1. CENTRAL BANKING AND MONETARY POLICY Section 4

2. MONETARY POLICY FRAMEWORK Intermediate Target/ Nominal Anchor Economic Indicator to Guide Expected Value of Currency. Operating Targets Financial Market Indicator Directly Influenced by Tools Tools/Instruments Direct powers of the Central bank. Policy Feedback Policy Goal Transmission Mechanism

3. WHAT IS THE ROLE OF THE CENTRAL BANK? Banker to the Government Manages F/X and other reserves. Major financier of the government. Banker to Banks Hold liquid deposits of commercial banks Operate interbank payment system Provide S/T financing Implement Monetary Policy Regulate Financial System

4. BALANCE SHEETS OF THE EXCHANGE FUND Bank of Government Bank of Bankers

5. BALANCE SHEETS OF THE BANK OF JAPAN Bank of Government Bank of Bankers

7. CENTRAL BANK OBJECTIVES Price Stability Business Cycle Stability Financial Stability Exchange Rate Stability

8. 8 Genberg, H and D He (2009): “Monetary and financial cooperation among central banks in East Asia and the Pacific”, in R Rajan, S Thangavelu and R Parinduri (eds), Exchange Rate, Monetary and Financial Issues and Policies in Asia, World Scientific Publishing Co, pp 247 – 70

9. 9 More Goals

10. BUSINESS CYCLE STABILITY Modern economies are beset by volatility in economic output and employment. Does the pursuit of price stability come at the expense of business cycle stability or are the two goals complementary. Always?

12. FINANCIAL STABILITY Financial Market Stability Financial markets and institutions play an important role in moving funds from savers to borrowers.  Stock Market Stability  Real Estate Market Stability In recent years, bubbles and busts have beset markets.  Interest Rate Stability: Businesses and consumers that rely on credit prefer a predictable exchange rate.

13. 9. FINANCIAL INSTABILITY Economist Guide to Global Housing Markets

14. INCREASED FINANCIALIZATION IN DEVELOPED COUNTRIES IMF World Economic Outlook 2008 Chapter 3

15. THE COST OF CLEANING UP AFTER FINANCIAL CRISES IS VERY HIGH. CHALLENGES TO MONETARY POLICY EFFECTIVENESS 15 Link

16. EXCHANGE RATE STABILITY Hong Kong’s monetary policy emphasizes exchange rate stability. Monetary Policy in Hong Kong  Convertibility Undertaking: An undertaking by the Central bank to convert domestic currency into foreign currency at a fixed exchange rate. Linked Exchange Rate System: Since October 17, 1983, Hong Kong has a convertibility undertaking with the US dollar. Why?

17. Monetary Policy Framework Intermediate Target/ Nominal Anchor Economic Indicator to Guide Expected Value of Currency. Operating Targets Financial Market Indicator Directly Influenced by Tools Tools/Instruments Direct powers of the Central bank. Policy Feedback Policy Goal Transmission Mechanism

18. CHAPTER 16 Interbank Rate as the Operating Target

19. INTERBANK MARKET In conducting payments, banks may face a shortfall of reserves and be forced to borrow reserves from other banks or the central bank at the interbank rate. Demand: Each bank would like to keep a certain amount on reserve at any time to meet their own liquidity needs. Tradeoff for keeping stock of reserves is you cannot lend them to others. If the interbank rate IBR is high, they will want to lend their own balances to other banks and hold small reserves in their own account. Supply: Central bank controls the supply of reserves.

20. INTERBANK MARKET: BASICS S D i IBR Reserve Accounts i*i*

21. EQUILIBRIUM Excess Supply: If i IBR > i*, banks will have funds in reserve accounts in excess of that required to meet their own liquidity needs. They will offer funds at competitive rates pushing rates down. Excess Demand: If i IBR < i*, banks will tend to hold on to reserves rather than lend them at unattractive rates. Banks facing shortfalls must offer better rates

22. CRITERION FOR OPERATING TARGETS 1.Controllable 2.Observable 3.Linked to Goals Operating Targets are set by central banks to guide day to day operations.

23. 23 WHY SHORT-TERM RATES AS OPERATING TARGET? 1.Controllable: Central bank controls liquidity conditions in certain market 2.Easily Observable: changes send clear signal of changes in policy 3.Helps to Achieve Goals A.Financial Stability: avoid fluctuating interest rates B.Predictable Effects: transmission mechanism from changes in interest rate to economy are relatively well understood Back

24. OPERATING TARGET: POLICY INTEREST RATE Many countries will target the interbank rate. This is done in two ways. 1.Explicit Policy Target for Interbank Interest Rate  US Fed: Fed Funds Rate;  Bank of Japan: Uncollateralized Call Money Rate  Reserve Bank of Australia: Cash Rate 2.Explicit Policy Instrument Rate for (some) Central Bank Operations Set in order to guide interbank rate to identical target level.  Bank of Korea: Base Rate (7-Day) → Interbank Call Rate  ECB: Main Refinancing Rate (14-Day Repo) → Euribor  Bank of Thailand Policy Rate → O/N Bibor  Bank Negara Malaysia Overnight Policy Rate → O/N Interbank Rate

25. POLICY INSTRUMENTS Defined (in general) as a policy lever directly under the control of policy makers. 1.Open Market Operations A.Under some frameworks can include the policy rate. 2.Standing Facilities 3. Reserve Requirements

26. POLICY RATE Link

27. TOOLS: OPEN MARKET OPERATIONS Open Market Purchase: Central bank buys short-term government bills from commercial banks. Credits counter-parties with additional funds in reserve accounts. Open Market Sale: Central bank sells bills to commercial banks. Debits counterparties reserve accounts. Sets supply of reserves OMO’s usually implemented with repo operations.

28. REPURCHASE AGREEMENTS: Repo Central bank purchases quantity of government securities from commercial bank. Central bank simultaneously contracts to sell securities back to the bank at some future date (typically 1 to 13 days) at a slightly higher price. Equivalent to perfectly collateralized loan with interest Reverse Repo Central bank sells quantity of government securities to commercial bank. Central bank simultaneously contracts to buy securities from the bank at some future date (typically 1 to 13 days) at a slightly higher price. Equivalent to perfectly collateralized deposit with interest

29. CENTRAL BANK BALANCE SHEETS AssetsLiabilities Monetary Liabilities Currency Reserves Non-monetary Liabilities Long-term “Stabilization Bonds Government Fiscal Reserves Government Bills Foreign Reserves Unconventional Assets

30. T-ACCOUNTS T-Accounts are a handy tool for examining the effects that any transaction has on balance sheets. A bank transaction will change both liabilities and assets (and possibly net worth). The total change in liabilities plus net worth must always equal the total change in assets.

31. OPEN MARKET PURCHASE: CENTRAL BANK PURCHASES $100 OF T-BILLS FROM BANK A CB credits the reserve accounts of Bank A which increases its liabilities and takes possession of an equal value of securities as assets. Bank A gets an extra amount of reserves and loses an equal amount of securities. AssetsLiabilities +100 T-Bills+ 100 Reserves AssetsLiabilities +100 Reserves -100 T-Bills CB Balance Sheet Bank A Balance Sheet

32. TOOLS: STANDING FACILITIES Loan Facility: Commercial banks can borrow reserves overnight at a loan facility rate. Deposit Facility: Commercial banks can deposit reserves overnight at a deposit facility rate. These opportunities keep interbank rate within narrow band of the policy rate. 32 For historical reasons, standing facilities are called the discount window.

33. INTERBANK MARKET: BASICS S D i IBR Reserve Accounts i TGT i LF i DF Central bank supplies reserves elastically when IBR = LF Rate Commercial banks willing to hold reserves elastically when IBR = DF Rate

34. FACILITY: SUPPLY AND DEMAND If the interbank rate rises above the lending facility rate, then banks can borrow as much as they want from the central bank through the discount window. Supply becomes perfectly elastic at i LF. If the interbank rate rises above the deposit facility rate, banks can lend as much to the central bank as they want through the window. Demand for reserves is perfectly elastic at i DF.

35. BANGKOK MONEY MARKET

36. IMPLEMENTING THE OPERATING TARGET

37. POLICY RATE IMPLEMENTATION Monetary policy committee announces policy rate. At regular intervals, central bank holds a reverse auction, offering to “lend”* banks as much reserves as they want to hold at policy rate.  Ex. Bank of Korea has weekly repo operations with 7 day rp agreements Banks take up enough to fill demand. * Engage in a repurchase agreement

38. MAIN REFINANCING OPERATION S D i IBR Reserve Accounts iPiP i LF i SF MRO

39. FINE TUNING OPERATIONS On a day-to-day, minute-to-minute basis the willingness of banks to hold reserves will change creating intra-refinancing period volatility in the market interbank rate for reserves. Standing facility creates a corridor for fluctuations in the interbank rate but this is only a backstop. Ex. Bank of Korea  Lending facility is policy rate +100 bps  Deposit facility is policy rate -100bs. Central bank conducts ad hoc OMSs to match fluctuations in demand for reserves with supply in order to stabilize interbank rate (ex. BoK stabilizes overnight call money rate) near policy rate. In USA & Japan, all OMO’s are ad hoc.

40. INCREASE IN DEMAND FOR RESERVES MATCHED BY FINE TUNING OMO PURCHASE TO KEEP INTERBANK RATE FROM RISING. S D i IBR Reserve Accounts iPiP i LF i DF MRO i*i*

41. BOK MONETARY POLICY REPORT

43. OPERATING TARGET IN EUROLAND The Governing Council (Monetary Policy committee) decides a rate of interest for these repos, the main financing rate, as the policy interest rate. Every week, the ECB engages in 1-week repurchase agreements with banks in member countries at policy rate providing reserves in exchange for securities. Auctions are decentralized and done through NCBs In between periods, The ECB intermittently conducts fine- tuning operations to make sure, the interbank interest rate called EURIBOR, stays near the target.

44. OUTRIGHT VS REPO Repo Operations – Many demand fluctuations are temporary. When demand shifts for reasons that policymakers think are likely to be reversed in the near future, they are likely to implement the supply adjustments with repo operations that are temporary by construction. Outright Operation – If policymakers have reason to believe that shifts in demand are likely to be permanent, they may accommodate the market by a purchase or sale of bills without an accompanying repurchase agreement. This will change the supply of liquidity on an indefinite basis.

45. OPEN MARKET OPERATIONS ELIGIBLE SECURITIES U.S. Fed only uses T-bills and T-bonds for repurchase ECB and BoJ use some private securities including collateralized bonds and high quality commercial paper. Bank of Korea uses Monetary Stabilization Bonds (i.e. BoK paper)

47. WHAT SHIFTS THE DEMAND FOR RESERVES? Demand for Broad Money – When households want to hold liquid assets, they hold liquid bank deposits. When bank deposits go up, demand for bank reserves go up. Reserve Requirements – When regulations require banks to hold a high share of reserves relative to deposits, demand for reserves goes up. Liquidity Risk – When the financial institutions want to hold liquidity, demand for liquidity goes up.

48. DEFENSIVE VS DYNAMIC DEFENSIVE TRANSACTIONS – Open Market Operations in which the central bank matches the changes in supply to meet changes in demand in order to maintain a target interest rate. DYNAMIC TRANSACTIONS – Open Market Operations in which the central bank changes the supply of reserves relative to demand in order to actively change the policy target.

49. CHANGING THE TARGET After a decision has been made to change the target, the central bank’s traders kick into action and conduct active open market operations.  To lower the target interest rate, the central bank will conduct open market purchases, making reserves more plentiful and reducing the cost of borrowing them.  To raise the target interest rate, the central bank will conduct open market sales, making reserves less plentiful and raising the cost of borrowing them.

50. DYNAMIC OPEN MARKET PURCHASE BASIC ECONOMICS S i IBR Reserve Accounts S´S´ D i* 1  The interbank market is in equilibrium with supply matching demand The central bank engages in an open market purchase increasing the supply of reserves. The interbank market has an excess supply of reserves creating downward pressure on rates.  The market reaches a new equilibrium only when rates full sufficiently that banks will hold them rather than lend. 2 i** Excess Supply

51. ADJUSTING POLICY RATES: PRACTICE At the main refinancing operation/regularly scheduled repo, policy makers announce a new rate for the operation (along with new standing facility rates. The commercial banks take up as many reserves as they need at the new rate. With demand equaling supply at the new rate, the market finds equilibrium at the same rate.

52. CUTTING POLICY RATES: PRACTICE S D i IBR Reserve Accounts iPiP i LF i DF MRO New Policy Rate and Corridor Announced At Refinancing Operation, Banks take up more reserves at lower rates. Since demand for reserves is satisfied, equilibrium in interbank market at the policy rate. i*=

53. CUTTING POLICY RATES: OM PURCHASE S D i IBR Reserve Accounts iPiP i LF i DF MRO S´S´ iP´iP´ i DF ´ i LF ´ D´D´ MRO ´

54. INTERBANK RATES AND THE MONEY MARKET Money market: Debt markets w/ maturity less than 1 year: CP, T-bills, NCDs, repos. Interbank rates steer rates in the broader money market through arbitrage.  If i IB < i MM, borrow in interbank market, lend in money market;  if i IB > i MM, then reverse. 54

55. MONEY MARKET Market for debt instruments with initial maturity less than 1 year  Treasury Bills  Commercial Paper: Corporate debt  NCD’s

56. KOREAN MONEY MARKET Source: CEIC Database

57. MONETARY TRANSMISSION MECHANISM Interbank Interest Rate Money Market Rates Forex Rates Economy Stock Prices LT Interest Rates

58. TERM STRUCTURE Chapter 6: The Risk and Term Structure of Interest Rates

59. TERM STRUCTURE OF INTEREST RATES Bonds of different maturities typically have different interest rates. Typically, bonds of longer maturity pay higher yields over their lifetime. Segmented Market Theory: Long-term bonds have greater interest rate risk and less liquidity. This explains why long-term bonds have greater yields on average.

60. AVERAGE YIELD CURVE: KOREA YIELD CURVE

61. EXPECTATIONS THEORY Assumption: Portfolio holders are indifferent between long and short- term bonds. Yield to maturity over the life of a long-term bond must be equal to average yields on repeated rollovers of short-term bond holdings during the same period.

62. Consider two strategies which should have the same expected pay-off. Starting with $1. 1. Buy a two year discount bond and hold it for two years. Payoff: 2.Buy a 1 year bond. After 1 year, invest pay-off in another 1 year bond. Payoff: Two Strategies

63. Arbitrage between markets implies equal returns on equal assets. Equal pay-offs imply that yield on a two year bond is equal to the expected average yield of 1 year bonds over the next two years.

64. In general, if the pay-off for investing in an n period bond should be the same as the pay-off from rolling over 1 year bonds for n periods: Then a n period bond yield is (approximately) equal to the average expected yield on 1 period bonds between today and date n.

65. PREFERRED HABITAT THEORY Bonds have some differences in risk and liquidity characteristics. Regardless, they are close substitutes and the expectation theory well describes the connection between bonds of different yields. Yields of bonds of period n are represented as the The maturity premium h n tends to increase in n.

68. FORECASTING WITH THE TERM STRUCTURE If the expectations theory holds, long-term interest rates can be used to infer market expectations of future interest rates. Steep yield curve indicates low short-term rates and high future interest rates. Inverted yield curve indicates high short-term rates and low future interest rates.

69. INTEREST RATES: PUZZLES & PROBLEMS The Zero Lower Bound

70. ZERO LOWER BOUND One constraint on using the interbank interest rate as an operating target: nominal interest rates cannot go below zero. As inflation drops, the central bank can purchase government securities to lower interest rates only up to the lower bound. Once, that point has been reached banks will no longer lend out their excess reserves preferring to keep them rather than accept a negative interest rate. A bank that sets a ZIRP, zero interest rate policy must also target a level of reserves

72. ZERO LOWER BOUND -THEORY S BR D BR i IBR Reserves i*i* S BR ′ i ** S BR ′ ′ i *** S BR ′ ′ ′ S BR ′ ′ ′ ′ 1 2 3 45 When nominal interest rate reaches zero, demand for money turns infinite since money pays just as good an interest rate as bonds.

73. LIQUIDITY EXPANSION

74. PROBLEM How to raise interest rates without changing the liquidating $2.4 trillion worth of bonds.

75. S D i IBR Reserve Accounts i DF i*i* FED currently sets a low 25 basis point deposit facility Banks willing to hold excess reserves at i DF rather than lend them for less When FED raises rates, they will raise i DF i DF’ Quota Uncompensated Reserves Reserves beyond the quota will not receive interest, so banks have an incentive to lend them out but impose quota on excess reserves will form the effective liquidity in interbank market S’ Equilibrium in Interbank Market where effective supply equals demand In the future, the FED will manage both the quota and the supply of uncompensated reserves until situation is normalized. D

76. SWITZERLAND SETS DEEP NEGATIVE RATE CHALLENGES TO MONETARY POLICY EFFECTIVENESS 76 Link

77. PUZZLE: WHY CAN INTEREST RATES BE PERSISTENTLY NEGATIVE? Commercial banks may be willing to hold reserves that pay negative interest since: (1)Reserves may be more convenient than paper currency in making payments. (2)Currency may have large holding costs US$1Million US$1Trillion

78. CENTRAL BANK SETS NEGATIVE DEPOSIT FACILITY S D i IBR Reserve Accounts 0 i LF i DF MRO i*i*