Conducting monetary policy How does a central bank go about changing monetary policy? The basic approach is simply to change the size of t...
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
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