private sector with the central bank paying for these assets by creating ‘central bank reserves’ (in Australia these are referred to as Exchange Settlement or ES balances).
• (Some people have referred to this as ‘printing money’, but the central bank does not actually print any banknotes to pay for the asset purchases.)
• When a central bank undertakes asset purchases, it can either set a target for the quantity of assets it will purchase (at any price) OR a target for the price of an asset (purchasing whatever quantity of assets will achieve that price); for a bond, the relevant price is its interest rate.
• A quantity target for asset purchases is also known as quantitative easing (QE).
• In this way, asset purchases by the central bank can lower a range of interest rates other than the policy interest rate

Term Funding Facilities

• Term funding facilities involve central banks providing low-cost, long-term funding to financial institutions at rates below the cost of most of their existing funding sources.
• Such facilities were used following the GFC and again more recently in response to the COVID-19 pandemic.
• Term funding facilities are useful when short-term interest rates are already very low, since they can help to lower the cost of longer-term funding for financial institutions.
• This helps to reduce interest rates for borrowers and support the supply of credit to the economy.

Adjustments to Market Operations

• In response to the GFC and later to the COVID-19 pandemic, many central banks made significant changes to their existing market operations to deal with strains in financial markets that were impairing the supply of credit to the economy.
• Changes to operations have included central banks:
  • providing much larger amounts of liquidity to the financial system than before the crises
  • expanding the range of collateral that they accept from financial institutions
  • increasing the range of ‘eligible counterparties’ that they allow to engage in domestic market operations.

Negative Interest Rates

• Negative interest rates are truly unconventional. They are also difficult to imagine, as they imply that instead of earning interest on money deposited in a bank, people would be charged by their bank to deposit money.
• Prior to the GFC, it was widely thought that there was a ‘zero lower bound’ for the policy interest rate, meaning that it was thought interest rates could never be negative.
• This was because if interest rates were negative, people would simply choose to hold their savings as banknotes outside the banking system (‘cash under the mattress’) so that deposits would be unavailable to banks for lending or other purposes.
• A zero lower bound did not prove to be a constraint.
• Policy interest rates became negative in several countries. However, commercial banks did not pass on negative policy interest rates and implement negative rates for all their customers – they judged that it did not make sense either commercially or politically to charge households and smaller businesses for holding their deposits.
• Nonetheless, there is still likely to be a lower bound.
• At some point depositors will withdraw money and hold banknotes, so central bankers began to talk about an ‘effective lower bound’ for policy interest rates rather than a zero lower bound.