Monetary Policy when Short-Term Interest Rates are Close at Zero - Essay Example

Monetary Policy when Short-Term Interest Rates are Close at Zero In order to boost an economy often the central bank of the country lowers the interest rate as a means of monetary policy. A reduced rate of interest will encourage investment and thereby the aggregate demand and output. (Branson, 1995; Froyen, 2002) Such reduction might also gradually approach to zero and since nominal interest rate cannot be negative, hence no further reduction is possible. In this situation monetary policy will lose one of the most vital armour from its arsenal that it used to control and influence the economy. This famous or infamous problem is known as the “zero bound problem” and had done havoc in 1930s USA as well as in Japan over the last decade. (Richard, 2008; Spiegel, 2006) Scholars believe that as the interest rate approaches zero or near zero monetary policy cannot operate or becomes ineffective if further stimulus needed to boost the economy or to rescue it from any prolonged economic stagnation. (Sellon, 2003) The monetary policy of the central bank operates through the alteration of price and volume of the reserve and settlement balances those other banks and financial institutions keep in hold at the central bank. If the central bank supplies more reserve at the current rate of interest then this will push the rate of interest down; this follows a simple demand supply interaction and is the result of excess supply of commodity (reserve) at the current price (interest rate). Central bank’s prime objective is price stability and sustainable economic growth and to achieve that it increases the supply of money to that extent that will allow the desired level of inflation and fulfil its growth objectives. (Sellon, 2003; Froyen, 2002; Branson, 1995) This is known as quantitative targeting and nowadays seldom practised by the central banks. In recent time most of the central banks have shifted to interest rate targeting from quantitative targeting and that on valid ground. Quantitative targeting requires a clear knowledge on the exact demand for money of the economy along with the banking behaviour. Owing to financial deregulation and innovation in banking sector both demand for money and banking behaviour has undergone considerable transformations in recent time and therefore involves significant risks in terms of quantitative targeting of the reserves. Interest rate targeting is technically much easier and it comes with much clarity. The clarity in interest rate targeting comes from the fact that it is a numerical value that offers a much clearer vision of short and long run monetary policy to the economic agents participating in financial market. (Sellon, 2003) However interest rate targeting has its complication and that arises from the zero bound problems. Lowering the interest rate, as a means of monetary policy is possible till it reaches zero and once it touches that mark further reduction is impossible. At this juncture the central bank will have to change its policy for further relaxing the monetary policy and might well again fall back to quantitative targeting for meeting long run goals. Quantitative targeting is bereft of this problem and only limited by the ability of the central bank to purchase long term or short-term assets together with the ability of providing fund through discount window. (Sellon, 2003) The immediate impact of zero bound would be on the market for reserve balance. The reserve balance market serves as a place of interaction among depository institutions where they get rid of their excess or deficiency of reserve balance. In order to reach the zero bound all the depository institutions need to be in excess reserve; otherwise any sort of extra demand for reserve from any of the institutions will put an upward pressure on the rate of interest and will result in a positive rate of interest. Hence the market for reserve balance would cease to act at zero bound. If the central bank now injects any more reserve into the reserve market to increase the supply of reserve even further; the depository institutions do not have any incentive to extend that extra reserve as a loan or to purchase any earning assets and might simply hold it as excess reserve. As the overnight rate falls to zero; investors extend the maturity term of their investment in hope of higher yield in a later time frame. Thus other interest rate in short term money market follow suit. These low rates of interests might cause problem for money market funds that are exclusively indulged in short term investment. They might experience an outflow of fund and thus an inevitable shrinkage in size as well as in number of money funds. Furthermore the money funds are the largest investor in commercial paper market thus a negative impact on them will bring the same fortune for the commercial paper market. This way the monetary transmission mechanism gets negatively affected in zero bound. However this impact can be reduced if the withdrawn funds of the investors get deposited in banks and the corporations approach banks for funds. Though impact on monetary transmission mechanism will get reduced through this process yet economic inefficiency in form of costly loans would prevail in the economy and thus the detrimental effect of zero bound cannot be ignored. (Sellon, 2003; Bernanke, 2004) In order to grasp the opportunity of monetary policy at zero bound; understanding the mechanism of monetary policy influencing the economy is necessary. The central bank can resort to any of the three available channels while considering monetary policy actions. Monetary policy by central bank can be implemented by influencing the short-term interest rate, altering the reserve requirement or adding extra reserve, and by directly affecting the long run interest rate. Any change in short-term interest will directly influence short run behaviour of consumer and business spending. Furthermore if that change eventually transmits to long run interest rate then the construction industry might get influenced and so as the fixed component of business investment. If instead of the short-term interest rate reserve requirement is lessened or extra reserve is injected into the banking system; then this will definitely result in increased loan volume together with n increase in the volume of investment in securities. These are the most rational steps available to the banks since keeping idle excess reserve would not be drawing any profit. This higher level of credit creation will lead to greater level of economic activity and simultaneously reduce the long run interest rate. The central bank if resort to the purchasing of long term securities or gets indulged in changing the expectations regarding the future monetary policy then it can also directly influence the long-term interest rate. These three channels are open options to all the central banks and they can resort to any of them with almost equal ease and effect while applying monetary policy. At zero bound any further lowering of short-term interest rate would be impossible. Hence for generating economic stimulus or to indirectly lower the long-term interest rate; downward adjustment of short-term interest rate as a means of monetary policy would no longer be a viable option to the central bank. However the other two channels still remains operative at zero bound and thus the central bank might resort to them in case it needs to provide any further economic stimulus at zero bound. (Sellon, 2003) The central bank can increase the volume of reserve available to the banking system even at zero bound. (Bernanke, 2004) This excess reserve would not be left idle by the banks rather they would be extending the added reserve as loan or might invest in long term assets and securities. This kind of credit creation and investment in long term securities would lead to the lowering of mid term and long term interest rates. However as discussed earlier that at zero bound banks are bereft of any incentive to use this excess reserves in credit creation or long-term asset acquisition. Therefore quantitative reserve targeting as a means to ease up the economy at zero bound might not be a viable option. Interestingly the above argument against quantitative targeting as a solution to zero bound problem holds as long as banks consider the excess reserve as a temporary phenomenon. It is true that if these excess reserves are temporary then there is no use to lend them at zero return in overnight reserve market. In contrast if the banks assume that these excess reserves are permanent then they will definitely invest this sum in earning assets having positive risk adjusted yield. Furthermore the reserve multiplier will come into play and banks will get indulged in multiple expansions of credit and thereby boosting the economy. However the earlier mentioned problem regarding quantitative targeting associated with an exact knowledge of the money demand of the economy will still remain and might seek a trial and error approach on behalf of the central bank in determining the exact level of reserve that should be injected into the banking system to get the desired result. Such a trial and error obviously will burden the economy with erratic outcomes and the economic agents might have to endure lots of friction before the restoration of equilibrium. The success of quantitative targeting mainly depends upon the stimulus it can develop from banking sector. This stimulus as discussed is the combined effect of higher level of credit creation and long term earning asset acquisition. It has been historically observed that when rate of interest is at a very low level; economic activities also follow a low pace. The demand for loan as well remains at a very low level during this time. Both of these combined puts a question mark against the efficient operating of the quantitative reserve targeting at zero bound and thus as a successful policy prescription against the same. (Sellon, 2003) Another option that the central bank has is to target the long-term interest directly without getting involved into quantitative reserve targeting. Purchasing of long-term securities in large volume would lead to higher demand for them and thus their price will move up and yield will decline (since price and yield are inversely related). On the other hand central bank can also put a ceiling on these securities at a targeted rate through purchasing of any securities having yield above the targeted rate. Usually the central bank sets a specific interest rate on these long-term securities and that below the current market rate of interest. Whenever the market rates pushes over this ceiling the central bank can buy back additional securities to keep the interest rate at the targeted level. Another alternative way to control the long-term interest rate can be through a shift of purchase from short-term securities to long-term securities in open market. (Bernanke, 2004) Unlike setting a ceiling on the yield to a pre specified level, here the rate of interest gets checked through the volume of purchase of long-term securities by the central bank in open market. (Portze, 2008) Along with these policies to affect the long-term interest rate directly; central bank often resorts to another way to influence the long-term interest rate. Often a central bank simultaneously sells short-term securities and purchases long-term securities. Selling of short-term securities pushes the short-term interest rate at an upper level and thereby acts as a counter veiling measure against the zero bound and as usual purchasing of long-term securities pushes its yield down. When the central bank indulges in purchasing long-term securities alone then it results in expansion of bank reserves. However when it gets involved into selling of short term securities and purchasing of long term securities simultaneously then owing to the offsetting power of sale of short term securities over the purchase of long term securities no addition to the bank reserves is accomplished. It has been historically found that central banks seldom get involved into directly influencing the long-term interest rate. This averseness has developed mainly owing to four reasons. Firstly, the long-term interest rate targeting through purchase of long-term securities suffers from the same problem as quantitative reserve targeting. It is hard to determine the exact volume of long-term securities that should be purchased in order to keep the long-term interest rate at the desired level. Secondly, at zero bound if the central bank purchases large volume of long term securities then it might have to incur huge loss once the economy bounce back and the rate of interest pushes upward. Thirdly the central bank is reluctant to leave any impact on the interest rate structure. The short term securities are much more liquid than their longer version, therefore the operation of central bank in short term securities market leaves almost no impression on the interest rate structure which is not possible while operating in long term securities. This might result in bad allocation of credit. When the central bank operates through the reserve market credit allocation is accomplished through demand supply interaction among the banking system and therefore is considered as more efficient form of economic allocation. Fourthly as the economic recovery begins and the rate of interest pushes upward; investors in long-term securities would court the possibility of huge loss. At this point if the central bank has previously announced a ceiling on the yield of the long-term securities; the investors would expect the bank to keep its word and purchase the securities at their disposal. This will increase the central bank’s reserve at the cost of huge loss considering the changing market scenario with increased rate of interest. Again the central bank would feel the necessity to stop this policy at once in order to stop the inflationary pressure that have already began to build up. A decision-making dilemma on behalf of the central bank and the government starts at this point, since the government is against the abolition of this policy owing to the rise in borrowing cost that such action will initiate. The economic agents indulged in financial market would now doubt the clarity in central bank’s action regarding its commitment towards price stability in the long run. This will lead to further catastrophe putting added pressure on rate of interest owing to inflation premiums. (Sellon, 2003) At zero bound Central bank might also resort to managing market expectations about future monetary policy and thereby lower the long-term interest rate. Statement of the bank regarding the future policy course is of substantial effect considering the control of the long-term interest rate. The bank can either issue an open ended or an explicit statement regarding its future policy action. An open-ended statement gives the bank relative flexibility regarding future policy action. However it is less effective regarding lowering the long term interest rate and might also ignite a rapid rise in rate if the economy bounces back earlier than expected. It is regarded by the economic agents involved in financial market that an open-ended statement reflects the temporary nature of the current monetary policy. An explicit statement or commitment on the other hand has a much better effect on lowering the long term interest rate, however if the economy experience a quick recovery shattering all the expectations then the bank might ponder over its long term commitments and regret not to be able to adopt a policy change. Since the main objective of the central bank is to attain price stability in long run and to lower the long term interest rate therefore an explicit commitment strategy based upon a targeted inflation rate would be superior to open end statement based upon short run economic goals. (Bernanke, 2004; Bernanke et al., 2004; Sellon, 2003) The above discussed policy options might fall sort of providing the necessary economic stimulus if the short and long term interest rates both approach zero, like what happened in Japan over the last decade. (Sellon, 2003; Richard, 2008; Spiegel, 2006) In that scenario the central bank might resort to bit unconventional measures including exchange rate depreciation, a mix of monetary and fiscal policies and direct participation of the central bank in financial intermediation. Even at zero bound exchange rate depreciation can stimulate the economy by decreasing the price of export thus raising its volume and on the other hand increasing the price of imports thereby decreasing its volume. However, lowering the value of domestic currency against the foreign currency can be attained in two ways. Lowering the domestic interest rate will result in outflow of foreign funds and thus the same volume of domestic currency will remain against less volume of foreign currency leading to less value of domestic currency against foreign one. Otherwise the central bank can directly intervene into foreign exchange market and purchase the necessary foreign exchange to keep the price of the domestic currency against the foreign currency at its desired level. (Krugman and Obstfeld, 2004) Since at zero bound the short term interest rate can not be lowered any further hence the bank needs to directly intervene into the foreign exchange market if it wishes to currency devaluation. The success of this policy at zero bound depends upon two factors; the size and term of central bank intervention into foreign exchange market and the response of foreign central banks courting an appreciation of their currency. If the foreign central bank does not consider a currency appreciation as a viable option for its domestic economic well being then it will intervene as well and we might see a price war leaving the domestic currency at its original level against the foreign currency. (Sellon, 2003) A coordinated fiscal and monetary policy stimulus can also be effective at zero bound in providing economic stimulus. Increasing government spending would boost the economy and lead to the rise in output. The spending can be financed through increased level of taxation or by selling government bonds. However as the supply of the bond rise its price declines and the market rate of interest pushes up. This rise in interest rate reduces the investment and thus the initial economic stimulus that was generated through increased government expenditure gets partially reduced through crowding out effect. Increased government expenditure can also be financed through selling of government securities to the central bank. In this manner the market rate of interest would not rise and thereby no risk of crowding out effect. However if this policy is adopted then the central bank is literally financing the increased government expenditure by printing money. This will increase the volume of money available to the economy and in the long run will lead to severe inflationary pressure. (Sellon, 2003; Miles, 2009; Branson, 1995; Froyen, 2002; Dornbusch and Fischer, 1994) It has been historically found that over dependence on the banking sector together with an underdeveloped capital market often leads to economic catastrophe in case inefficiency creeps up into the banking system. In this scenario central bank’s intervention in developing an efficient and developed capital market is considered as a shield against this risk. At zero bound if the banking system ceases to function efficiently; it is expected that the capital market will remain unaffected and provide an avenue for shy of relief. The relatively less impact on USA economy following the 1990s banking crisis (the capital market in USA remained fairly unaffected during this crisis) in comparison with the same of 1930s provides strong ground for the establishment of a well developed capital market through the intervention of the central bank. (Sellon, 2003; Duthel, 2008; Protze, 2008) The above discussions on policy options to the central bank at zero bound reveals the fact that the central bank is still left with a series of traditional and non traditional policy measures at zero bound that can effectively inject stimulus into the economy. However all these options involve own costs and risks and minimization of that depends upon the efficiency of the central bank in communicating with the economic agents involved in financial market together with the common public. References Bernanke, B.S. (2004), Conducting monetary policy at very low short-term interest rates, BIS Review. Available at: http://www.federalreserve.gov/pubs/feds/2004/200448/200448pap.pdf (accessed on October 27, 2010) Bernanke, B.S., Reinhart, V.R. & B.P. Sack, (2004), Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment, Brookings Panel on Economic Activity, 1-86. Available at: http://www.bis.org/review/r040121e.pdf (accessed on October 27, 2010) Branson, W.H. (1995), Macroeconomic Theory and Policy, A.I.T.B.S., New Delhi. Dornbush, R & Fischer, S. (1994)., Macroeconomics, McGraw-Hill, Inc., New York. Duthel, H. (2008), From the Caves, to the Moon, to the Caves – the End is Near, Lulu.com. Froyen, R.T. (2002). Macroeconomics: Theory and Policies, Prentice Hall, New Jersey. Krugman, P.R. & M. Obstfeld, (2004), International Economics, Pearson Education Miles, D. (2009)., Money, Banks and Quantitative Easing, BANK OF ENGLAND, 1-18. Available at: http://www.bankofengland.co.uk/publications/speeches/2009/speech404.pdf (accessed on October 27, 2010) Protze, L. (2008)., Zero lower bound and monetary policy in the euro area, Diplomica Verlag. Richards, J. (December 2008), Quantitative easing: Lessons from Japan, Economists’ Forum, Available at: http://blogs.ft.com/economistsforum/2008/12/quantitative-easing-lessons-from-japan/ (accessed on October 27 2010) Sellon, G.H. (2003), Monetary Policy and the Zero Bound: Policy Options When Short-term Rates Reach Zero, Economic Review, Fourth Quarter Spiegel, M. (2006), ‘Did Quantitative Easing by the Bank of Japan “Work”?’, FRBSF Economic Letter, 28, 1-4, Available at: http://www.frbsf.org/publications/economics/letter/2006/el2006-28.pdf (accessed on October 27, 2010) . Read More