What Is Monetary Policy?
Monetary policy, the demand side of economic policy, refers to the actions undertaken by a nation's central bank to control money supply and achieve macroeconomic goals that promote sustainable economic growth.
- Monetary policy refers to the actions undertaken by a nation's central bank to control money supply and achieve sustainable economic growth.
- Monetary policy can be broadly classified as either expansionary or contractionary.
- Tools include open market operations, direct lending to banks, bank reserve requirements, unconventional emergency lending programs, and managing market expectations—subject to the central bank's credibility.
Understanding Monetary Policy
Monetary policy is the process of drafting, announcing, and implementing the plan of actions taken by the central bank, currency board, or other competent monetary authority of a country that controls the quantity of money in an economy and the channels by which new money is supplied.
Monetary policy consists of the management of money supply and interest rates, aimed at meeting macroeconomic objectives such as controlling inflation, consumption, growth, and liquidity. This is achieved by actions such as modifying the interest rate, buying or selling government bonds, regulating foreign exchange (forex) rates, and changing the amount of money banks are required to maintain as reserves.
Economists, analysts, investors, and financial experts across the globe eagerly await monetary policy reports and the outcome of meetings involving monetary policy decision-makers. Such developments have a long-lasting impact on the overall economy, as well as on specific industry sectors or markets.
Monetary policy is formulated based on inputs gathered from a variety of sources. For instance, the monetary authority may look at macroeconomic numbers such as gross domestic product (GDP) and inflation, industry/sector-specific growth rates and associated figures, as well as geopolitical developments in international markets—including oil embargos or trade tariffs. These entities may also ponder concerns raised by groups representing industries and businesses, survey results from organizations of repute, and inputs from the government and other credible sources.
Monetary Policy Requirements
Monetary policy can be used in combination with or as an alternative to fiscal policy, which uses taxes, government borrowing, and spending to manage the economy.
The Federal Reserve Bank is in charge of monetary policy in the United States. The Federal Reserve (Fed) has what is commonly referred to as a "dual mandate": to achieve maximum employment while keeping inflation in check.
Simply put, it is the Fed's responsibility to balance economic growth and inflation. In addition, it aims to keep long-term interest rates relatively low. Its core role is to be the lender of last resort, providing banks with liquidity and regulatory scrutiny in order to prevent them from failing and panic spreading in the financial services sector.
August 27, 2020
The day the Fed announced that it will no longer raise interest rates due to unemployment falling below a certain level if inflation remains low. It also changed its inflation target to an average, allowing prices to rise somewhat above its 2% target to make up for periods when it was below 2%.
Types of Monetary Policies
Broadly speaking, monetary policies can be categorized as either:
If a country is facing a high unemployment rate during a slowdown or a recession, the monetary authority can opt for an expansionary policy aimed at increasing economic growth and expanding economic activity. As a part of expansionary monetary policy, the monetary authority often lowers the interest rates through various measures, serving to promote spending and make money-saving relatively unfavorable.
Increased money supply in the market aims to boost investment and consumer spending. Lower interest rates mean that businesses and individuals can secure loans on convenient terms to expand productive activities and spend more on big-ticket consumer goods. An example of this expansionary approach is the low to zero interest rates maintained by many leading economies across the globe since the 2008 financial crisis.
Increased money supply can lead to higher inflation, raising the cost of living and cost of doing business. Contractionary monetary policy, increasing interest rates, and slowing the growth of the money supply, aims to bring down inflation. This can slow economic growth and increase unemployment, but is often necessary to cool down the economy and keep it in check.
In the early 1980s when inflation hit record highs and was hovering in the double-digit range of around 15%, the Fed raised its benchmark interest rate to a record 20%. Though the high rates resulted in a recession, it managed to bring back inflation to the desired range of 3% to 4% over the next few years.
Tools to Implement Monetary Policy
Central banks use a number of tools to shape and implement monetary policy.
- First is the buying and selling of short-term bonds on the open market using newly created bank reserves. This is known as open market operations. Open market operations traditionally target short-term interest rates such as the federal funds rate.
The central bank adds money into the banking system by buying assets—or removes it by selling assets—and banks respond by loaning the money more easily at lower rates—or more dearly, at higher rates—until the central bank's interest rate target is met. Open market operations can also target specific increases in the money supply to get banks to loan funds more easily by purchasing a specified quantity of assets, in a process known as quantitative easing (QE)
- The second option used by monetary authorities is to change the interest rates and/or the required collateral that the central bank demands for emergency direct loans to banks in its role as lender-of-last-resort. In the U.S., this rate is known as the discount rate.
Charging higher rates and requiring more collateral, an example of contractionary monetary policy, will mean that banks have to be more cautious with their own lending or risk failure. Conversely, lending to banks at lower rates and at looser collateral requirements will enable banks to make riskier loans at lower rates and run with lower reserves
- Authorities also use a third option: the reserve requirements, which refer to the funds that banks must retain as a proportion of the deposits made by their customers in order to ensure that they are able to meet their liabilities.
Lowering this reserve requirement releases more capital for the banks to offer loans or to buy other assets. Increasing the reserve requirement, meanwhile, has a reverse effect, curtailing bank lending and slowing growth of the money supply.
- In addition to the standard expansionary and contractionary monetary policies, unconventional monetary policy has also gained tremendous popularity in recent times.
During periods of extreme economic turmoil, such as the financial crisis of 2008, the U.S. Fed loaded its balance sheet with trillions of dollars in treasury notes and mortgage-backed securities (MBS), introducing new lending and asset-purchase programs that combined aspects of discount lending, open market operations, and QE. Monetary authorities of other leading economies across the globe followed suit, with the Bank of England (BoE), the European Central Bank (ECB), and the Bank of Japan (BoJ) pursuing similar policies.
- Lastly, in addition to direct influence over the money supply and bank lending environment, central banks have a powerful tool in their ability to shape market expectations by their public announcements about the central bank's own future policies. Central bank statements and policy announcements move markets, and investors who guess right about what the central banks will do can profit handsomely.
Some central bankers choose to be deliberately opaque to market participants in the belief that this will maximize the effectiveness of monetary policy shifts by making them unpredictable and not "baked-in" to market prices in advance. Others choose the opposite course of action, being more open and predictable in the hopes that they can shape and stabilize market expectations and curb the volatile market swings sometimes triggered by unexpected policy shifts.
Policy announcements are effective only to the extent of the credibility of the authority responsible for drafting, announcing, and implementing the necessary measures. In an ideal world, such monetary authorities should work completely independent of influence from the government, political pressure, or any other policy-making authorities.
In reality, governments across the globe might have varying levels of interference with the monetary authority’s working. It may vary from the government, judiciary, or political parties having a role limited to only appointing the key members of the authority. Alternatively, it could extend to forcing them to announce populist measures, say, for example, to influence an approaching election.
If a central bank announces a particular policy to put curbs on increasing inflation, the inflation may continue to remain high if the common public has no or little trust in the authority. While making investment decisions based on the announced monetary policy, one should also consider the credibility of the authority.