Lecture 4

• Central banks are independent government authorities managing monetary policies.
• Central bank actions influence interest rates, credit and money supply, impacting housing loans, investments, corporations, and pension funds.
• Interest rate and inflation risk are also influenced by central banks

Price Stability

• The main goal for central banks is to maintain price stability
• A target inflation rate of 2% is a typical nominal anchor.
• Changing the target rate can destabilize investor expectations and influence inflation.
• Central bank independence helps keep inflation low, avoiding policymakers funding projects with new money, preventing short-termism.
• Short-termism is when policy makers prioritize immediate actions to boost the economy, regardless of long-term effects.
• Other central bank goals include high employment, economic growth, stability of interest rates, financial markets, and foreign exchange rates.
• These goals can conflict with each other.
• The European Central Bank (ECB) focuses on price stability, targeting 2% inflation.
• The Federal Reserve (FED) has a dual mandate; maximizing employment and price stability.

Central Bank Tools

• One tool central banks have is lending to banks
• Banks can borrow monetary reserves from central banks.
• Central bank interest rates are higher than interbank rates to discourage over-reliance on central bank funding.

Reserve Requirements

• Reserve requirements require financial institutions to hold liquid cash against deposits.
• Illiquidity risk is that banks might not have enough liquid assets to meet withdrawal demands.
• Central banks act as lenders of last resort, reducing illiquidity risk
• Without regulations, banks may avoid holding liquid assets, addressed by reserve requirements.
• The ECB requires keep 1% in reserves
• Increasing reserve requirements decreases money supply and increases interest rates.
• Due to the impact on money supply, reserve requirements are rarely used.

Monetary Policy

• Monetary policy involves adjusting interest rates to either stimulate or reduce borrowing and spending, stabilizing inflation to around 2%
• Lowering rates reduces borrowing costs and loan payments, stimulating spending and borrowing.
• ECB lowered rates to 3%.
• ECB interest rates have varied, from negative rates in 2014 to a steep incline from 2022.
• Banks with deposits in central banks during negative interest rates had to pay to deposit money.
• This isn usually reflected in interest rates, floored to 0% due to unattractiveness to customers, preventing bank runs.

Unconventional monetary policy

• Monetary policy works by adjusting interest rates to either stimulate or reduce borrowing and spending, in attempt to stabilize inflation to 2%
• Several banks have been known to set negative rates to billionaire accounts, such as those in in Switzerland or Germany.

Central Bank Response to Crisis

• Central banks need to respond in the event of a credit driven bubble
• A credit-driven bubble is where easy credit inflates asset prices, encouraging more lending, creating a bubble and a financial downturn if it bursts
• The GFC (Global Finance Crisis) is an example where the Fed (Federal Reserve) had to intervene
• Optimism-driven bubbles carries less risk to the financial system compared to credit driven risks
• This is when there excessive optimism about future asset prices, creating a bubble
• In the event of an optimism-driven bubble the banks shouldn't respond
• The tech-bubble is a good example of this, as the investors take all of the profit and loss

Unconventional Monetary Policy

• This is when central banks use tools other than changing policy interest rates.
• Different central banks use different unconventional monetary policies

Forward Guidance

• A communication tool used by central banks to inform the public about future monetary policies, such as interest rates or asset purchases

Non-Standard Monetary Policy Measures

• LTROs (Long-term Refinancing Operations) provides liquidity
• Regular operations have been complemented by two liquidity-providing long-term refinancing operations in euro with a three-year maturity and US dollar liquidity-providing operations
• TLTROs (Targeted Longer-Term Refinancing Operations)
• The Eurosystem operations provide financing to credit institutions for up to four years
• They offer long-term funding at attractive conditions to banks in order to further ease private sector credit conditions and stimulate bank lending to the real economy.
• APP (Asset Purchase Programs) are implemented since 2009, these programs of outright asset purchases have been implemented to sustain growth across the euro area and in consistency with the aim of achieving inflation rates below, but close to, 2% over the medium term
• In 2014 the ECB introduced three different unconventional monetary policies
• Long-term refinancing operations (LTRO): loans provided by the central bank to improve liquidity in the banking system
• Targeted long-term refinancing operation (TLTRO): loans provided by the banks to banks, on favorable terms, with the banks interest being based on how much is loaned to targeted sectors.
• It serves to increase lending to the economy, households and non-financial corporations
• Asset-purchase programs (APP): central banks buy financial assets from the market to inject liquidity into the economy; a form of quantitative easing
• In 2015: the ECB had cut interest rates so low, it was no longer an option to cut them further, so APP was put in place to solve this.
• From 2015-2019 the ECBs QE and Monetary policy program the following happened:
• Because the ECB could no longer cut their interest rates an asset purchase program was proposed
• Bond purchases increased to 80 bn EUR, and cut their deposit rate to negative, charging banks for holding excess reserves to encourage lending
• TLTRO was in place to incentivize lending to households and businesses
• Then in 2017 reduction of APP to 30bn a month
• Program ended in in 2018 and there was a pledge to keep interest rates low through 2019.
• A temporary APP of public and private sector securities was created called the Pandemic emergency purchase program (PEPP): a public total of 1850 bn.

ECB Covid Response

• Kept unchanged low interest rates
• Continuation of APP
• PEPP
• TLTRO II
• During covid pandemic central banks across all major economies undertook massive APP programs
  • Now shift of monetary policies back to normal via quantitative tightening, as CBs start to sell their assets
• Interest rates post-pandemic had been changing rapidly and aggressively, rising quickly to up to 6%, to suppress inflation.
• Interest rates went to 4% from negative/zero which increased interest rate costs as borrowers now suddenlty experienced significantly higher borrowing costs.

Unconventional monetary policy drawbacks

• Central banks need to practice precise forward guidance to ensure the action has the intended impact
• They are pressured to be transparent, such as detailing expectations during press conferences
• If investors can identify and preempt CB actions they will begin using unconventional policies themselves, signaling pessimistic economic outlook.
• It leads to excessive risk as Investors believe the CB will give them a warning of rising interest rates, so they may start
• ECB has one goal to keep inflation at 2% and claimed the inflation growth was only transitory and would come back down to 2%

Lagarde era in the ECB

• The ECB economists were consistently estimating that the inflation would grow, this was inaccurate for many years - showing how hard forecast inflation is
• As EU inflation continued growing, Lagarde supported the idea that it was transitory and was due to rising electricity prices
• However, inflation continued to grow, rising to 10% and proved to not be transitory
• Lagarde blamed Russia for the inflation increase and shifted from focus to facts
• Changed some models with more of a focus on real-time indicators like price trends
• Switched from dovish policies to hawkish, investors prefer dovish in short run, as low-interest rate environments are more attractive
• Has been shown that The ECB is very active and innovative organization.