Fundamentals of Financial Markets and Institutions Lecture 4

**Fundamentals of Financial Markets and Institutions** **16.01.2025 -- Lecture 4** Central Bank: an independent government authority in charge of monetary policies. - CB actions influence everyone through interest rates, credit supply, money supply. - *Housing loans, investments, cor...

**Fundamentals of Financial Markets and Institutions** **16.01.2025 -- Lecture 4** Central Bank: an independent government authority in charge of monetary policies. - CB actions influence everyone through interest rates, credit supply, money supply. - *Housing loans, investments, corporates, pension funds.* - Interest rate and inflation risk. - The primary goal is price stability. - Typically, the established nominal anchor is a target inflation rate of 2%. - Why is it set to this? If CB would change their target rate, the expectations of investors would change -\> possibility of it being changed again -\> these expectations influence inflation -\> this would be destabilising. - It avoids time-inconsistency problems/short-termism of policymakers - Short-termism: the tendency of policy makers to prioritize immediate actions that boost the economy, regardless of the long-term effects. [Independence of CB:] - It has been historically proven that keeping the CB independent helps keep inflation low. - Avoids policymakers funding projects with new money instead of takes and avoid short-termism. - However, there are cases when this is not possible. - *Covid pandemic* - Other potential goals are high employment, economic growth, stability of interest rates, financial markets, and foreign exchange rates. - However, CB tend to only focus on one goal to as methods to achieving multiple may be contradictory. - *ECB has one goal, price stability -\> keep inflation at 2%, while FED has a dual mandate, maximizing employment and price stability*. - It is not clear which policy is the best. - *FED decision to focus on both had senators who voted against it, which policy to implement can be argued for and against. -\> it is not a black and white case.* [CB Tools] 1. Lending to banks. - Banks can borrow reserves from CB. - However, the interest rates are higher than if banks borrow from each other, to discourage banks from relying excessively on CB funding. 2. Reserve requirements. - Illiquidity risk: the risk that banks do not have enough liquid assets to meet withdrawal demands. - Depositors are promised to pay on demand, making the system inherently fragile. - To reduce this risk, CB acts as a lender of last resort. - However, without regulations, banks may be incentivized to not hold any liquid - Remedy: reserve requirements - Reserve Requirements (RR): requirements on financial institutions to hold liquid cash against deposits. - *ECB requires 1%* - Issues: if CB increases RR -\> banks hold more money in reserves -\> decreases money supply -\> increases IR. - Therefore, RR are rarely used a policy tool. 3. Monetary policy.  - There has been a lot of variation in ECB interest rates, with 2014 having negative interest rates, to a steep incline from 2022 onwards. - During times of negative interest rates banks with deposits in CB (mandatory via RR), had to pay to deposit their money there. - This would usually be reflected in banks interest rates; however, it is unattractive to customers and could lead to bank runs, therefore they are floored to 0%. - In some cases, like in Switzerland or Germany, some banks set negative rates to billionaire's accounts, knowing they would accept this. - Monetary policy works by adjusting interest rates to either stimulate or reduce borrowing and spending, in attempt to stabilize inflation to 2%. - Lowering interest rates -\> lower borrowing costs, lower loan payments -\> stimulates spending and borrowing. [CB response to crisis] Credit-driven bubble: when easy credit (low interest rates) inflates asset prices, encouraging more lending, creating a bubble with severe financial downturn when it bursts. - CB should respond as not responding poses massive risk of the whole banking system collapsing. - *GFC -\> FED had to intervene* Optimism-driven bubble: excessive optimism about future asset prices, creating a bubble, posing less risk to the financial system than a credit-driven risk. - Optimism-driven bubbles banks should not respond, if the investor takes risk, then that is on them, there should be downside risks with the upside profits. - *Tech-bubble* Unconventional monetary policy: when tools other than changing policy interest rates are used. - Different CB use different unconventional monetary policies. Forward guidance: a communication tool used by CB to inform the public about future monetary policies such as interest rates or asset purchases.  - 2014 ECB introduced three different unconventional monetary policies. Long-term refinancing operation (LTRO): loans provided by the CB to improve liquidity in the banking system. Targeted long-term refinancing operation (TLTRO): loans provided by the CB to banks, on favourable terms, with the interest being based on how much is the banks lend to targeted sectors. It is used to increase lending to the economy, so households and non-financial cooperations. - *2014 TLTRO: banks were struggling with high credit risk premiums, and significant loses from mortgage loans due to economic downturn -\> CB loaned money at negative rates -\> banks bought government bonds -\> credit risk premiums/interest rates came done -\> banks made profit.* Asset purchase programs (APP): CB buys financial assets from the market to inject liquidity into the economy. - A form of QE. - 2015: ECB had cut interest rates so low, it was no longer an option to cut them further -\> APP in its place. ECB's QE and Monetary policy program 2015-2019: 1. ECB could no longer cut their interest rates, so they came forth with an APP program. 2. 2016 increased bond purchases to 80 bn EUR, and cut their deposit rate to negative, charging banks for holding excess reserves to encourage lending. 3. 2016 implemented TLTRO, at same negative rate to deposits, incentivizing lending to households and businesses. 4. 2017 reduction of APP to 30bn a month. 5. 2018 end of QE program, and pledge to keep interest rates low through 2019. Pandemic emergency purchase program (PEPP): a temporary APP of public and private sector securities to a new annual total of 1850 bn. ECB covid response: - Unchanged low interest rates. - Continuation of APP. - PEPP. - TLTRO II. A graph of a bank bond AI-generated content may be incorrect. - During the covid pandemic CB across all major economies undertook massive APP programs. - Now there is quantitative tightening, as CBs are selling their assets, shift of monetary policies back to normal. - Interest rates post-pandemic have had rapid and aggressive changes, quickly rising to up to 6%, to reduce inflation. - In a very short period, the interest rates went from negative/zero to 4%, large increase in interest rate costs (pay interest rate + risk premium), with borrowers suddenly experiencing significantly higher borrowing costs. [Unconventional monetary policy drawbacks:] - CBs need to be careful of forward guidance and the effects it may have. - CB have been pressured to be more transparent. - *Press conferences about actions, expectations.* - Investors are quick to learn, if the CB hints, they will begin using unconventional policies, it signals a pessimistic economic outlook. - Investors believe the CB will give them a warning of rising interest rates, so they may start taking excessive risk. - *Ex: ECB said they will keep interest rates at zero as long as possible, by communicating this to investors, the investors began taking more risk.* - ECB has one goal to keep inflation at 2% and claimed the inflation growth was only transitory and would come back down.  - ECB economists were consistently estimating that the inflation would grow, this was inaccurate for many years -\> showing how hard it is to forecast inflation. A graph of a graph showing the amount of inflation AI-generated content may be incorrect. - As EU inflation continued growing, Lagarde supported the idea that it was transitory and was due to rising electricity prices. - However, it kept growing, rising to 10% and was not transitory. - Once it became clear it was not transitory (2022), Lagarde was forced to justify and did so by blaming Putin.  - However, by looking at the figure, it is apparent that the inflation growth began before Russia's invasion of Ukraine, and it cannot be solely blamed on that. A red and blue chart with white text AI-generated content may be incorrect. - Also looking at the global situation it is clear inflation was on the rise everywhere, again disproving Lagarde's blame on Russia only. What is happening now? - Lagarde has since taking responsibility, admitting inflation forecasting models were inaccurate. - Shift from focus on forecast to facts. - She also said she stuck to the constraints of forward guidance too much, which caused delays in interest rate hikes as the ECB had promised to keep them low (forward guidance). - ECB has since changes some of its models, with more of a focus on real-time indicators like price trends. - ECB has shifted from dovish (focus stimulating growth through low interest rates.) to hawkish (focus on controlling inflation through high interest rates). - Investors prefer dovish at least in short run, as low-interest rate environments are more attractive. - Overall, ECB has shown they are very active and innovative.