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A Note on Monetary Policy A Note on Monetary Policy John Whittaker In the UK and other countries with developed financial markets, central banks set the short-term nominal interest rate for the currency that they issue: the short-term interest rate is the monetary instrument. In recent years, monetary policy has been supplemented in the major economies by quantitative easing: the purchase by the central bank of government debt and other assets. The first part of this note describes how the central bank interacts with financial markets and how its policy choices are transmitted to the wider economy. The second part describes how the central bank makes its policy choices. 1. What is monetary policy? 1.1 The functions of commercial banks 1 1.2 The Bank of England’s operations 2 1.3 Interest rates in the money-market, and banks’ retail rates 3 1.4 Effects of the financial crisis and the recession 5 1.5 Bank regulation 6 2. How does the central bank choose the interest rate? 2.1 The effects of changes in interest rate: the transmission mechanism of monetary policy 9 2.2 The role of expectations 10 2.3 The central bank’s choice of interest rate 11 2.4 Quantitative easing 13 Appendix: Monetary base control 15 Economics Department Lancaster University January 2017 http://www.lancaster.ac.uk/staff/whittaj1/ 1. What is monetary policy? 1.1 The functions of commercial banks account holder makes a payment (see the The traditional business of commercial banks is simplified balance sheet below). But loans are to take deposits and to lend, and they make the largest component of banks’ assets and they profits from the interest margin between the rate are illiquid: they may, for instance, be loans to they charge for loans and the rate they pay to firms which are used to purchase fixed assets or depositors. Many large banks also perform mortgage finance to householders, and cannot other functions such as managing investment easily be sold if the bank needs to repay its funds and dealing in securities, although depositors. regulation is now attempting to enforce separation of these functions from retail To cope with net withdrawals of deposits, banks banking, in response to the financial crisis. need liquid assets, the most liquid being holdings of currency (banknotes) and reserves. The other important function of commercial Reserves are the banks’ own deposits at the banks is to operate the payments system. For central bank (hence they appear as liabilities on this purpose, about half of private sector the Bank of England’s balance sheet) and they deposits in UK banks are sight deposits that are liquid because they may be immediately may be withdrawn without notice when the withdrawn in the form of currency. __________________________________________________________________________________ UK banks and building societies: consolidated account. Sterling balances, £ billions assets Feb.06 Aug.16 liabilities Feb.06 Aug.16 £ currency (vault cash) 5.7 10.9 private sector deposits 1668.7 2628.7 reserve deposits at BoE 0.8 333.2 public sector deposits 38.2 41.6 govt and private securities 126.5 434.2 repo loans from BoE 26.7 24.2 loans to UK private sector 1776.7 2335.0 capital and net other 176.1 418.8 1909.7 3113.3 1909.7 3113.3 Bank of England (BoE), £ billions assets Feb.06 Aug.16 liabilities Feb.06 Aug.16 government securities 15.6 469.2 £ currency issued 36.9 72.7 repo lending to banks 26.7 24.2 bank reserve deposits 0.8 333.2 government deposits 0.8 4.1 net other 3.8 83.4 42.3 493.4 42.3 493.4 Simplified balance sheets for UK banks (£ sterling balances) and the Bank of England. The earlier date (Feb. 2006) is included to show the difference before interest was paid on reserve balances and before quantitative easing: see section 2.4. Source: Monetary and Financial Statistics, Bank of England (‘Bankstats’), tables B1.1.2, B2.1, B2.2, B2.2.1 1 As currency earns no interest, the banks keep changes on the consolidated balance sheet of stocks of ‘vault cash’ that are only a small the banks presented above and are not relevant fraction of their deposit liabilities (see balance for monetary policy. The transactions that are of sheet). They prefer to hold their liquidity in the interest are those that involve the central bank. form of reserves1 which (since May 2006) earn interest at the Bank of England’s official Bank Rate (0.5% since 2009, reduced to 0.25% in 1.2 The Bank of England’s operations August 2016) or interest-earning securities such as treasury bills and government bonds. These While monetary systems in all the major assets are liquid as they may easily be sold in economies operate in similar ways, the financial markets or used as collateral security following is a simplified description of for loans from other institutions. The banks’ transactions that involve the Bank of England. holdings of reserves have increased markedly since 2009 as a result of quantitative easing Suppose that individuals decide to hold more (see Section 2.4 below). currency, as they regularly do during holiday seasons, and they draw on their bank deposits When a retail payment is made, for instance by for this purpose. Since commercial banks only a cheque drawn on the payer’s bank account hold small stocks of currency (‘vault cash’), which the payee deposits in a different bank, or they must obtain the extra from the Bank of using a debit card, the paying bank owes the England. In the above balance sheets, deposits amount of the payment to the receiving bank. at banks fall while the currency liability of the The wholesale debts between banks thus Bank of England rises. created by retail payments may be settled in a variety of ways: for example by transfers of The banks pay the Bank of England for this bank reserve deposits at the Bank of England, currency by drawing on their reserve deposits: by sales of assets, by loans that are secured on the relevant bookkeeping entry is a reduction in assets (usually in the form of ‘repos’: sale and bank reserves equal to the amount of the extra repurchase agreements2) or by unsecured currency. interbank loans. Settlement by transfers of As another example, suppose the government reserves is now more common, given the banks’ receives a payment of tax which the payer large holdings of reserves. draws from his deposit at a commercial bank. If Note that these transactions are between the the government pays the tax into its deposit at banks – one bank’s loss of a deposit is another the Bank of England, this again causes a debt of bank’s gain – hence they will not cause any the commercial bank to the Bank of England which is settled by an increase in the bank’s 1 reserves. The opposite transactions take place Some central banks oblige their banks to hold required reserves as a minimum ratio (e.g. 2%) of their own short- when the government spends out of its Bank of term deposit liabilities. However, the ability to vary this England deposits. ratio is not an additional tool of monetary policy, given that the central bank must always supply sufficient Changes in banks’ reserves at the Bank of reserves to cover any such requirement (see section 1.2 England are the balancing entry whenever any and Appendix). The Bank of England does not apply reserve requirements. of the central bank’s other liabilities or assets 2 change. The above transactions are Under a ‘repo’ or ‘sale and repurchase agreement’, the ‘autonomous factors’ that change banks’ borrowing bank sells the lending bank a security (such as a government bond or ‘gilt’) with an agreement to reserve balances, (i.e. they are not under the repurchase it later. A repo thus amounts to a loan backed control of the Bank of England). If they cause by the collateral security. Interest is effected as the banks, in aggregate, to run short of reserves, the difference between the sale and repurchase price of the Bank of England itself makes further reserves bond. available. Normally, it does this by routinely 2 granting them short-term ‘repo’ loans3. The Since 2009, however, the banks have had large interest rate charged for repo lending is close to excess reserve balances because of quantitative Bank Rate that it pays on reserve deposits. easing (QE, Section 2.4). There has been no need for the Bank of England to supply them The important point is that, by its own dealing with more reserves and it has suspended its with the banks, the Bank of England supplies routine short-term repos. In this situation, Bank the banks with reserves (provides liquidity) as Rate, as the rate paid on reserve balances, is the needed to ensure that, collectively, they always opportunity cost of short-term funding for the have positive reserve balances. It cannot do banks. This rate is transmitted to the wider otherwise. This is fundamentally because all economy via the sterling interbank market, as is financial liabilities denominated in sterling are explained in the following section. ultimately claims on sterling currency, the most obvious example being ‘sight’ deposits in 1.3 Interest rates in the interbank market commercial banks which the depositor can and banks’ retail rates withdraw as currency on demand, and because the Bank of England is, by law, the only issuer With the Bank of England lending to banks as of sterling currency. This is the defining required at its chosen Bank Rate and paying difference between the central bank and other interest to banks on their reserve balances, also financial institutions.
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