What does Monetary Policy Actually Do? Part I

With the Fed meeting coming up, a lot has being discussed on about whether the US Central Bank is about to raise interest rates. Nonetheless, there appears to be a lack of available articles which explain what monetary policy is, its objectives, and the incentives of monetary authorities when they resort to policy actions. This post aims at elaborating on all these topics in an effort to provide a deeper understanding of monetary policy.

Introduction

Before we start, we need to differentiate between the two main sectors of the economy: the real and the financial one. The real economy refers to businesses which produce goods and services which are used by the public. The financial sector refers to all activities which are related to financing, particularly commercial banks (i.e. banks which deal with offering loans and deposits to consumers), investment banks (i.e. banks which focus on providing services to other firms), and the stock market. The financial sector also referred to as the monetary sector.

In the past, the monetary sector was just a fraction of the real sector. This started to change in the 20th century when economists realized that the financial sector was growing in importance. Furthermore, they also understood that as this happened its importance on determining the amount of money in the economy was also growing. Note that money is determined by the amount of outstanding deposits, with an increase in loans suggesting an increase in the overall amount of deposits in an economy. To put this in perspective, imagine that you are obtaining a loan for some reason. Usually, this money is obtained to be spent, i.e. it will end up in someone else’s account. Hence, banks can generate money through their loan-creation process. In a similar manner, if the stock market is continuously rising, new money is expected to be created. Remember that an increase in the supply of money in the economy will cause higher inflation, which could hurt consumers’ purchasing power.

This theme of rising inflation became more evident in the stagflation periods of the 1970s, which underlined the use of policy actions to fight increased inflation. To this end, as the name suggests, monetary policy aims to affect the monetary sector and stabilize the inflation rate by controlling new lending in the economy. This is made possible through the manipulation of the interest rate that the Central Bank charges when lending to or accepting deposits of money from the commercial banks in its jurisdiction. These are commonly known as policy rates, although official names differ from country to country: in the US, the two are collectively named as the Federal Funds Rates, while in Europe the ECB can potentially set a different rate for the Deposit Facility and the Marginal Refinancing Operations (i.e. lending) rate.

How does Monetary Policy affect the Economy?

Banks, in any usual operating day, could end up with a small money deficit or surplus as people may choose to withdraw or deposit more money with them. To meet this change in their position, they tend to borrow either from the Central Bank or from each other, for often as small a horizon, often for a period as short as one night. The policy rate not only defines the overnight lending rate banks would pay the Central Bank, but also serves to define the overnight inter-bank interest rate. The mechanism is simple: if a bank seeks to borrow from another bank it would be to its benefit only if the interest rate charged was less than the Central Bank rate. Hence, the policy rate serves as a ceiling for all inter-bank lending activities.

Banks can borrow at the policy rate, or in the inter-bank market at a rate lower than the official policy rate (otherwise the banks would only borrow from the Central Bank). This means that the policy rate would serve as a floor for their lending to consumers or businesses. For example, if the policy rate stands at 2%, then the minimum a bank would charge in order to avoid losses would be that plus its operating costs. If, for example, the policy rate increases by 1%, then the commercial bank would have to borrow from the Central Bank at a higher rate and increase its interest rate on loans by that amount if it wants to maintain its profit margin and not experience a reduction in its profits.

The same holds for the interest rate offered on bank deposits: as the Central Bank increases policy rates then banks need to increase their deposit rates. Suppose the policy rate is increased by 1% but commercial banks do not raise their interest rates by a similar extent. Then, it could be the case that a single bank could actually raise its rate by, say, 0.25%, and receive an influx of deposits which it could actually lend back to Central Bank and enjoy a hefty profit from the 0.75% difference (the 1% increase minus the 0.25% increase in deposit rates). However, another bank could do the same by increasing its deposit rates by 0.30%, another could do it by 0.35% and so on. This arbitrage (i.e. certain profit with zero risk) opportunity would be zeroed out only if banks raised their deposit rates by 1%. This chain of events hence confirms that any change in the policy rate will subsequently be passed on to consumers and businesses.

Through this, Central Banks affect the public’s inclination to borrow: as interest rates increase, less people will find it profitable to borrow. For example, if the total cost of lending is 3%, then an investment with a return of 4% would be profitable. However, if the lending rate is raised to 4.5% then an investment offering the same return will no longer be that appealing. As such, people would be less willing to borrow for investments which would yield lower returns and will also be less willing to borrow for those yielding higher returns as these are, by definition, riskier. Reducing the amount of lending is expected to stabilize the amount of money in the economy and hence ease inflationary pressures and cool down the demand side of the economy.

In a similar manner, higher policy rates would result in higher deposit rates which would in turn also substitute riskier investments. In other words, an increase of the deposit rate to 3% would make a potential investment yielding the same return less attractive given that the risk for the former is almost zero, while in the latter it is much higher. This would mean that less money will go for investment purposes and more money will remain at the bank, again cooling off the economy.

The above has put monetary policy in context, overviewing the channels through which it impacts the economy. Which leaves us with the next important question, related to when Central Banks decide that the time has come to move policy rates. More on that in the second part of this series. Stay tuned!