Introductory Macroeconomics Lecture 10: Monetary Policy II PDF

Introductory Macroeconomics Lecture 10: Monetary Policy II Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Monetary Policy, Part Two – unconventional monetary policy – response to the pandemic...

Introductory Macroeconomics Lecture 10: Monetary Policy II Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Monetary Policy, Part Two – unconventional monetary policy – response to the pandemic – ongoing challenges for monetary policy BOFAH Chapter 10 2 Unconventional Monetary Policy 3  Unconventional Monetary Policy Because of the corridor system, the effective lower bound on the RBA’s cash rate target is 0.10 percent As the cash rate approached this lower bound, much attention turned to unconventional monetary policy tools, including (1) negative interest rates (2) extended liquidity programs (3) asset purchases (‘quantitative easing’) (4) forward guidance Items (2) and (3) are balance sheet tools 4 RBA Balance Sheet 5 RBA Balance Sheet: Liabilities 6 RBA Balance Sheet: Assets 7 RBA Balance Sheet has changed dramatically March 2020 August 2024 Total Size $190b $437b ESA Balances $32b $245b Currency, notes on issues $83b $101b Government deposits etc. $34b $92b Gold and Foreign Exchange $100b $103b Australian Investments $89b $331 These changes reflect the implementation of unconventional policy. 8  (1) Negative Interest Rates Instead of earning interest, charged interest to store money – Effectively a tax on storing money In response to the global financial crisis, policy interest rates in some countries did go negative e.g., in Denmark, Sweden and Switzerland most negative was −0.75 percent in Switzerland But these negative policy rates mostly not passed on by banks to consumers and firms. Actual market interest rates stayed positive Not used by the RBA in response to coronavirus crisis (or GFC) 9  (2) Extended Liquidity Programs In this context, liquidity refers to how easily an asset can be converted to cash – liquid asset can be bought or sold without much price impact – usually because there are many good substitutes for it, so bringing the asset to market has not much price impact Sometimes we say a liquid asset trades in a thick market and an illiquid asset trades in a thin market Market liquidity (thickness) is not a fixed characteristic of nature, but changes with economic conditions 10  (2) Extended Liquidity Programs Most central banks have lender of last resort type facilities to help financial institutes navigate times of temporary market illiquidity Goal of such facilities is to help prevent financial institutions failing when they are ‘fundamentally sound’, especially institutions that play a key systemic role e.g., a bank may need to repay a loan by selling an asset. But when the market for the asset is illiquid, the bank may have to sell at a big discount, sometimes known as a fire sale Problem may be so severe that at fire sale prices bank is insolvent So how do we judge when a bank is ’fundamentally sound’ ? 11  (2) Extended Liquidity Programs Extended liquidity programs extend lender of last resort facilities – expanding the range of collateral accepted * in particular, accepting lower-quality collateral to back loan to distressed bank * for example, risky tranches of mortgage backed securities – expanding the set of ‘eligible counterparties’ In general terms, making funding available at lower than usual cost 12  (3) Asset Purchases (‘Quantitative Easing’) The outright purchase of assets in an open market operation Sometimes loosely referred to as printing money. Why? – Purchases of assets paid for by crediting ESA balances, increasing the amount of money in the ESA system, thereby increasing the amount of money more broadly in the economy. – In other words, the central bank expands its balance sheet, creating new money and using that money to purchase assets Ironically, this was once the more usual tool for setting policy interest rates, before the switch to repos (temporary purchases) 13  (3) Asset Purchases (‘Quantitative Easing’) In response to the global financial crisis, US Federal Reserve and other central banks (but not the RBA) dramatically scaled up magnitude of asset purchase programs (’LSAPs’) – Large purchases of high-quality assets like government bonds from traditional counterparties, as in traditional open market operations – Sometimes also purchases of low-quality assets like risky tranches of mortgage backed securities from broader range of financial institutions, as in the liquidity programs above Goal of such purchases is to increase demand for and hence drive down interest rates on broad range of assets – interest rates on risky assets, shrinking risk premia – interest rates on longer-term safe assets, shrinking term premia 14  (3) Asset Purchases (‘Quantitative Easing’) Two ways to conduct such programs (1) setting quantity targets, letting market prices respond (2) setting price targets, letting market quantities respond The term ’quantitative easing’ originates from Bank of Japan’s use of such policies in late 1990s & early 2000s, in particular their use of larger quantity targets — i.e., more expansionary policy 15  (4) Forward Guidance Refers to communication of monetary policy. Two kinds (i) time dependent, commitments not to change policy until a certain calendar date (ii) state dependent, commitments not to change policy until certain conditions are met Basic idea is to reinforce the seriousness of the central bank’s commitment to its unconventional policies Goal is to reduce uncertainty about the stance of future policy and make current policy more effective Efficacy is highly dependent on the credibility of the central bank! 16 Unconventional Monetary Policy in Australia 17  Australian Monetary Response to the GFC Unconventional monetary policy was not a feature of our response to the global financial crisis Unlike other countries, where it was a dominant theme We mostly relied on conventional monetary policy and fiscal policy Cash rate did not approach zero lower bound during this time But has been a feature of the response to the coronavirus crisis 18  Australian Monetary Response to Covid (1) Cash rate – target at 0.1 percent – corridor floor at 0.10 percent – not zero, not negative (2) Extended liquidity programs – $200 billion Term Funding Facility (TFF) – 3-year loans at 0.25 percent, collateralised as per repo – initial allowance based on existing bank lending – additional 1:1 access if new loans to big business – additional 5:1 access if new loans to small or medium business 19  Australian Monetary Response to Covid (3) Asset purchases – Yield Curve Control – target 0.25 percent interest rate on 3-year government bond (AGS) – price target, RBA has to be prepared to buy quantity required – purchase by auction in secondary market – purchases increase ESA balances (4) Forward guidance – “... not increase the cash rate from its current level until progress was made towards full employment and that we were confident that inflation will be sustainably within the 2-3 percent range... we are likely to be at this level of interest rates for an extended period.” – is this state dependent or time dependent? 20 Ongoing Challenges for Monetary Policy 21  Aside: Monetary-Fiscal Interactions Government budget deficits financed by selling government bonds to private sector at market interest rates Separation between monetary and fiscal policy achieved when government does not sell bonds to central bank Traditionally, Treasury interacts with RBA through – balances at RBA as buffer for day-to-day spending mismatches – overdraft facility from RBA in case of large mismatch With large scale balance sheet changes, requiring tight coordination between Treasury and Reserve Bank, historical conceptual distinctions less clear. 22  Unwinding Unconventional Measures (1) Cash rate – increase from 0.1% to 0.35% in May 2022 – further increases in 0.5% and 0.25% steps to %4.35 in Nov 2023 (2) Extended liquidity programs — Term Funding Facility – closed to new loans in June 2021 – last loans matured in June 2024 (3) Asset purchases — Yield Curve Control – discontinued in Nov 2021 (4) Forward guidance – generally considered a mess as RBA struggled to communicate difference between its forecasts and its state-dependent policy – recent reform introducing more channels of communications including media conference following decision 23  Ongoing Criticism about Forward Guidance Recall the most recent decision... ⋆ The Board does not foresee a “near-term” cut (even though the market has “priced-in” a cut by the end of the year) Source: AFR, Reserve Bank has finally taken the inflation crisis seriously (11 Aug 2024) 24 New Challenges for Monetary Policy 25 New Challenges for Monetary Policy 26 New Challenges for Monetary Policy 27  Another Theoretical Framework? So far, our theoretical framework has been the Keynesian model – restricted to short-run demand-side dynamics – no place for prices and price adjustment – no place for monetary policy! Now, we need another framework that can – incorporate monetary and fiscal policy – analyze interactions between inflation and economic activity in both short run and long run – distinguish between effects of demand and supply shocks We need Aggregate Demand – Aggregate Supply Model! 28  Learning Outcomes 1 Be familiar with some basic trends in the RBA’s balance sheet and other data related to monetary policy, including inflation. 2 Understand and explain the four different kinds of unconventional monetary policy: negative interest rates, extended liquidity programs, asset purchases, and forward guidance. 3 Understand and explain the policy goals and implementation of extended liquidity programs. 4 Understand and explain the policy goals and implementation of asset purchase programs. 5 Be familiar with Australia’s responses to the GFC and Covid using unconventional monetary policy tools. 29  New Formula(s) and Notation None! 30  Next Lecture The AD-AS Model I (a framework for analysing monetary and fiscal policy) – Aggregate Demand * interest rates and aggregate output * monetary policy reaction function – Aggregate Supply * Phillips Curve and Okun’s Law * inflation expectations BOFAH Chapter 11; Review Lectures 3 and 4 31