HOW SHOULD CENTRAL BANKS TAKE THE QUANTITY OF MONEY INTO ACCOUNT WHEN DETERMINING MONETARY POLICY CHANGES?

By Rishi Shah

Monetary Policy is a vital tool used by central banks as a form of liquidity management in order to meet output and/ or inflation targets, through the availability of money and the cost of credit. It was instrumental in the financial crisis, or more aptly the global liquidity crisis of 2008, to stimulate economic growth. The Monetary Policy Committee (MPC) is the 9-member group who ensure that nominal supply and demand in the economy meet. They have a plethora of devices available, notably the Bank Rate and quantitative easing (QE), which is the large-scale purchasing of financial assets in return for Central Bank reserves. It became the foremost weapon during the financial crash due to the Bank Rate having already plummeted close to the zero-lower bound. Through this essay, I will consider the reasons for the evolving nature of monetary policy, the international disparity in its implementation and the rationale that should be used when determining monetary policy changes. Keynesian economics argues that increasing demand (and hence AD) during a time of demand-deficiency, regardless of the means, is beneficial, which the transmission mechanism of QE does exactly. Therefore, it is crucial to evaluate the effectiveness of QE as an open market operation (OMO) and dwell on the stability derived as a result of monetary policies.

evolution of monetary policy

The use of money can be confidently traced back to 700 B.C., where it acted as a standardised unit of account. Since the advent of money, monetary policy was conceptualised and first implemented. Historically, it would only have required the rudimentary institutional organisation to ensure there was the optimal liquidity in circulation, to facilitate desired levels of trade. However, through the economic events during the 18th and 19th Century, such as the foundation of finance in commerce and industry, mercantilism, the industrial revolution and the rise of strong nation-states conducive to capitalism, monetary policy advanced to adapt to this change. Walter Bagehot wrote about the ideal response of central banks in crises in his book Lombard Street: A Description of the Money Market, in response to the collapse of Overend, Gurney and Company[1]. He believed that the Bank of England should lend freely, at a high rate of interest and on good securities to avoid panic, hence shaping the characteristics of the then monetary policy decisions.

With the increasing influence of Keynes, countercyclical monetary policy became widely used. This is where during times of economic downturn, expansionary monetary policy (namely increasing the money supply through low-interest rates and the employment of QE) was pursued, and the converse during a boom. Between the two world wars there was hyperinflation in many Central Powers, most memorably in Germany, finally ended by the deviation away from the gold standard [2] after World War 1. Subsequently, however, came the “Goldilocks” economy during the 1980s, where inflation rates fell to “low and stable” levels and was seen as the golden age of monetary policy.

Overall, we see that before the 1980s central bankers were concerned chiefly with maintaining financial stability holistically. William Martin[3] famously said “The role of the Federal Reserve was “to take away the punchbowl just as the party gets going”, a metaphor with the party representing booms and the punchbowl the excess liquidity. After the 1980s, central banks became convinced that by maintaining stable inflation then the intervention of bubbles was unnecessary and the crises wouldn’t occur.

Overall, the use of monetary policy by central banks has greatly evolved over time, such that historically it had multiple roles from debt management to looking after dysfunctional markets, but now it has focused on the seldom goal of inflation targeting.

MONETARY POLICY DURING AND AFTER THE 2008-2009 FINANCIAL CRISIS

There is a complicated relationship between monetary policy and crises. Generally, bubbles which are a common cause of crises are very hard to control with monetary policy. As seen with the Dutch tulip mania, the dot.com bubble and other times when “irrational” exuberance is shown (hence prices do not accurately represent risk), it is very hard to predict a crisis as the central bankers would need to judge that hundreds and thousands of investors are deluded. Hence, monetary policy mainly acts after the crisis, and it is very hard, if not impossible, to prick the bubble that is the root of major crises. The financial crisis highlighted a flaw in standard monetary policy, whereby when there is a loss of confidence of businesses and consumers, there is little that is possible.

To best explore the role of policy after the crash, I will highlight the causes. Initially, once financial organisations couldn’t sell packaged loans (notably sub-prime mortgages) easily to a third party, due to the growing lack of trust, they had to either stop lending to the majority or keep the loans. Moreover, the interconnectedness of global banking, combined with the leverage each bank held over others, meant that a fall in trust was disastrous. Finally, the lack of liquidity held by banks, compounded by the risky securities they sold, whilst betting against them, meant when the bank-run came, and consumers flocked to retrieve their money, the bank failed. At the time, banks had enough liquidity to last a meagre 3 days[4], now it is a respectable 90. Thus, a financial crash was induced,

Since 1997, the Bank of England was given operational independence to pursue the inflation target and hence given control over interest rates, relieved from the government. Despite the fact that the policy paradigm since 1997, guiding the flurry of policy decisions during the credit crunch, remained steadfast (maintaining price stability), the tools used greatly evolved since the rudimentary measures used historically.

One of the initial responses to the financial crash was one the then BoE governor, Mervyn King was against, whereby the BoE increased bank funding and acted as lender of last resort for the Northern Rock Bank, who accounted for 1/5th of the UK mortgage market.  As the crisis deepened, international monetary policy innovation grew. Alongside driving up public debt by taking private equity stakes in large banks such as Lloyds and RBS (the UK Asset Protection Programme), nominal interest rates were reduced to near-zero levels. This was accompanied by an Asset Purchase Facility, where QE was used to purchase £200bn of government debt by creating central bank reserves. Cumulatively, monetary policy was instrumental in bank rescue and prevent a deflationary spiral, and limit the effects only to those we faced.

Quantitative Easing: The aftermath of the financial crash saw the implementation of 2 forms of QE. The first being central banks purchasing government securities and the second, more unconventional method being central banks procuring high corporate bonds. The latter aimed to increase liquidity in the private sector and ultimately increase the flow of corporate credit, which had all but frozen post-2008. Moreover, the use of QE also reinforced a psychological message, such that although interest rates were close to zero/ negative, the BoE was prepared to go to all lengths to rekindle the “animal spirits” in the economy.

Quantitative easing wasn’t without controversy, notably the doubt of its effectiveness. Its success very much lies in the action of banks in response to the liquidity the receive from the central banks, the response of households relative to inflation expectations and finally the response of capital markets to the purchases of corporate debt. Many believe that QE won’t encourage investment, as, during times of economic downturn where economic growth forecasts are skewed negatively, investors will hold cash rather than investing. Critics of monetary policy post-crash highlight that QE increased inequality. The economic agents who held assets benefitted greatly, yet there was a stark difference to others who on top of being rendered unemployed, faced negative equity.

Near-Zero and Negative Interest Rates: In June 2014, The European Central Bank become the first bank to push interest rates below zero on deposits commercial banks held with them. The aim of this was to encourage banks to lend more and direct capital to investments, instead of storing money (0.4% interest was charged to hold their cash overnight). The two-pronged attack of low-interest rates had the transmission mechanism such that the weakened currency increased the competitiveness of exports and also boosted investment, therefore, increasing inflation to healthier levels. Figure 1 shows the plummeting of interest rates to 0.5%, which was used by the BoE in conjunction with the APF, to bring the UK out of the recession.

However, as with all radical policies, negative interest rates came with their own issues. Banks, who couldn’t pass on the higher costs incurred by the negative interest rates onto depositors, faced a liquidity squeeze and hence reduced their ability to provide credit. This is a recurring theme in the credit crunch and hence negative interest rates acted counter-productive in some manners. Economic agents who face negative interest rates will take their money out of the economic cycle, and hence as per monetarist’s logic, deflationary pressure is increased as there is “less money chasing the same number of goods”.

A juxtaposing line of thought is that as OMO’s, namely QE in this instance, allow for the discretion of banks and hence their effectiveness is limited.   The financial markets lacked certainty when the £200bn QE programme was rolled out in the UK, and the opportunity for discretion renders this form of monetary policy tentative at-best.

Overall, the financial crash forced the hand of central bankers, to diversify into other policies, as people reverted to cash as interest rates plummeted. Monetary policy went through a period of rapid innovation during the crisis and I have explored the numerous methods in which central bankers dampened the effects of the crisis.

HOW SHOULD CENTRAL BANKS DETERMINE MONETARY POLICY CHANGES?

It is evident that monetary policy needs to adapt to the plethora of challenges it faces, and hence the MPC and international counterparts should consider a range of factors when determining these instrumental changes.

Foremost should be the concern for financial stability, such that financial crises and their disastrous consequences should be pre-empted and averted with monetary policy. The loss of output from the 2008 crisis is something that we will never recover. When a central bank suspects a bubble is forming, it is best to “prick” it early, with monetary policy. Perhaps interest rates were kept “too low for too long”, during the dot.com technology (400% increase in NASDAQ), where the eventual late hike in interest rates to reign-in inflation was “too little too late”. Rather than facilitating the frenzy with overly accommodating policy and instead of fuelling policy that benefits the masses, central banks should systematically and incrementally increase interest rates, rather than resort to a large hike very late, with it potentially causing a recession. Hence, monetary policy can be effectively used to induce a moderate recession today to prevent a mammoth one tomorrow. When risk accumulates in the financial system monetary policy should respond to ensure long-term financial stability.

Given recent events, the political influence on monetary policy is one that should also be noted. Naturally, central banks should discount any political sway when making decisions. Mr. Trump has repeatedly commented on the actions of the Federal Reserve and even recommended to them the course of action he deems ideal. Any political inclination must be ignored to allow for successful, neutral and equitable policy changes. Incessantly Mr. Trump has publicised his belief that the interest rate rises are occurring too soon, and this is increasing scrutiny of every monetary policy decision the Federal Open Market Committee makes. This could likely influence future decisions and therefore is a harmful precedent.

The quantity of money is perhaps the crucial factor when considering monetary policy, such that when central banks find a large money supply there should be expansionary policy. When we model an economy, “borrowed money” can be seen as a good, and therefore when there is high supply, the cost falls and hence interest rates are lower. When combined with a risk premium, and factoring in market risk, the actual cost of borrowing is derived.

As seen in Figure 2, when there is constrained liquidity and low supply of money in the economy, central banks internationally took action. The growth in the balance sheets, such as that of the Federal Reserve from mid-2010 to 2011, shows the effect of quantitative easing. Monetary policy ensured that deflation was avoided, or its impacts lessened.

CONCLUDING REMARKS

Through exploring the stability that ensues after successful monetary policy and the controversy that surrounds it, I have explored the foremost factors that central bankers must acknowledge when considering the supply of money. However, as the free-market pioneer, Friedrich August Von Hayek, once said, “With the exception only of the period of the gold standard, practically all governments of history have used their exclusive power to issue money to defraud and plunder the people.”, it is very easy for monetary policy to become a weapon. Money supply should be sacred, and all decisions must be considerate of all possible outcomes.

With regards to the financial crash, however, the supply of money was atrociously managed. In the immediate aftermath of the crisis, so-called bright economists at the Federal Reserve were clueless about the state of the economy, namely in 2007, when they described the status of the economy as “likely to continue to expand at a moderate pace” (FOMC Press Release 2007). This shows an unforgivable ignorance, which in turn caused the tardy decreases in interest rates. They should have recognised the need to inject “easy money” rapidly. Perhaps the premise of monetary policy had been misguided. Instead of the steadfast focus on inflation, regardless of other macroeconomic conditions, growth and stability would have been a more apt aim, which in all likelihood would have increased the rate that interest rates were cut. However, one must acknowledge the success of QE to prevent a deflationary tragedy, similar to that we faced during the Great Depression. Central bankers have been entrusted with the instrumental task of controlling the supply of money, and hence they must rise up and shoulder this responsibility, through diversifying their focus from inflation. As Keynes once said, “The difficulty lies not so much in developing new ideas as in escaping old ones”. Central bankers must rise up to this challenge, and evolve monetary policy to foster a prosperous, equitable and stable economy.

[1] A wholesale discount firm, which was seen as a lender of last resort, or more colloquially “the bankers’ bank” which collapsed during the Panic of 1866, followed immediately by a financial crisis. 

[2] monetary system where a country's currency or paper money has a value directly linked to gold.

[3] William McChesney Martin was the chairman of the Federal Reserve from 1951 to 1970.

[4] https://faculty.insead.edu/jean-dermine/documents/RegulationsAfterCrisis2013-March.pdf