Monetary Policy

The Role of Central Banks

Central Banks (CB’s) have the role of maintaining monetary and financial stability, they produce bank notes and supervise banks and insurance companies. Financial stability may require them to act as “Lender of last resort” to commercial banks. In this way, they provide facilities that promote confidence in the banking sector and more widely in the value of money. In many cases they are independent of government however some commentators believe government influences their decisions, not least by having a hand in the appointment of senior central bankers. Several tools are used to conduct policy. These are discussed below.

Repo Rates (short term rates)

Short term interest rates (0-12 months) influence economic activity. Central banks target these by setting the repo rate. This is the official rate as which the CB’s lend to commercial banks. In the UK the repo rate is called Base Rate.

Commercial banks (unlike companies and individuals) therefore have direct access to obtain funding from CB’s. Commercial banks must provide suitable collateral to the CB. The collateral is returned on the maturity of the repurchase facility, hence “repo” rate.

The repo rate is also used to price commercial bank deposits with central banks. The deposit accounts are called “reserve accounts” and count as high quality liquidity for the banking system.

Some authorities impose a bid-offer spread on the repo rate whereby the deposit rate with the central bank is lower than the borrowing rate. This cost is designed to discourage excessive depositing by commercial banks at the CB.

Excessive deposits mean that money is not being lent by the banks in the wider economy thereby blunting the effect of measures designed to stimulate the economy.

Some central banks do not impose such a cost. They argue that to do so would weaken bank earnings and thereby increase fragility of the banking system.

In setting the repo rate the CB is mindful of its mandate (inflation, growth, employment) in the context of the economic outlook. If it looks as if the economy is weakening the CB may cut the repo rate and conversely to rein in expansion the repo rate may be increased.

Transmission: Lowering the repo rates reduces the cost of borrowing. This is passed on through the banking system to the wider economy. (Banks can borrow cheaply from the CB, this drags down the interbank Libor rate which in turn should affect lending and deposit rates. In normal market conditions the interbank overnight rate should mirror the repo rate unless the banking system is under severe stress. Three month Libor rates may lead or lag the repo rate depending on the market’s expectation for changes in the repo rate).

With the cost of credit falling businesses and individuals find debt servicing is easier and borrow more and/or spend more. Consumption and capital investment should increase. The economy grows. Furthermore, savers see their returns decline and have an incentive to spend. Increasing the repo rate should reverse the effect. The true economic impact is subjective.

Savers may decide to save even more to make up for the lost interest. Credit expansion may not pick up if the banking sector is risk averse or economic uncertainty puts people off borrowing.

On balance, lower interest rates should be expansionary however Keynes pointed out that at very low rates a “Liquidity trap” may exist where individuals are largely impervious to further rate changes.

In some countries, the authorities have introduced negative repo rates leading to negative interest rates in the economy. The additional cost of holding cash is designed to spur banks to lend and individuals to spend. The true effect of this policy is uncertain.

With the repo rate targeting short term interest rates the longer maturity rates (1-30 years) remain free to settle where supply of and demand for money balance. This can lead to steep upward sloping or downward sloping yield curves. From a central banker’s viewpoint, this may not be desirable. The higher long term rates may negate part or all the expansionary impact of lower short term rates. To offset this Central Banks have engaged in Quantitative Easing (QE).

Quantitative Easing (long term rates)

QE is an unconventional policy and is controversial. It involves the CB’s expanding their balance sheets by buying government debt (now extended into high quality corporate debt).

Transmission mechanism: By purchasing sufficient amounts (as they have) they force up debt prices and thereby lower yields. Falling interest rates increase the incentive to borrow more and save less.

The consumption generated boosts the economy lifting employment, prices, imports and tax receipts. The full effect being very dependent on banks wanting to lend and individuals wanting to borrow.

There is also a wealth effect. As long term interest rates fall government bond prices rise. To increase income and gains investors move into riskier financial assets. These can include corporate bonds, equities and property. These prices also rise. Investors feel better off. This encourages further spending and consumption. Weaker companies also become economically more viable as their financing costs fall.

Bank multiplier: QE also operates through the banking system. When CBs buy bonds the sellers (banks, pension funds, insurance companies and wealth funds) receive cash. This cash ends up being redeposited in the banking system. What banks now do with that cash is important.

They may decide to lend it out. If they do this is credit expansion and boosts the economy. The loans are spent and eventually the cash is again redeposited back in the banking system. A large proportion can be re-lent. There is therefore a bank credit multiplier in action.

The potency of this depends on the willingness of banks to lend and the desire by firms and individuals to borrow. If economic expectations are strong the effect should be robust. If confidence is weak the effect will be muted.

Bank regulation may limit the full effect of QE. Banks have been required to hold a more high quality liquidity and capital. This reduces the incentive to lend as it can make lending uneconomic.

Term Repo (lending to banks)

A further policy tool has also been adopted by CBs. Commercial Banks can provide less liquid assets like mortgage pools or bonds as collateral. The CB then exchanges these for higher quality assets like government bonds. These in turn can be used by commercial banks to obtain cash from the repo market. This improves commercial bank balance sheet liquidity. Long term repo facilities of this nature make commercial banks less reliant on retail funding and indirectly cut interest rates on retail deposits.

Helicopter Money

Some economists and politicians think that current policy does not go far enough to reflate the economy. They advocate a more direct approach to monetary policy. This uses “Helicopter money” a term coined by economist Milton Friedman.

The idea is that by directly crediting everyone’s bank account with some free money the desired monetary expansion will occur because individuals will spend (particularly if unspent cash is forfeited). This extreme measure would undoubtedly inflate the economy but it also highly controversial as it debases the value of money.

Q&A

Q. In the past very low interest rates would have been very inflationary. Why hasn’t this happened?

A. Financial asset prices have already been boosted by monetary policy. This may spill over later into the real economy for goods and services. Inflation relies on people spending money. Currently rebuilding of the banking system and concern about the future suppress lending and consumption. If expectations change inflation may rapidly increase.

Q. How does Fiscal policy fit in?

A. Fiscal policy is about government spending and taxation. It too can be used as a tool to regulate the economy. Spending and borrowing more and taxing less is expansionary but there are limits on the headroom that a country can safely undertake debt financing before borrowing costs rise.

Q. Could the current low interest rates be used by the government to borrow more for investment?

A. Yes. Low rates would make debt servicing less burdensome (at least in the short run) but government spending does not automatically lift productivity which is really what you need to get sustainable growth.

Q. How does QE end?

A. A good question. To be honest I don’t know. Monetary expansion can be curtailed by increasing the repo rate but unwinding QE would require the sale of government debt to the market. Which in turn may destabilise financial markets. A slower effect would be for the CB to hold the bonds it has purchased until maturity. The government (Treasury) could then cancel the debt in effect creating a permanent increase in the money supply.

Q. Is QE a fool proof tool?

A. Far from it. The lasting effects are unknown. It may be inflationary. It takes from savers and gives to borrowers. This may be damaging for the economy as it means that money is potentially channelled into goods and services that have little value in raising long term productivity. It also keeps “Zombie Companies” going. This is a poor use of resources and leads to low productivity.

Q. Why is deflation feared?

A. Because if consumers’ think prices will fall they may defer consumption and prices will fall. This cycle continues and can depress wages. Debt in real terms increases and this means that borrowers are locked in to higher and higher real debt servicing costs. On the flip side savers become better off. It’s a fine balance where equality should be.

Q. Are demographics important?

A. It would appear so. As populations age their productivity, savings and consumption alter. Some economists argue this is the root of the problem. Falling productivity will mean that the real growth will be permanently below what we would have estimated a decade ago. In other words, we may be better off but not by as much as we expected to be.

First Published by Barbican Consulting Limited 2017