December 09, 2022
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    CAN MONETARY POLICIES DELIVER THEIR PROMISES?

    May 30, 2019

    How Monetary Policies are implemented

    * Nature of Monetary Policy

    The monetary policy is largely about regulating/controlling money, i.e., currency, credit, interest rates and exchange rates, to facilitate the flow of economic activities at levels desirable for the economy. The money is an economic facility or factor that helps mobilise resources to produce, trade, consume, save and invest that improves living standards. Everybody knows the economic role/ importance of money to value transactions, make payments, save and lend/invest. The general view is that more and more money will facilitate and stimulate economic activities.

    Therefore, monetary policy decisions or changes in control of money will cause different shocks to economic activities, i.e., money market, commodity market, labour market and international trade, that may eventually affect inflation, growth and employment of the economy over time.

    * Inflation control

    Many central banks state that they drive monetary policies to control inflation to keep it low and stable in the medium to long-term. Some central banks announce targets (fixed or flexible) of inflation for the monetary policy, for example, 2% by the US Federal Reserve (Fed), Bank of England, European Central Bank (ECB) and Bank of Japan. Some central banks communicate a range of targets, e.g., 4%-6%. Some central banks further qualify the target, for example, symmetrically around 2% by the Fed and close to but below 2% by the ECB.

    Central banks’ justification for inflation target is that people/markets will believe the inflation control by the central bank and use stable inflation expectations around the target to plan their economic activities which will bring the stability to the economy in the medium to long-term.

    Although inflation target-based monetary policies were commenced in early 1990s, central banks in advanced market economies commenced explicit inflation targets in their policy packages after the financial crisis 2007/09, for example, the Fed in 2012. Some emerging market central banks now propose to legalize this approach to satisfy the IMF/World Bank without any regard to fundamental differences between advanced market economies and emerging market economies, differences in monetary and financial systems and frequent monetary policy failures of advanced market economies.

    * Multiple mandates

    In the monetary policy, central banks also monitor diverse goals explicit or implicit to improve the economic growth and employment. No central bank can separate inflation from growth and employment and keep inflation under its control independently because inflation and production activities are inter-connected. The economic growth is the overall growth of production determined by demand and supply factors. The inflation is the overall increase in prices of consumer goods and services in general which is also determined by demand and supply factors. Therefore, inflation and growth are the two sides of the economic coin. In this background, many central banks follow multiple mandates/economic goals for the monetary policy.

    * Policy implementation model

    Many central banks adopt policy tools to control the overnight liquidity or availability of funds in the inter-bank market. For this purpose, they set their policy interest rates to lend to or accept deposits/excess funds from banks. Accordingly, central banks deal with banks at those rates in open market so that inter-bank interest rates will be kept stable within the policy rates. They believe that such open market monetary operations will facilitate the delivery of credit across the economic activities at stable interest rates. Therefore, overnight inter-bank market is the conduit through which central banks control money and economic activities for their targets. Some central banks have open market operations beyond overnight, i.e., 7 days and 3 months.

    Therefore, major monetary policy decisions are the changes in policy interest rates and volume of liquidity operations (lending net of deposits) of central banks. They use other policy tools such as statutory reserve ratios and other credit controls to fine-tune the inter-bank liquidity to keep overnight inter-bank interest rates stable in a narrow range.

    They assess latest economic data (received in various time lags) that they think appropriate to identify pressures on inflation monthly or bi-monthly and change policy interest rates by small proportions over time in anticipation of the economy moving towards the inflation target in the medium to long-term. They always think of possible impact of policy changes on the economy in the future without knowing any future shocks to the economy that will negate or support the present monetary policy. Accordingly, they wait for few months, or being patient, to assess the economic impact of the latest policy decisions before moving for another policy decision. In some occasions, they are patient for years without any policy changes.

    Policy reality

    Although central banks paint above monetary policy story, nobody knows the quantum, time duration and routes of economic impact of money or monetary policy. Therefore, periodical policy explanations provided by central banks are only personal views of relevant officials based on economic data and economic theories that they believe from time to time. If anyone closely monitors the contents of such policy statements and views, the policy irrationality and inconsistency can be easily established through contradictions of views and data/forecasts.

    The issue here is whether central banks have made big mistakes in policy decisions, i.e., changes in policy rates or changes in market liquidity or both, and how adverse they are on the public if they have not delivered the promised targets, i.e., inflation or other targets. For example, if a series of policy rate hike does not reduce inflation to the target level, the increased cost of credit would constrain economic activities and fuel inflation. Some analysts may even try to estimate economic costs based on own intellectual hypotheses.

    Selected policy issues

    * Recent US policy issues

    Members of the Fed/FOMC, state authorities and market analysts have recently expressed diverse views on monetary policy inconstancy and uncertainty as highlighted below, especially on fast policy tightening in 2017-2018 with interest rate hike by 2%.

    * Gerome Powell, the Chairman of the Fed, stated that the mandates of the Fed are stable prices and maximum employment. The Fed chose an inflation target as against a target for unemployment as inflation depends less on structural factors than unemployment and the Fed reviews present monetary tools whether they are effective and to be strengthened. According to Powell, the long-term interest rate and unemployment rate (stars) change over the time with the economy and they are far away from the Fed’s estimates which are uncertain. Therefore, the Fed refers to many indicators when judging the slackness of the economy or the degree of accommodation in the current monetary policy. At the last press conference, he stated that data did not support a policy change in either direction (i.e., cutting rates and raising rates) whereas recent lower inflation rate than the target was transitory.

    * The US President has repeatedly criticized the Fed’s monetary tightening and insisted policy relaxation (1% interest rate cut) and resumption of purchase of securities by the Fed to support the economy. The Vice President also commented that the Fed should look into cut interest rate to continue the growth as no inflationary pressures were seen. His view is that the Fed should focus on a single mandate to make monetary policy, instead of its current dual mandate of inflation and full employment. He disclosed that a single mandate for the Fed focusing on inflation is not something he and President Trump have talked about.

    * Eric Rosengren, the President of the Boston Fed, commented that the Fed should accept inflation below 2% during recessions and commit to achieve above 2% in good times. He proposes an inflation target range of 1.5%-2.5%.

    * Charles Evans, the President of the Chicago Fed, proposed that the Fed should embrace inflation above its target half the time and consider cutting interest rates if prices do not rise as fast as expected.

    * John Williams, the President of the New York Fed, commented that new tariff hikes are negative supply shocks like other shocks to be looked at the medium term and can boost inflation by few tenths and affect spending and other economic activities. The tariff impact has to be assessed in broader sense over time and a special interest rate cut is not necessary at this moment.

    * James Bullard, the President of the St. Luis Fed, commented that the Fed may have slightly overdone with December interest rates hike (rate hike by 0.25%) and inflation expectations running below the target (2%) could be justified to a rate cut. Inflation expectations falling behind the target while growth and unemployment performing better than expected in last two years are concerned and the Fed has to resend inflation expectations at the target and gain the credibility.

    His views with regard to tariffs/trade disputes are that such concerns have to wait quite a while at least six months and they will be considered in the Fed policy only if there is no resolution for trade disputes. He commented that the agriculture (being subject to new tariffs) is not one of stronger sectors of the US economy and other sectors are doing well. Meanwhile, he advocates for replacing the current inflation target approach with the nominal GDP target approach to allow the Fed to target prices by allowing inflation to rise when economic growth is low but pushing inflation down when growth is high.

    * Market analysts propose a rate cut in the second half of this year in view of slowdown of the economy with deceleration of inflation and economic difficulties and uncertainties arising from recent tariff hikes and trade disputes between the US and China. However, some academic economists confirm the Fed’s tightening stance on grounds of possible future inflationary pressures due to monetary relaxation adopted during the past decade.

    * Medium and Long-Term not stipulated

    Central banks always talk of their goals to be achieved in the medium and long-term. However, they never stipulate the terms in calendar periods. Officials who carry out monetary policies get changed periodically and new comers also talk of same medium and long-term that never end. Therefore, modern time-bound performance assessment cannot be adopted for the monetary policy.

    * Inflation and Interest Rates not being stable

    Past data in any country do not show any stability in inflation or interest rates when several years are considered. Countries pass through cycles of interest rates, inflation, growth and unemployment, despite the stability-based monetary policy. Some countries even confront financial crises and collapse of credit markets from time to time. Therefore, the fundamental promise of monetary policies for stability cannot be delivered as stipulated in present monetary policy models. Economies are much more dynamic, sophisticated and active than what central bank believe or know in their macroeconomic models and, therefore, their lethargic, patient and lagged-policy actions that are phased out for years in cycles cause macroeconomic instabilities and risks, some of which could end up in financial crises or economic recessions.

    For example, even with a decade-long ultra-relaxed monetary policy, advanced market economies have not been able to strongly recover from recession and deflation caused by financial crisis 2007/09. The Fed policy tightening faster in 2017-18 based on intellectually cited future inflationary pressures has caused considerable uncertainties in both the US and emerging market economies as seen from sudden capital reversals and global currency market turmoil in the second half of 2018 and resulting economic slacks thereafter. Nobody has any studies whether nearly US$ 12 trillions of new money printed by central banks in advanced market economies to recover from the financial crisis 2007/09 pause threats to the world economy in the future as a part of this money still remains in excess reserves.

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