The transmission mechanism of monetary policy

Banco Central do Brasil conference:

“One year of inflation targeting”

10th July 2000Alec 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. (BoE 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

Officialrate

Inflation?

The transmission mechanism

Officialrate

Market rates

Asset prices

Exchange rate

Expectations/confidence

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

Officialrate

Market rates

Asset prices

Exchange rate

Domestic demand

Net externaldemand

Total demand

Expectations/confidence

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

Officialrate

Market rates

Asset prices

Exchange rate

Domestic demand

Net externaldemand

Total demand

Domesticinflationarypressure

Expectations/confidence

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

Officialrate

Market rates

Asset prices

Exchange rate

Domestic demand

Net externaldemand

Total demand

Domesticinflationarypressure

Importedinflation

Inflation

Note: For simplicity of exposition, this chart does not show interactions between variables, but these can be important.

Expectations/confidence

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

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

Some simulations

Estimated average length and strength of transmission mechanisms1

0

5

10

15

20

25

30

35

40

45

50

-1

-0.5

0

0.5

1

1.5

2Points (right had scale) represent estimated average strength of full impact of change in interest rates on inflation

Bars (left-hand scale) represent estimated average time for full impact of change in policy instrument to affect inflation

months percentage points

Source: Bank of England survey of Monetary Frameworks

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 and 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