Economics Explorer #3: Monetary Policy and the Economy

Economics Explorer Series Monetary Authority of Singapore 3 MONETARY POLICY & THE ECONOMY A closer look at the nuts and bolts behind monetary policy in Singapore – what its objectives are, how it is conducted by MAS, and how it affects the economy. Economics Explorer Series Monetary Policy & The Economy Monetary Policy Monetary policy refers to the actions taken by central banks to affect monetary and financial conditions in order to achieve broad macroeconomic objectives. By controlling the amount of money available, interest rates, or, in Singapore’s case, the exchange rate, central banks aim to influence the rate of change in the general level of prices in the economy. What Are The Objectives Of Monetary Policy? In the 1960s and 1970s, policymakers in many advanced countries believed that they could reduce unemployment by stimulating the economy with monetary or fiscal policy without compromising on low and stable price inflation. In hindsight, the unemployment target was set too low and when combined with the oil price hikes in 1973 and 1979, the result was unprecedentedly high inflation in the 1970s and early 1980s – dubbed the ‘Great Inflation.’ Many economists now believe that central banks should focus primarily on achieving price stability, or low and stable consumer price index (CPI) inflation of between 1–3%, in their conduct of monetary policy. This is based on evidence accumulated over many decades that countries with high inflation not only have higher price volatility, but also tend to have lower rates of economic growth. In contrast, in an environment of price stability, movements in the relative prices of goods and services can serve as clear signals to consumers, businesses and the government, so that resources are allocated efficiently. In addition, price stability encourages saving and investment as it prevents the value of assets from being eroded by unanticipated inflation. Focusing monetary policy on achieving price stability does not, however, mean that central banks cannot pursue other policy objectives. By law, the European Central Bank (ECB) assigns overriding importance to price stability, but it also seeks to achieve full employment and balanced economic growth. The US central bank, the Federal Reserve (or ‘Fed’), has a ‘dual mandate’ whereby stable inflation and maximum sustainable employment are given equal priority. 1 Economics Explorer Series Monetary Policy & The Economy How Does a Central Bank Conduct Monetary Policy? Many central banks typically use a very short-term interest rate as their primary instrument of monetary policy. The Fed, for example, targets the federal funds rate or the interest rate at which banks lend to each other on an overnight maturity. To control the target interest rate, the central bank can vary the amount of liquidity (the amount of cash reserves held by banks): when the central bank provides more liquidity, banks have more funds to lend out, the money supply increases accordingly, and the interest rate falls. The reverse happens when the central bank drains liquidity from the banks. Figure 1: Monetary Policy Instruments of monetary policy: EXCHANGE RATE To As the MONETARY achieve basis for BASE price sustained stability growth INTEREST RATES There are three conventional ways in which the central bank can change liquidity in the banking system, although not all of them are available or used in every country. First, if the central bank wishes to change the money supply and interest rates it could vary the monetary base, which consists of currency (notes and coins) in circulation, and the total reserves of banks which are held on deposit with the central bank or as cash in their vaults. In countries with developed financial markets, the easiest way to alter the monetary base is to carry out ‘open market operations’ by buying or selling short-term government securities from or to the banks. In this way, the central bank can effect changes in the desired level of reserves held by commercial banks. A second way for the central bank to increase the money supply is to allow banks to borrow more reserves from it. This is usually accomplished by lowering the interest rate they must pay on these loans — the discount rate. 2 Economics Explorer Series Monetary Policy & The Economy Third, the central bank could raise reserve requirements. This means that banks will be required to keep with the central bank a larger portion of each dollar deposited with them. However, this policy is rarely used in the more advanced countries as it could disrupt the business of banking. It has also become less effective nowadays because many banks already hold ‘excess reserves’. It is, however, still used in developing or emerging market economies where the first two instruments of monetary policy could be less effective, reflecting the relatively less advanced stage of development of their financial systems. In some small open economies, central banks have eschewed their ability to conduct monetary policy by choosing to peg the domestic currency to the value of another currency, called the ‘anchor currency’. This is a means for the country to achieve long-term price stability through the provision of a nominal anchor for the average price level. An even stronger commitment to monetary discipline is achieved by setting up a currency board, whereby the currency is backed 100% by the anchor currency and the monetary authority stands ready to exchange its currency for the anchor currency at a fixed rate. This is the case in Hong Kong, which has fixed the HK$ to the US$ since 1983. If capital is free to move in and out of the country, the central bank effectively relinquishes an independent monetary policy when it pegs the exchange rate to another currency. If, for example, the US tightens monetary policy by raising interest rates, this will cause capital to flow out of Hong Kong where interest rates are lower and the HK$ would depreciate. The Hong Kong Monetary Authority would then be obliged to buy the HK$ with its official foreign reserves of US$. The money supply in Hong Kong would automatically decrease, which, all other things equal, would cause interest rates to rise to match US interest rates. In less extreme cases, countries may choose to keep their currency at a particular value which is neither fixed to an anchor nor freely floating. This is known as ‘managed floating’. As we shall see, Singapore practices a variant of this arrangement, whereby the MAS manages the Singapore dollar against a basket of currencies, also called the S$ nominal effective exchange rate (S$NEER). 3 Economics Explorer Series Monetary Policy & The Economy Quantitative Easing and the Problem of the Zero Lower Bound One of the challenges thrown up by the Global Financial Crisis and the ‘Great Recession’ of 2009 is that if inflation falls to a low level and, at the same time, the economy is growing very slowly or is in recession, conventional interest rate-based monetary policy can become ineffective. This is because the nominal interest rate set by the central bank to stimulate investment and consumption of interest- sensitive goods, such as houses and cars, cannot in theory be pushed below zero. This is known as the problem of the zero lower bound. For example, if inflation is 2% and the central bank lowers its nominal policy interest rate to zero, as the Fed did in December 2008, the real interest rate relevant to investment and consumption decisions would be minus 2% (0%–2%)1. This might be sufficient to stimulate the economy but what if inflation now falls to 1%? The real interest rate would actually rise to minus 1% (0%–1%). Of course the central bank could, in practice, make the banks pay a negative interest rate on their reserves. In fact, the Swedish and Danish central banks in recent times have used negative interest rates to stimulate the economy, as have the ECB and the Bank of Japan (BOJ). However, it is too early to say whether this policy can solve the problem of the zero lower bound. After all, banks would be accepting a return on their reserves which is less than if they kept them in their vaults as cash. At the same time, it is not clear whether they would be able to recoup their losses by imposing negative interest rates on the deposits of their customers. Another solution might be to raise the central bank’s inflation target to say, 4% which would give them more room to lower real interest rates during a downturn. But would the public understand this change? Ironically, it is because the major central banks have been so successful in achieving their target of around 2% inflation and anchoring public expectations to that level, that they are now disinclined to raise the target for fear that inflation and inflation expectations might spiral upwards. This would cause central banks to lose the credibility they have painstakingly built up in recent decades. A potentially more effective solution when conventional monetary policy breaks down is to adopt unconventional monetary policy, otherwise known as quantitative easing (QE). Instead of targeting a short-term policy interest rate which might already be at the zero bound, quantitative targets are put in place to increase the monetary base. During the recent Global Financial Crisis, central banks around the world provided financial institutions with emergency liquidity and acted in their capacity as the lender of last resort. In the aftermath of the crisis, the Fed, the Bank of England and the ECB purchased large amounts of private assets, including consumer and corporate debt, as well as long-term government debt. This was done with the aim of lowering long-term interest rates and expediting the recovery from the recession.

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