The transmission mechanism of monetary policy Banco Central

The transmission mechanism of monetary policy Banco Central do Brasil conference: “One year of inflation targeting” 10 th July 2000 Alec Chrystal Bank of England www. bankofengland. co. uk

Structure of remarks • Briefly outline main elements of the transmission mechanism of monetary policy as set out by the UK Monetary Policy Committee. (Bo. E Quarterly Bulletin, May 1999; available on web site. ) • Does “money” have a role? • Suggest some aspects that might differ in other countries and other institutional arrangements • Discuss some puzzles and problems for monetary policy makers

The transmission mechanism Official rate ? Inflation

The transmission mechanism Market rates Asset prices Official rate Expectations/ confidence Exchange rate

Official rate changes other market rates • Bank of England sets 2 week repo rate • This affects other market short rates similarly • Banks adjust their “base” lending rates, mortgage rates, and savings rates • Long rates respond to any new information about course of future short rates and expected inflation

Asset prices • Equity and bond prices respond to new information about term structure of discount rates, real growth prospects, and inflation prospects • House and other property prices adjust (maybe slowly) to new borrowing costs

Expectations and confidence • Policy actions and policy announcements have effects on expectations of future growth in real activity and inflation • They also affect the confidence with which such expectations are held and the credibility of the monetary authorities themselves • Specific policy decisions may have small effects in this regard but the cumulative impact of decisions and pronouncements can be important • Credibility is hard to gain but easy to lose

The exchange rate • Official rate changes may create changes in the FX value of domestic currency • Lower rates generally cause depreciation and vice versa • BUT anything can happen, depending on impact on market expectation • ALSO interest rate changes explain only small part of variation in the exchange rate

The transmission mechanism Market rates Asset prices Official rate Expectations/ confidence Exchange rate Domestic demand Net external demand Total demand

Interest rates, asset prices, expectations, and the exchange rate affect domestic and net external demand • Consumer spending: interest rates, wealth effect, confidence, income and employment prospects • Investment: cost of capital, asset values, prospective demand, confidence • Net trade: affected by domestic demand relative to supply and real exchange rate • Total demand relative to supply leads to domestic inflationary pressure

The transmission mechanism Market rates Asset prices Official rate Expectations/ confidence Exchange rate Domestic demand Net external demand Total demand Domestic inflationary pressure

Domestic inflation results from combination of domestic inflationary pressure and imported inflation • Imported inflation depends on world inflation (in foreign currency) combined with the exchange rate • So depreciating currency will be associated with higher inflation for given world inflation rate • NB: domestic price level and exchange rate are two different measures of the same thing: the value of domestic money

The transmission mechanism Market rates Asset prices Official rate Expectations/ confidence Domestic demand Total demand Domestic inflationary pressure Net external demand Inflation Imported inflation Exchange rate Note: For simplicity of exposition, this chart does not show interactions between variables, but these can be important.

How long does it take for a change in the official rate to affect output and then inflation? • Old rule of thumb was: one year to output and two years to prices • Simulation with Bank model suggests similar order of magnitude • However, truth may be different in different circumstances and may be asymmetrical • Range of outcomes based on different reaction functions

Some simulations Effect on real GDP, relative to base, of 100 bp increase in the official rate maintained for 1 year

Some simulations Effect on inflation rate, relative to base, of 100 bp increase in the official rate maintained for 1 year

Estimated average length and strength of transmission mechanisms 1 50 45 40 35 months Bars (left-hand scale) represent estimated average time for full impact of change in policy instrument to affect inflation percentage points 2 Points (right had scale) represent estimated average strength of full impact of change in interest rates on inflation 1. 5 30 25 20 15 10 5 0 Source: Bank of England survey of Monetary Frameworks 1 0. 5 0 -0. 5 -1

Implications of lags for policy • Latest inflation level is history: cannot do anything about it. • The same is true for some time in the future. • Decisions taken today do start to have effects a year or so later. • Inflation forecast takes on key role. • “Inflation forecast targeting”

The role of money • ‘inflation is. . . a monetary phenomenon’? • Long-run relationship between M and P. • For each path of official rate, there is an implied path for M. • With inflation target, monetary aggregates are not instruments or targets, but indicators. • Possible shocks to the monetary system. • Credit aggregates may be at least as useful.

Potential elements of MTM in other systems • Other instruments: – monetary base – exchange rate – credit controls – exchange controls – prudential controls on banks – fiscal policy constraints • These may have direct and more powerful effect on domestic demand net trade • So lags and scale of impact may be very different in different countries • Institutional differences and different inflation history also create a different response to policy rate changes---especially until credibility of the regime is established.

Puzzles and problems I • Easy to tell what lags and scale of impact are in specific model but very hard to know in reality • Policy is designed to offset shocks, so successful policy changes may not appear to have any relationship with targets • Taylor Rules: OK? • It is simple to cause ripples but it is very hard to offset exogenous shocks and internal cycles to achieve stability • Business cycles have been around a long time. It requires great optimism (or stupidity? ) to believe that they have been eliminated

Puzzles and problems II • Does the recent benign inflation environment in many countries result from successful inflation targeting and understanding of the MTM? • Good policy or good luck? • To what extent does inflation control depend on credibility rather than actual policy decisions? • Does uncertainty about MTM mean that it is better to do too little rather than too much? • Or do the lags involved mean that pre-emptive action is better than delayed reaction?

The End