Monetary policy

Monetary policy has become the preferred policy instrument to be used in the pursuit of economic stability. It is customarily operated for that purpose by open market operations and by varying the central bank discount rate in response to indications concerning the degree of capacity utilisation in the economy. It has also been used as a temporary expedient to counter the threat of deflation by central bank purchases of government bonds and private sector securities - a practice termed quantitative easing or credit easing (and popularly known as "printing money"). The practice of the day-to-day targeting of monetary policy on the money supply in order to counter inflationary tendencies has generally fallen into disuse. Some authorities are, however, considering the use of monetary instruments to prevent the potentially destabilising buildup of asset-price bubbles.

The monetary policy consensus

The Deputy Governor of the Bank of England has traced the evolution of monetary policy from the early post-war years when it was assigned only a marginal stabilisation role in favour of what was then thought of as the Keynesian use of fiscal policy - through the unsuccessful attempts in the 1980s to target the money supply, that he attributes to monetarism - to the current consensus, which he classifies as "the neo-classical synthesis" or as "new Keynesian". That "new consensus" gives monetary policy the central stabilisation role, and - with rare exceptions - assigns a marginal role to fiscal policy. It adopts the classical contention of long-run neutrality of money and the sensitivity of expectations to the policy regime, together with the Keynesian theory's contention that market rigidities result in a short-term trade-off between economic activity and inflation . The magnitude of that tradeoff (termed the sacrifice ratio) depends primarily upon labour market price flexibility. The existence of a trade-off can reduce the credibility and effectiveness of monetary policy if it is believed that policy action will subsequently be relaxed when the regulatory authority comes under political pressure to avoid any further reduction in economic activity (a problem that is termed time inconsistency).

Regulatory policy

Policy Objectives

The remits of the major central banks differ only in respect of the relative weights to be given to their main objectives. The remit of the United States Federal Reserve Board is "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates" . The remit given to the European Central Bank, on the other hand, assigns overriding importance to price stability by requiring it "without prejudice to the objective of price stability" to "support the general economic policies in the Community" including a "high level of employment" and "sustainable and non-inflationary growth". . The British Government's 1997 remit to the Bank of England also gives priority to the control of inflation by requiring it to "deliver price stability" ..."and without prejudice to that objective to support the Government's policies including its objectives for growth and employment"

The effects of discount rate changes

The term "monetary transmission mechanism" is sometimes used to refer to the ways in which an increase or reduction in a central bank's discount rate reduces output and prices.

The Bank of England has identified the expected effects of an increase in its discount rate on the British economy as

• a general increase in short-term interest rates;
• a rise in the exchange rate as the interest rate increase raises the relative returns on domestic assets, making imported goods cheaper;
• a reduction in consumer spending because it stimulates saving and discourages borrowing;
• an increase in mortgage rates, leaving householders with less to spend;
• a fall in house prices as the mortgage rate raises the cost of buying a house, which reduces homeowners' opportunities to finance their purchases by extending their mortgages

(the last two effects are, of course, peculiar to countries in which flexible mortgage rates are customary)

The Bank estimates the full effect on prices price inflation to take up to about two years and the maximum effect on output to take up to about one year (the output effect is generally expected to be transitory).

An account of the monetary transmission mechanism issued by the European Central Bank states that changes to its discount rate are expected to:

• affect banks and money-market interest rates;
• influence expectations of future inflation, which promotes price stability by reducing people's motives to raise their prices for fear of higher inflation or reduce them for fear of deflation;
• affect asset prices for comparable reasons;
• affect saving and investment decisions since higher interest rates make it less attractive to take out loans for financing consumption or investment;
• have have an impact on aggregate demand via the value of collateral that allows borrowers to get more loans and/or to reduce the risk premia demanded by lenders/banks, and by creating tighter or looser conditions in the labour and intermediate product markets;
• affect the supply of credit as higher interest rates increase the risk that borrowers may default on repayment of loans, and banks cut back on loans to households and firms.

The Federal Reserve Board has issued a statement on similar lines .

Implementation of regulatory policy

Implementation has usually been guided by empirical data concerning the relation between interest rates, the inflation rate and the output gap such as is embodied in the Taylor Rule. The central bank announces its intended discount rate and supports the announcement by open market operations The relevant open market operations are temporary loans of money by repurchase operationsand the buying or selling of securities, and the techniques employed differ only in detail as between the major central banks

.

Since it takes about a year for interest rate changes to affect output and about two years to affect inflation, policy action depends upon judgements of forthcoming inflation. The authorities make use of economic forecasting models to assist those judgements, but they usually take account also of a range of factors including inflationary expectations (as indicated by the differences between the prices of fixed-interest and index-linked bonds) and the state of the housing market.