The path of monetary policy: from interest to inflation

Visits to central banks' websites will reveal that all of them have an objective of monetary policy and it is that inflation should be subdued. The rationale underlying this objective is that a low inflation environment is conducive to sustainable economic growth. High inflation can be destructive for economic growth because the attention of the consumer and business is directed at safeguarding / hedging wealth as opposed to efficiency in production. Inflation feeds upon itself and it is difficult indeed to eradicate.

To give substance to the objective, most of the developed countries of the world have inflation targets in place, and they are either set at 2% pa or have a range of 2-3% pa (or have a flexible target as in the case of the US). The target is generally set by government and executed by the CB, which is in most cases operationally independent of government. This separation from government is generally accepted as crucial because the CB may need to take monetary policy actions that are counter-veiling to government financial (and other) activities. A country whose CB is not operationally independent of government is not taken to be part of the big league.

Inflation of 2-3% is considered acceptable because at this level economic growth and wealth creation prospects are optimal. At higher and lower levels the destructive effects of safeguarding / hedging wealth enter the equation. The principal cause of unacceptably high inflation is total demand [C + I + X - M = GDP (expenditure on)] outstripping the capacity of the economy to deliver (total supply). Underlying the growth in demand and supply is the capacity of the banking system to create money. The principal cause of deflation is stagnant or negative money creation.

Giving rise to money creation is the demand for loans by government, businesses and individuals, and underlying growth in the demand for loans in the bank's lending rate (PR and related). The corporate and household sectors are particularly interest rate sensitive. The lending rate of the banks is determined almost exactly by the CB through the operational tools it has at its disposal: the reserve requirement (in most cases), open market operations to influence bank liquidity, and the rate/s set by the CB for their loans to banks (BR) (KIR-L) or for excess reserves (ER) (KIR-D).

Essentially the above is the path of monetary policy in reverse. We now present a brief description of the so-called monetary policy transmission mechanism (MPTM) which starts with the central bank's rates and ends with the inflation rate.

Another visit to central banks' websites will reveal that many of them have illustrations of their view of the MPTM, i.e. the path from CB rates to price developments (inflation or the dreaded deflation). Figure 5 is an amalgamation of some of them168.

Before we begin with an elucidation of the MPTM we need to underscore the significant reality that the transmission of a change in monetary policy can take between one and two years to influence price developments. Therefore, monetary policy needs to be anticipatory in nature; for this reason central banks make use of extremely sophisticated econometric modeling, which is constantly under revision.


Figure 5: MPTM

The genesis of interest rates is the administratively determined rates of the CB. As we have seen, some central banks have one "official" rate - a KIR-L - which is applied to a liquidity shortage and some have two "official" rates: the aforementioned and a deposit rate for bank surpluses - KIR-D. Both models impact directly on the b2b IBM rate, which in turn impacts significantly on the call money rates of the banks (especially the rate on wholesale one-day deposits). All other deposit rates of the banks are affected by this rate.

The banks, in their endeavors to maximise profits for shareholders, attempt to maintain a fixed margin between the cost of deposits / loans and earnings on assets. Therefore a change in the official rates impacts significantly on bank lending rates. The high profile loans extension rate of the banks is prime rate (PR); all lending rates of the banks for NMD are benchmarked on PR. The rates on marketable debt (MD -such as treasury bills and commercial paper) are also significantly influenced. In general, changes in the central banks' KIRs are matched by a change in bank lending rates.

Bank lending rates are a major input in decisions to borrow. Individuals borrow from the banks and consume in anticipation of future income. Companies borrow for the purpose of expansion (on inventories and expansion to business infrastructure). The banking sector accommodates the demand for loans and creates money (deposits), provided individuals are creditworthy (employed and able to service the debt) and companies are borrowing for new projects on which the future cash flows / returns (FVs) exceed the cost of borrowing. A rise in rates will render more individuals un-creditworthy and more projects unviable, reducing the growth rate in bank loans, while a fall in rates will do the opposite. Borrowing / money creation is a major factor in changes in domestic demand (C + I).

Not every individual and company borrows from the banking sector. A large number of the public are lenders / savers, and interest rates to them are just as important as for borrowers. A lower interest rate makes saving less attractive and spending more attractive. The converse also applies.

A change in the official rates has an immediate impact also on other asset prices. What are these? These are the prices of assets other than bank asset prices, and they are bonds, equities (shares), property, and commodities. With the exception of commodities, the assets mentioned (bonds, shares and property) all have cash flows in the future. You will recall that to value them (= PV) their future cash flows (FVs) are discounted by certain relevant interest rates to PV. Thus when rates rise asset values fall, and vice versa. Commodities don't have cash flows in the future, but higher rates make them less attractive and vice versa. Because individuals and companies are the owners of the assets of the financial system (directly or indirectly via the banks and investment vehicles) asset values have a major impact on domestic demand (C + I).

Changes in the central bank's official rates also impact on the expectations and the confidence levels of companies and individuals, which have an impact on domestic demand. They also impact on the foreign sector and therefore on the exchange rate. The exchange rate impacts significantly on net external demand (X - M) and on import prices.

Changes in domestic demand have an impact on employment. If there is pressure on the supply of skills, there is pressure on wages, which in turn impacts on consumer prices.

As seen, all of the above are significant factors in domestic demand, and the banking system assists demand through the provision of loans [loans satisfaction is the counterpart of new bank deposits (= money)]. The ability of the economy to supply new goods and services to satisfy increased demand is a critical factor. The wider the gap between aggregate (= total) demand and aggregate supply is the foremost factor in price developments. The change in the prices of imported goods, to a large degree a function of the exchange rate, is the other important factor, but this depends on the size of net external demand relative to domestic demand.

The circle is completed when one considers that price developments in turn impact on monetary policy decisions.

A final word: in the last couple of years we have seen the ugly side of the monetary system. Money creation was excessive and we saw inflation rising worldwide, as reflected in rising international commodity prices such as oil, food, steel and so on. As you know, it was to a large extent (in the US) based on bank lending to un-creditworthy (non-prime) borrowers. This was a failure not only of the position of trust that banks occupy, given their ability to create money - because we the public generally accept bank deposits as our main means of payments - but also of the failure of some of the allied participants in the monetary system: the central banks in their ineffectual conduct of monetary policy, the bank regulators who did not supervise the banks effectively, and some of the large loans rating agencies which were blinded by the revenues emanating from rating the debt of special purpose vehicles / entities (SPVs / SPEs) and forgot about the significant conflict of interests they have. Obviously, this did not apply to all countries.

But we must not forget the good times preceding this period when wealth creation was unprecedented. This was the elegant side of the monetary system, made possible by the miracle of money creation.