The Economics of Money, Banking, and Financial Markets PDF

The Economics of Money, Banking, and Financial Markets Eighth Canadian Edition Chapter 16 Tools of Monetary Policy Copyright © 2023 Pearson Canada Inc. 16 - 1 Learning Objectives (1 of 2) 1. Ch...

The Economics of Money, Banking, and Financial Markets Eighth Canadian Edition Chapter 16 Tools of Monetary Policy Copyright © 2023 Pearson Canada Inc. 16 - 1 Learning Objectives (1 of 2) 1. Characterize the framework for the implementation of monetary policy in Canada (the LVTS, the target and the operating band for the overnight interest rate, and the Bank of Canada’s standing liquidity facilities). 2. Illustrate the market for reserves and how changes in monetary policy affect overnight interest rates. 3. Discuss the Bank of Canada’s approach to monetary policy. Copyright © 2023 Pearson Canada Inc. 16 - 2 Learning Objectives (2 of 2) 4. Summarize how conventional monetary policy tools are implemented and the strength and weaknesses of each tool. 5. Explain the key monetary policy tools that are used when conventional policy is no longer effective. 6. Identify the distinctions and similarities between the monetary policy tools of the Bank of Canada and those of the Federal Reserve and the European Central Bank. Copyright © 2023 Pearson Canada Inc. 16 - 3 The Large Value Transfer System (LVTS) The Large Value Transfer System (LVTS) – Operated by Payments Canada The LVTS participants know the balance of their large-value (over $50,000) transactions in real time LVTS transactions account for < 1% of the total number of transactions, but 87% of the value Settlement at the end of each day – The LVTS uses multilateral netting. Only the net credit or debit position of each participant vis-à-vis all other participants is calculated for settlement Copyright © 2023 Pearson Canada Inc. 16 - 4 Systemic Risk and the LVTS The possible inability of one financial institution to fulfill its payment obligations poses a risk to the entire payments system The setup of the LVTS helps eliminate this source of systemic risk Participants can make a payment only if: – they have positive settlement balances in their accounts with the Bank of Canada, – posted collateral (such as T-bills and bonds), or – explicit lines of credit with other LVTS participants Copyright © 2023 Pearson Canada Inc. 16 - 5 Non-LVTS (ACSS) Transactions These are non-LVTS (paper-based) payment items, such as cheques These items are cleared through the Automated Clearing Settlement System (ACSS), an electronic payments system also operated by the Payments Canada The ACSS aggregates interbank payments and calculates the net amounts to be transferred from and to each participant’s settlement account with the Bank of Canada The Direct Clearers are subset of LVTS participants who participate directly in the ACSS Copyright © 2023 Pearson Canada Inc. 16 - 6 The Bank of Canada’s Policy Rate Let’s turn to the overnight interbank market, the interbank market for funds with a maturity of 1 day Overnight interest rate or the Reference rate – The interest rate at which banks borrow and lend overnight funds to each other in the interbank market The policy rate – The target for the overnight rate that is announced by the BoC - the main target the BoC adopts when conducting monetary policy Copyright © 2023 Pearson Canada Inc. 16 - 7 The Operating Band for the Overnight Rate The Bank’s objective is to keep the overnight rate within a band of 50 basis points (1/2 of 1%) There are exceptions at times: – In response to the global financial crisis, the BoC temporarily narrowed the operating band for the overnight interest rate to 25 basis points (1/4 of 1%) – During the COVID-19 pandemic this happened again – In both cases the BoC moved to a “floor system” The Bank operates under a system of eight “fixed” dates throughout the year for announcing changes to the operating band Copyright © 2023 Pearson Canada Inc. 16 - 8 The Bank of Canada’s Standing Facilities (1 of 2) At the end of each banking day, each LVTS participant must bring its settlement balances with the BoC to zero The Bank of Canada therefore stands ready (with standing liquidity facilities) to lend reserves to bring possible negative settlement balances of a bank to zero – The BoC stands also ready to absorb (borrow) any positive settlement balances of a bank – Yet, as we will see later excess reserves are typically best lent out in the overnight market, and in case of a shortage banks would normally best borrow on the overnight market – Indeed, the overnight interbank market should be seen as the daily market for reserves Copyright © 2023 Pearson Canada Inc. 16 - 9 The Bank of Canada’s Standing Facilities (2 of 2) More about the standing facilities… The initiative is on the side of the LVTS participant – Participants may use the BoC’s lending facility to obtain overnight liquidity in case of a shortage, or – Participants may use the deposit facility to make deposits in case of excess liquidity – When deciding participants know the rates applicable to positive & negative settlement balances  The bank rate – 50 bps on the deposit facility  The bank rate on the lending facility Copyright © 2023 Pearson Canada Inc. 16 - 10 Figure 16-2: Equilibrium in the Market for Reserves Equilibrium occurs at the intersection of the supply curve Rs and the demand curve Rd at point 1 and an interest rate of i*or. Copyright © 2020 Pearson Canada Inc. 16 - 11 Demand curve for reserves LVTS banks exercise both demand and supply How to make sense of the demand curve for reserves? – In general the lower is the rate paid on reserves, ior, the higher is the quantity demanded by the banks. – The demand curve becomes flat (infinitely elastic) at ior = ier Reason: if we had ior ib then reserves can be borrowed for ib from the BoC and profitably lent in the market for ior Copyright © 2023 Pearson Canada Inc. 16 - 13 How the BoC Limits Fluctuations in the Overnight Interest Rate The Bank of Canada’s standing facilities and operating procedures implement the operating band for the overnight interest rate They establish a limit for the fluctuations of the overnight interest rate to between the deposit rate ier = ib − 0.50 and the bank rate ib Copyright © 2023 Pearson Canada Inc. 16 - 14 Figure 16-3: How the Bank of Canada’s Operating Procedures Limit Fluctuations in the Overnight Interest Rate Copyright © 2020 Pearson Canada Inc. 16 - 15 The BoC’s approach to Monetary Policy Bank of Canada maintains an inflation target – keep inflation between 1 and 3 percent, ideally close to 2 percent. Alternative is price level targeting See box: FYI Price-Level Targeting Versus Inflation-Rate Targeting Copyright © 2023 Pearson Canada Inc. 16 - 16 Figure 16-4: Inflation Rates and Inflation Targets for Canada, 1980–2020 Canada has significantly reduced the rate of inflation and over time has achieved its inflation targets. Source: Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Poson, Inflation Targeting: Lessons from the International Experience (Princeton: Princeton University Press, 1999); and Federal Reserve Bank of St. Louis, FRED database: research.stlouisfed.org/fred2 Copyright © 2020 Pearson Canada Inc. 16 - 17 How Monetary Policy Affects the Economy Changes in the overnight rate influence other (longer- term) interest rates and the exchange rate These, in turn, affect economic activity Strictly speaking, the BoC must be able to influence the real interest rates and exchange rates Copyright © 2023 Pearson Canada Inc. 16 - 18 Figure 16-5: How the Bank of Canada Keeps the Rate of Inflation from Falling Below the Lower Limit of the Inflation Target Range Source: Bank of Canada website: www.bankofcanada.ca. Copyright © 2020 Pearson Canada Inc. 16 - 19 Figure 16-6: How the Bank of Canada Keeps the Rate of Inflation from Moving Above the Upper Limit of the Inflation Target Range Source: Bank of Canada website: www.bankofcanada.ca Copyright © 2020 Pearson Canada Inc. 16 - 20 The Three Conventional Monetary Policy Tools 1. Open market operations – Open market purchases – Open market sales 2. Settlement Balances Management 3. Standing facilities – Through the maintenance of the “corridor” by the standing lending facility and accepting deposits of excess reserves All are called “interest-rate MP tools” – These all try to maintain the policy rate, which itself aims to keep inflation on target Copyright © 2023 Pearson Canada Inc. 16 - 21 Open Market Operations Open market operations are an important monetary policy tool for many central banks Open market purchases: – Expand bank reserves and the monetary base – Lower short-term interest rates – Raise the money supply Open market sales: – Shrink bank reserves and the monetary base – Raise short-term interest rates – Lower the money supply Copyright © 2023 Pearson Canada Inc. 16 - 22 Open market operations in practice: Repurchase Transactions Bank of Canada stopped conducting open market operations in Government T-bills in 1994, instead uses: Repos or Specials – Special Purchase and Resale Agreements (Special PRAs or SPRAs) – Used as a tool to reduce undesired upward pressure on the overnight interest rate Reverse Repos or Reverses – Sale and Repurchase Agreements (SRAs) – Used as a tool to reduce undesired downward pressure on the overnight rate Copyright © 2023 Pearson Canada Inc. 16 - 23 Special PRAs If overnight funds are traded at a rate above the target ior, the Bank enters into SPRAs at a price that works out to the target ior. Hence, SPRAs relieve undesired upward pressure on overnight interest rates Bank of Canada Primary Dealers Assets Liabilities Assets Liabilities Government +$100m Settlement +$100m Settlement +$100m SPRAs +$100m Securities Balances Balances Copyright © 2023 Pearson Canada Inc. 16 - 24 SRAs If, on the other hand, overnight funds are traded at a rate below the target rate, the Bank of Canada enters into SRAs Hence, sale and repurchase agreements alleviate undesired downward pressure on overnight rates Bank of Canada Primary Dealers Assets Liabilities Assets Liabilities Blank Blank Settlement −$100m Settlement − Blank Blank Balances Balances $100m Blank Blank SRAs +$100m Government + Blank Blank Securities $100m Copyright © 2023 Pearson Canada Inc. 16 - 25 Figure 16-7: The Mechanics of a Special PRA Operation Note: In a special PRA (SPRA), the Bank of Canada buys securities from a primary dealer in exchange for cash, and the primary dealer agrees to buy the securities back (repurchase them) the next day at the original price plus interest, regardless of what happens in the market. In that arrangement, the primary dealer gets an overnight collateralized loan and the Bank of Canada gets some interest. Copyright © 2020 Pearson Canada Inc. 16 - 26 Settlement Balances Management Bank of Canada also influences the level of settlement balances in the system Typically, target level is announced the previous day Bank neutralizes the impact on settlement balances via open-market buyback operations Bank neutralizes SRA operations as well Shifts (transfers) of government deposits – Transfer deposits from banks to Bank of Canada: drawdowns – Transfer deposits from Bank of Canada to banks: redeposits Copyright © 2023 Pearson Canada Inc. 16 - 27 Bank of Canada Lending The Bank of Canada’s standing facilities – BoC stands ready to lend overnight settlement balances to LVTS participants with negative clearing balances – Large increase in demand for reserves shifts demand right and equilibrium ior increases – At ib, the standing lending facility puts ceiling on overnight rate. – By accepting deposits of excess reserves at ib – 50 bps the Bank also puts in a floor under the overnight rate. Copyright © 2023 Pearson Canada Inc. 16 - 28 Figure 16-8: How the Bank of Canada’s Standing Facility Puts a Ceiling on the Overnight Interest Rate The rightward shift of the demand curve for reserves from Rd1 to Rd2 moves the equilibrium from point 1 to point 2, where ior = ib and borrowed reserves increase from zero to BR. Copyright © 2020 Pearson Canada Inc. 16 - 29 Beyond MP: BoC as Lender of Last Resort The Bank of Canada is important in preventing financial panics Chapter 14: Bank also acts as lender of last resort Provides emergency lending assistance (against eligible collateral) for maximum of 6 months Prevents bank failures and financial panics Why not just rely on CDIC? – CDIC insurance fund is small fraction of total deposits – Large-denomination deposits are not guaranteed by CDIC Copyright © 2023 Pearson Canada Inc. 16 - 30 Figure 16-9: Bank of Canada Advances to Members of Payments Canada, 1975–2020 (in Millions of Dollars) Source: Statistics Canada CANSIM series V36663. Copyright © 2020 Pearson Canada Inc. 16 - 31 Nonconventional Monetary Policy Tools In normal times, conventional policy tools are enough In time of financial crisis, they may no longer suffice – The financial system seizes up to such an extent that it becomes unable to allocate capital – A large negative shock to the economy can lead to the zero-lower-bound problem, where the central bank is unable to lower short-term interest rates Central banks therefore need non-interest-rate tools known as nonconventional monetary policy tools Copyright © 2023 Pearson Canada Inc. 16 - 32 Tool 1: (Longer-term) Liquidity Provision The Bank of Canada introduced new tools during the financial crisis to address aggregate system liquidity issues These and additional facilities were made available during the COVID-19 crisis: – Expansion of the Standing Lending Facility  Plus narrowing the corridor to 25 basis points, while targeting the overnight interest rate at the bottom of the corridor – March 31, 2020: new Standing Term Liquidity Facility – New Lending Programs (including to non-banks) Copyright © 2023 Pearson Canada Inc. 16 - 33 Tool 2: Large-Scale Asset Purchases Open market operations typically involve temporary purchases and sales of government securities At the start of the COVID-19 pandemic the BoC initiated a big buying program of Canada bonds – At least 5 Bln worth per week from April 1, 2020 – In March 2020 it held about 100Bln of Canada Bonds. The BoC’s balance sheet was 115 Bln – In December 2020 the balance sheet of the BoC had grown to over 600 Bln Copyright © 2023 Pearson Canada Inc. 16 - 34 Figure 16-10: The Expansion of the Bank of Canada’s Balance Sheet, 2001–2021 The size of the Bank of Canada’s balance sheet increased significantly during the coronavirus pandemic. Source: Data from Statistics Canada CANSIM series v36651. Copyright © 2020 Pearson Canada Inc. 16 - 35 Quantitative Easing Versus Credit Easing (1 of 2) Expansion of central bank balance sheets is referred to as quantitative easing (QE) – i.e. through Non-Conventional MP Tools 1 & 2 – It leads to a huge increase in the monetary base Will this stimulate the economy in the near term and produce inflation down the road? – Balance sheet expansion does not necessarily increase the money supply, since excess reserves can increase – Anyway “higher inflation” does not mean “high inflation” in absolute terms. The counterfactual may have been deflation. Copyright © 2023 Pearson Canada Inc. 16 - 36 Quantitative Easing Versus Credit Easing (2 of 2) Was nonconventional monetary policy actions during the crisis therefore ineffective? Former Fed Chair Ben Bernanke argues no – Fed’s policies were directed not at expanding the balance sheet of the Fed, but rather at credit easing – Alters the composition of the Fed’s balance sheet in order to improve the functioning of particular segments of the credit markets – Liquidity helps unfreeze particular markets and increases demand for certain securities and lowers rates (i.e., long-term) Copyright © 2023 Pearson Canada Inc. 16 - 37 Figure 16-12: Excess Reserves of Depository Institutions in the United States (in $ Billions) Source: Federal Reserve Bank of St. Louis FRED database. Copyright © 2020 Pearson Canada Inc. 16 - 38 Tool 3: Forward Guidance and the Commitment to Future Policy Actions Although short-term interest rates could be at zero, central banks can take different routes to lower long- term rates (and provide further stimulus) In particular, they can make commitments to keep policy rates at zero for an extended period of time – Commonly referred to as forward guidance – Would lower expectations of future short-term rates (and hence also lower long-term rates, see Chapter 6) Copyright © 2023 Pearson Canada Inc. 16 - 39 Tool 4: Negative Interest Rates on Reserves Central banks can charge banks for depositing their funds (i.e. set negative interest rate) Encourages banks to lend more & buy more securities Sweden first implemented this in July 2009 – Denmark (July 2012), ECB (June 2014), Switzerland (December 2014), and Japan (January 2016) Copyright © 2023 Pearson Canada Inc. 16 - 40 Monetary Policy Tools of the Federal Reserve Federal Funds Rate Open Market Operations Discount Lending Required Reserves Interest on Reserves Copyright © 2023 Pearson Canada Inc. 16 - 41 The Federal Funds Rate The Fed’s lending of reserves to banks is called discount window lending The interest rate charged banks for these loans is called the discount rate The primary indicator of the stance of monetary policy in the United States is the federal funds rate, the interest rate on overnight loans of reserves (known as federal funds ) that banks trade among themselves Copyright © 2023 Pearson Canada Inc. 16 - 42 FIGURE 16-13 Equilibrium in the Market for Reserves in the United States Equilibrium occurs at the intersection of the supply curve Rs and the demand curve Rd at point 1 and an interest rate of i*ff. Copyright © 2020 Pearson Canada Inc. 16 - 43 FIGURE 16-14 Response to an Open Market Operation An open market purchase increases nonborrowed reserves, and hence the reserves supplied, and shifts the supply curve from Rs1 to Rs2. In panel (a), the equilibrium moves from point 1 to point 2, lowering the federal funds rate from to i1ff to i2ff. In panel (b), the equilibrium moves from point 1 to point 2, but the federal funds rate remains unchanged, i1ff = i2ff = ier. Copyright © 2020 Pearson Canada Inc. 16 - 44 FIGURE 16-15 Response to a Change in the Discount Rate In panel (a), when the discount rate is lowered by the Fed from i1d to i2d, the horizontal section of the supply curve falls, as in Rs2, and the equilibrium federal funds rate remains unchanged at i1ff. In panel (b), when the discount rate is lowered by the Fed from i1d to i2d, the horizontal section of the supply curve Rs2 falls, and the equilibrium federal funds rate falls from i1ff to i2ff as borrowed reserves increase. Copyright © 2020 Pearson Canada Inc. 16 - 45 FIGURE 16-16 Response to a Change in Required Reserves When the Fed raises reserve requirements, required reserves increase, which raises the demand for reserves. The demand curve shifts from Rd1 to Rd2, the equilibrium moves from point 1 to point 2, and the federal fund rate rises from i1ff to i2ff. Copyright © 2020 Pearson Canada Inc. 16 - 46 FIGURE 16-17 Response to a Change in the Interest Rate on Reserves In panel (a), when the equilibrium federal funds rate is above the interest rate paid on reserves, a rise in the interest rate on reserves from i1er to i2er raises the horizontal section of the demand curve, as in Rd1, but the equilibrium federal funds rate remains unchanged at i1ff. In panel (b), when the equilibrium federal funds rate is equal to the interest rate paid on reserves, a rise in the interest rate on reserves from i1er to i2er raises the equilibrium federal funds rate to i1ff = i1er to i2ff = i2er. Copyright © 2020 Pearson Canada Inc. 16 - 47 Monetary Policy Tools of the European Central Bank Open market operations – Main refinancing operations – Longer-term refinancing operations Lending to banks – Marginal lending facility/marginal lending rate – Deposit facility Reserve Requirements – 2% of the total amount of checking deposits and other short-term deposits – Pays interest on those deposits so cost of complying is low Copyright © 2023 Pearson Canada Inc. 16 - 48