Primary objective of the Eurosystem (2)
- Maintain price stability
Secondary objective
- Without prejudice to price stability, support the general economic policies in the Union (economic growth, full employment,…)
Eurosystem's definition of price stability
- Year-on-year increase of HICP of around 2% over the medium term in the euro area on average
Important parts of the price stability definition (3)
- "around 2%" -> symmetric target
- "medium term" -> effects of monetary policy on inflation takes 1,5-2 years to kick in
- Euro area on average -> does not mean that inflation will be at 2% in all individual EMU Member States
Prices the Eurosystem is targeting (2)
Examples (6)
- HICP -> consumer prices
- Representative shopping basket for each EMU country
Examples
- Food
- Tobacco
- Housing
- Water, electricity, gas
- Transport
- restaurants
Goals of other central banks
- US: stable prices (inflation rate of 2%), maximum employment, moderate long-term interest rates
- UK: inflation of 2%
- China: maintain "stability of the value of the currency" (internal value (= inflation), external value (= exchange rate)), economic growth
Has ECB met price stability target?
- Yes; overall, has kept inflation around 2% from beginning until late 2022
- Some periods where inflation was significantly below 2% -> adoption of symmetric goal
- Since 2022 inflation much above 2% but ECB reaction led to rather quick reduction again (can be discussed whether they reacted too late to oil price shock)
Main instrument of conventional monetary policy
- Raising or lowering policy rates in the positive territory to steer short-term money market rates
o Marginal lending facility
o Main refinancing operations
o Deposit facility
Transmission channels (7)
- Wealth channel (Asset prices)
- Balance sheet channel (firms' collateral)
- Bank lending channel (banks' collateral)
- Capital channel (banks' capital)
- Risk taking channel (risk perception)
- Interest rate channel (retail rates)
- Exchange rate channel (exchange rates)
Describe interest rate channel (8)
- ECB increases policy interest rate
- Money market rates go up
- Market interest rates go up
- Refinancing cost for banks go up
- Banks increase retail rates
- (with inflation expectations) Increase in real retail interest rates
- Loans are more expensive, saving gives more return
- Customers spend less, less demand, consumer prices go down (= dampens inflation)
Describe exchange rate channel (6)
- Nominal exchange rate appreciates
- (with inflation expectations) Real exchange rate appreciates (Euro appreciates)
- Home products more expensive abroad -> less foreign demand
- Foreign products cheaper -> less domestic demand (= dampen inflation)
- -> less aggregate demand (= dampen inflation)
Describe wealth channel (6)
- ECB increases policy rates
- Market interest rates increase
- Value of old bonds (with lower rates) and shares falls
- Asset values fall
- Wealth is decreased
- Demand (Consumption and investment) shrinks (= dampening inflation)
Describe balance sheet channel (5)
- Balance sheet of firms are affected
o Expected future cash flows are discounted
o Asset values decrease
o Expected future revenues decrease
- Firms have less collateral for loans
- Loans become more expensive -> lower loan demand
- Reduced borrowing -> less investment and consumption -> lower aggregate demand (= dampens inflation)
Components of real interest rates (3+equasion)
What is driving real interest rates?
- Nominal risk free interest rate (+)
- Risk premia (+)
- Expected inflation (-)
- Real rates = nominal risk free interest rate + risk premia – expected inflation
- Expected inflation
What will happen to real interest rates, if inflation expectations increase? (1)
- If the expected inflation increases, real interest rates decrease
Is a change in inflation expectations relevant for the transmission of monetary policy to the real economy?
Examples (2)
- Relevant because increased inflation expectations -> decreased real interest rates -> set transmission channel in motion in the opposite way than raising policy rates would
- Wealth channel
o Decreased real interest rates
o -> increased asset prices
o -> higher household wealth
o -> more spending
- Interest rate channel
o -> borrowing is cheaper, saving less attractive
What will happen to the real economy, if inflation expectations change? How is the inflation path (ceteris paribus) affected?
- More inflation expectation -> lower real interest rates -> more borrowing, less saving -> more spending -> more aggregate demand -> economy is boosted -> higher inflation
- Lower inflation expectation -> higher real interest rates -> less borrowing -> less consumption, investment -> less aggregate demand -> economy is dampened -> lower inflation
There are empirical findings describing the effects of monetary policy. What are the transmission-lags of monetary policy for output and inflation?
Transmission lags of monetary policy for output (GDP)
- Growth rate starts decreasing very soon
- Relevant decrease reached after approx. 5 quarters
- Then increase again (no long term effect of monetary policy on growth)
Transmission lags of monetary policy for inflation
- No immediate effect
- Decrease in inflation only once GDP has been affected, so after 5-6 quarters
- Inflation stays longer (long term effect of monetary policy on inflation)
Does monetary policy have a long-run effect on output? Does monetary policy have a long-run effect on prices?
Long run effect of monetary policy
- On output: no
- On prices: yes
Why does the Eurosystem have an inflation target and not a GDP growth target?
- Monetary policy can influence prices over the long-term, but can only influence growth over the short-term
- Monetary policy cannot be used to foster long term growth
Different types of money (3) and their characteristics (2 each)
- Cash (tangible, claim against central bank)
- Bank deposits (intangible, claim against commercial bank)
- Central Bank Digital Currency (intangible, claim against central bank)
Are crypto assets money? (3)
- No
- Arg: no claim against anybody (neither central bank, nor commercial bank)
- Arg: significant fluctuations of value (no one insures stable value)
What do (commercial) banks need central bank reserves for? (3)
- To fulfill legal minimum reserve requirements
- To fulfill their promise to clients to exchange bank deposits for cash
- To settle liabilities between banks (or on the financial markets)
What is the Eurosystem’s operational target? (3)
- Short-term money market rates
- €STR
o = euro short term rate
o = wholesale euro unsecured overnight borrowing costs of banks in the euro area
- EONIA
o = euro overnight index average
o Predecessor of €STR
How many key policy interest rates does the Eurosystem have? Explain what they describe
Key policy interest rates (how many, names, what they mean)
- 3 key policy interest rates
- Marginal lending facility
o Interest rate at which banks can get central bank reserves from national central banks with a maturity overnight (necessary to have a balanced central bank account every day)
- Main refinancing operations (MRO)
o Interest rate at which banks can get central bank reserves with a maturity of one week
- Deposit facility
o Interest rate that banks get for excess central bank reserves with a maturity overnight
Please rank the Eurosystem’s policy interest rates according to their level (highest to lowest).
- Main refinancing operations
Why does the Eurosystem have three different policy interest rates?
- Marginal lending facility and deposit facility are necessary because they drive the money market and thereby enable transmission
- The MRO is necessary to get liquidity into the markets / manage liquidity (it provides banks with central bank reserves).
What are EONIA / €STR? (3 each)
o Former standard reference rate for the euro money market
o = euro short-term rate
o Reflects euro overnight borrowing costs – wholesale & unsecured – of banks located in the euro are
o Standard reference rate for the euro money market
What will be the position of the EONIA / €STR, if the central bank provides exactly as much liquidity as is needed by the banking system?
- EIONA/€STR will on average be squarely in the middle between the marginal lending facility rate and the deposit facility rate (often close to MRO)
- (because here, every demand for excess liquidity corresponds to offer of excess liquidity, meaning there is a balanced money market)
What will be the position of the EONIA and €STR, if the central bank provides more liquidity than is needed by the banking system?
- EIONA/€ESTR will likely settle near the deposit facility rate
- (Because there is more offer of excess liquidity than demand for excess liquidity, meaning that those with excess liquidity can demand less interest from those needing excess liquidity)
What determines the position of the EONIA within the policy interest rate corridor?
- Whether the central bank provides too little, just enough, or too much liquidity
What is the Effective Lower Bound of monetary policy? (2)
- = technical minimum nominal interest rate at which market actors switch to using cash instead of central bank liquidity
- very low, likely considerably below zero in many economies
Is the Effective Lower Bound necessarily the same in different countries? Examples?(2)
- No, because it depends on cost of storage and insurance of cash and economy's ability to switch to cash
- E.g. Sweden: -1,6%; US: -0,35%
Has the Effective Lower Bound constrained monetary policy in the euro area in recent years? (3)
- because ELB is likely at least -0,7% in euro area and Eurosystem did not fully exploit this range (no increase in demand for banknotes)
- rather limited by reversal rate (interest rate where bans are negatively affected and rate cuts do not further stimulate the economy)
If conventional monetary policy hits the Effective Lower Bound, what else can monetary policy do? (1+3)
- use unconventional monetary policy, i.e. tools other than changing policy interest rates
- e.g. asset purchases
- e.g. term-funding facilities
- e.g. forward guidance
Why do most central banks around the world have an inflation target larger than zero? (5)
- Inflation can "soften" the effective lower bound
o ELB only concerns nominal interest rates
o Economic behaviours are determined by real interest rates
o Higher inflation expectations -> lower real interest rates
- -> (low positive) Inflation provides a "safety buffer" for monetary policy
Unconventional monetary policy instruments (5)
- Negative interest rates
- Asset purchases
- Term-funding facilities
- Forward guidance
- Adjustments to market operations
What is forward guidance? (3)
- Central banks provide information about future monetary policy intentions
- Essentially promising a certain interest rate path, subject to conditions
- Steers long-term money market interest rates
Why did central banks (not only the Eurosystem) buy (government) bonds during the crisis? (3)
- Asset purchases by central banks change (increase) bond prices
- Increased bond prices -> decreased effective interest rates of existing bonds
- lower effective interest rates of existing bonds -> new bonds can be issued with lower coupons -> longer-term interest rates go down
What does quantitative easing (QE) mean and how does it affect the economy? (5)
- = Central banks purchase bonds
- Increases bond prices and brings money into the banking system
- Lowers a wide range of (longer term) interest rates
- Businesses and people borrow more, consume and investment more
- Boosts economic growth
Do you think that announcing a new inflation target could help to reshape inflation expectations? (4)
- Announcing new inflation target is a form of forward guidance
- Shapes market actors' inflation expectations if credible
- thereby shapes real interest rates; real interest rates affect economic behaviour
o e.g. if announced target is higher -> higher inflation expectation -> lower real interest rate -> more spending
- downside: to remain credible, central bank is in a way "bound" (inflexible) for a certain period of time
How should monetry policy react to one off oil price shock (2) / steadily increasing energy prices for multiple years (2)
Reaction to one-off oil price shock
- No reaction
- because monetary policy has time lag of 1,5-2 years to influence inflation, by then shock will no longer be relevant
Reaction to steadily increasing energy prices for multiple years
- Increase in policy rates
- Because increase in energy prices over multiple years means higher inflation over multiple years -> after time lag of 1,5 years, shock will still be relevant and monetary policy intervention thus necessary
How to proceed from expansionary monetary policy to tightened monetary policy (3)
- First: stop asset purchases (otherwise counteracts policy normalisation on the long end oft he yield curve)
- Then: Increase policy rates and quantiative tightening
In 2021/22 the ECB decided to tighten monetary policy: Why did the ECB stop buying assets before it increased policy rates? (2)
- Because ongoing asset purchases would have counteracted policy normalisation on the long end of the yield curve
- and would have created a flatter yield curve
What does quantitative tightening (QT) mean?
- decrease financial assets held on central bank balance sheet to decrease the amount of liquidity in the economy
What is the difference between active and passive QT? (3)
- active QT: central bank proactively sells assets from its balance sheet
- passive QT: central bank lets assets on its balance sheet mature without reinvesting the proceeds
- difference: active QT is quicker, more "radical", can disturb markets; both aim to tighten monetary conditions
Drivers of government bond yields (3)
- country specific credit risk (risk of government default)
- country specific liquidity risk (difficulty in finding counterparty)
- risk aversion / risk appetite (economic environment)
Reasons to be cautious with active QT (2)
- QT drives down asset prices -> risk of disrupting financial markets (nervousness and instability can ensue)
- heterogeneity in the euro area
You are in the position of a central banker, and you are confronted with an inflation rate above target and increasing inflation expectations. What would you do? (3)
- because of high inflation and high inflation expectations, real rates are down -> more demand -> more inflation
- to deal with this: would increase policy rates to increase real rates
- would announce sticking to inflation target (e.g. "around 2%") to anchor inflation expectations and stopping self-fulfilling prophecy
How does a steady increase in the demand for banknotes (on the liability side of a central bank’s balance sheet) affect the amount of excess reserves (also on the liability side of a central bank’s balance sheet), if the central bank balance sheet remains constant?
- Increase in banknotes demand means decrease in amount of excess reserves
Systems to steer operational targets within interest rate corridor (3)
- Broad corridor system
- Floor system (supply driven)
- reserve system (demand driven)
Broad corridor system – advantages (2), downsides (2)
Advantages
- active interbank market
- lean central bank balance sheet
Downsides:
- high volatility on unsecured overnight money market
- need to accurately forecast reserve demand
What are the virtues of a floor system?
Floor system – advantages (2), downsides (3)
- little volatility on unsecured overnight money market
- only rough estimate of reserve demand needed
Downsides
- Small interbank market
- Large central bank balance sheet
- Less room for manoeuvre in case of crisis
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