The me­chan­ics of cen­tral bank­ing

The Pak Banker - - OPINION - Alok Sheel

THE global fi­nan­cial cri­sis has gen­er­ated a keen de­bate in fi­nan­cial dailies on the pri­mary ob­jec­tive of mon­e­tary pol­icy-price sta­bil­ity, em­ploy­ment or fi­nan­cial sta­bil­ity. De­spite the gen­eral in­ter­est sur­round­ing quan­ti­ta­tive eas­ing, there is un­der­stand­ably much less fo­cus on the ar­cane, but equally ger­mane, sub­ject of the pol­icy tools and the me­chan­ics through which mon­e­tary pol­icy ac­tions are trans­mit­ted to the real econ­omy.

The cen­tral bank or­di­nar­ily reg­u­lates liq­uid­ity in fi­nan­cial mar­kets through sales and pur­chase of fi­nan­cial as­sets (usu­ally trea­sury bonds) from de­pos­i­tory banks through overnight repo (re­pur­chase) agree­ments. It then de­fends this rate in the mar­ket through open mar­ket op­er­a­tions to en­sure that its overnight pol­icy rate be­comes the risk-free mar­ket rate, thereby in­flu­enc­ing the yield curve. The ac­com­pa­ny­ing styl­ized rep­re­sen­ta­tion of mon­e­tary flows il­lus­trates how the mon­e­tary sys­tem works.

The cur­rency in cir­cu­la­tion and bank­ing re­serves to­gether com­prise the mon­e­tary base. Un­der frac­tional bank­ing, de­pos­i­tory banks park a small frac­tion of their re­sources with the cen­tral bank as re­serves. This frac­tion can be used as a mon­e­tary pol­icy tool for reg­u­lat­ing liq­uid­ity. Since no in­ter­est is or­di­nar­ily payable on re­serves, banks tend to park only the man­dated amount as re­serves. There is, how­ever, noth­ing to pre­vent them from park­ing higher amounts should they turn risk-averse. This is ex­actly what had hap­pened dur­ing the re­cent global fi­nan­cial cri­sis, best de­scribed as a 'liq­uid­ity trap' in which liq­uid­ity in­jected into the fi­nan­cial sys­tem by the cen­tral bank is washed back as re­serves and the money mul­ti­plier de­clines sharply.

The mon­e­tary base is from where the fi­nan­cial sys­tem ex­tends credit. Ce­teris paribus, ex­pan­sion of credit leads to an in­crease in the money mul­ti­plier (or the ve­loc­ity of money, money sup­ply di­vided by the mon­e­tary base), which is money cre­ation by the fi­nan­cial sys­tem. There are var­i­ous mea­sures of money sup- ply, such as M1, M2, M3, de­pend­ing on what types of de­posits and liq­uid money are in­cluded, with M2, or broad money, the most com­mon.

The overnight rate is not the only tool avail­able with cen­tral banks. The Bank of Ja­pan was the first to use what is pop­u­larly known as 'Quan­ti­ta­tive Eas­ing' (QE), or the out­right pur­chase of se­cu­ri­ties, when the pol­icy rate hit zero in the 1990s. Since 2007, the as­sets of the US Fed­eral Re­serve and the Bank of Eng­land have in­creased five times, those of the Bank of Ja­pan have tre­bled, and those of the Euro­pean Cen­tral Bank have dou­bled.

The short-term pol­icy rate in­flu­ences long-term rates, crit­i­cal for in­vest­ment and sav­ing, only in­di­rectly. QE can be used to di­rectly in­flu­ence long-term rates. Ben Ber­nanke, for­mer Fed chair­man, drew a dis­tinc­tion be­tween 'quan­ti­ta­tive eas­ing' and 'credit eas­ing'. The for­mer en­tails the pur­chase of bonds by cen­tral banks. Credit eas­ing, such as 'op­er­a­tion twist' con­ducted by the Fed­eral Re­serve in Septem­ber 2011 that en­tailed sell­ing short-term bonds to pur­chase longterm ones, af­fects the yield curve di­rectly with­out in­creas­ing the size of the bal­ance sheet. This dis­tinc­tion is not merely tech­ni­cal. It has a crit­i­cal bear­ing on how the cen­tral bank bal­ance sheet can be un­wound.

There are also other pol­icy tools avail­able with cen­tral banks. The process of nor­mal­iza­tion of mon­e­tary pol­icy may con­strain them to use some of th­ese other tools, rather than the pol­icy rate, as their main pol­icy in­stru­ments. This is be­cause only about a quar­ter of the Fed's as­set pur­chases were fi­nanced by newly cre­ated money. About three-quar­ters were fi­nanced through ex­cess re­serves parked with the Fed on ac­count of risk aver­sion. Once banks start lend­ing again, or if in­ter­est rates were to rise, banks may with­draw th­ese dis­cre­tionary re­serves, which are more than twice the cur­rency in cir­cu­la­tion. Most of the monetization of the bal­ance sheet could hap­pen the­nun­less the Fed in­creases the manda­tory re­serve re­quire­ments, in­creases the in­ter­est it pays on the ex­cess re­serves (IOER), or uses other ster­il­iza­tion in­stru­ments such as the re­verse repo (RR) or sells as­sets.

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