ECON 0024: Economic Policy Analysis
Monetary Policy Objectives and Monitoring the Economy
Daniel Lewis
University College London
December 1, 2022
Overview
This section of the module will focus on the conduct of monetary policy.
• Monetary policy is action taken by a central bank to alter the supply of
money available in the economy.
• Typically, such actions target an interest rate, so we refer to “setting
interest rates” as short-hand.
• In today’s lecture, we’ll review the role of central banks in the economy.
• We’ll also cover the types of methods they use to monitor economic
conditions.
• Next lecture, we’ll focus on how to assess the effects of monetary policy.
• Office Hours: 4-5pm after lecture, Drayton House 202
• Assignment: Econometric/coding focus, mostly next week’s material
What is a central bank?
A central bank/reserve bank/monetary authority is not like a normal bank: it is
a public (or quasi-private) institution that manages the money supply and
sometimes the banking system of a country or monetary union.
• Modern central banks emerged in the late 1800s.
• Central banks are “lenders of last resort”.
• Bank of England, Federal Reserve, European Central Bank, Reserve Bank
of Australia, People’s Bank of China, Reserve Bank of India,...
• What about the Bundesbank, Banque de France, etc.?
• Some central banks are responsible for much more than monetary policy.
• Financial regulation
• Printing/circulating/retiring physical currency
• “Macroprudential policy”
• A key feature of modern central banks is independence.
What is monetary policy?
Monetary policy is the management of the money supply to further some
economic objective(s).
• Idea: by moderating money available, you can alter behaviour.
• Monetary policy exploits trade off btwn saving/borrowing & consumption.
• The monetary policy stance is usually summarized as “setting an interest
rate”, some “policy rate”. Rates ↓=expansionary, rates ↑=contractionary
• The Bank of England Base Rate, the Federal Reserve’s Federal Funds Rate
• Central banks may not actually set these rates, but only targets for them.
• The FFR is the average rate charged by one bank to another bank to
borrow (uncollateralized) reserves at the Federal Reserve overnight - a
market rate.
• They are convenient summaries of a central bank’s current target for
monetary conditions.
The yield curve
The target rate is (typically) an overnight interbank rate. How does this impact
the economy?
• The idea is these rates filter through the economy.
• If it costs a bank more to borrow, it will charge other
institutions/individuals more to borrow to maintain its profit margins.
• Overnight lending of reserves is risk free (why?). Other interest rates
build in a risk premium.
• Long term interest rates integrate expected rates over the duration of
the loan - plus risk premium and term premium.
How would a corporate bond’s yield curve compare?
A simple model for intuition
Think back to your core macroeconomics module. You should remember the
consumption Euler Equation:
Ct+1 1 + it
= β (1 + rt ) = β (1)
Ct 1 + πt
Note: we’ve assumed log utility and perfect information.
Central bank mandates
What are the objectives of monetary policy?
• Central banks are generally given very specific legal mandates:
• Bank of England: Price stability (2% inflation) and then support gov’s
growth and employment objectives
• Federal Reserve: Maximum employment and stable prices (2% inflation).
• ECB: Price stability (2% inflation)
• A dual mandate necessitates a trade-off:
πt = βE [πt+1 ] + κut (unemployment NK PC). (2)
• How should a dual mandate central bank act when its objectives are in
conflict?
• Hot issue: “green mandates”? Inequality as an objective?
Detour: monetary policy a “solved problem”?
From the mid 1990s, inflation stabilised around 2% in many developed nations
- and lower after 2008 financial crisis!
• Central banks started to worry inflation was too low!
• Recent events were unthinkable - today’s inflation not seen since 1980s.
• A “flat” Phillips Curve: no trade-off
• Flip side: allowing higher unemployment has no impact on inflation?
Challenges to central bank independence
A key tenet of modern central banks is independence from
government/political authority.
• Insulation from politics allows long-term thinking, not 4-year cycle.
• Monetary tools cannot be used for political objectives.
• When lines are blurred, inflation runs rampant: Argentinean experience.
• Post-pandemic has seen unprecedented threats to central bank
independence.
• U.S.: retaliation to perceived “mandate creep”
• What about buying government bonds/gilts directly? Truss budget &
September 28th announcement
Monetary policy implementation: conventional
The Bank of England just sets the base rate - not all monetary policy is easy!
• Federal Reserve (and others) conducts open market operations.
• These are purchases and sales of government bonds on the secondary
market in exchange for reserves held at the central bank.
• In conventional policy, aim is to impact the level of reserves banks hold.
• Sell bonds ⇒ smaller reserves ⇒ banks cut lending/charge more
• Buy bonds ⇒ higher reserves ⇒ banks lend more/charge less
• These transactions used to work with the reserve requirement; now,
interest on reserves.
• End result: purchase or sale of bonds move the Fed Funds rate.
• Changing interest rate paid on reserves can have same effect.
Monetary policy implementation: unconventional
In 2008, ≈ 0 interest rates (“zero lower bound”) still left the economy in
recession.
1 Forward guidance:
• Recall that the yield curve - and many economic decisions - depends on
expected interest rates.
• Forward guidance makes a promise about future interest rates.
• In theory, setting rate to zero for longer can be more powerful.
2 Quantitative easing:
• Purchase of government bonds, corporate bonds, MBS, etc. to lower
those interest rates (yields) directly.
• Normally, rely on the yield curve to pass through changes in risk-free
overnight rates.
• Buying bonds directly decreases their supply, raising their price, lowering
the yield.
3 “Central bank information” effects?
Stagflation, the bane of central bankers
Current economic conditions can be characterized as stagflation: the economy
is stagnant, while inflation is high (what would Phillips Curve say?).
• Problem for dual mandate central banks: persistently high inflation calls
for aggressive rate hikes.
• Rate hikes push the economy further into recession.
• Today’s inflation is worryingly persistent.
• Further bad news is unemployment is artificially low.
• Since 2008, many people have dropped out of the labour force, so not
counted as unemployed. Worse since pandemic.
The challenge of the pandemic
The pandemic presented a unique challenge for monetary policy.
• Monetary policy is primarily equipped to stimulate demand.
• While initially there was a drop in demand (uncertainty, lost income, lack
of spending opportunities), most of recession was supply driven.
• No amount of interest rate cuts can alleviate lockdowns at factories,
ports etc. or reopen restaurants or entertainment venues.
• Nevertheless, central banks lowered interest rates to zero almost
immediately.
• No better tools available? Better than nothing?
• Did this contribute to current inflation?
The policy cycle
Central banks continuously assess the state of the economy and meet on a
regular schedule to decide appropriate action.
• In both UK and US, 8 times a year (≈ twice a quarter), MPC and FOMC.
• Research and policy teams prepare forecasts, briefings, and make
recommendations to committees.
• Committees make policy decision, release statement, press conference,
minutes...
• Occasionally, unscheduled meetings are necessary.
• The policy decision itself is not the only challenge...
Collecting data
Assessing the state of the economy is actually a major challenge!
1 Crucial macroeconomic data is often unavailable (release lag).
2 Available values of data may be inaccurate (data vintages and revisions).
• Key releases like GDP only available nearly a month after quarter ends!
• There are at least four vintages of US GDP data - change from first to
fourth can be significant!
• How to assess the economy in real time?
• Monetary policy can only be as good as its inputs!
• Headline inflation data is very noisy due to food & energy: core inflation.
Nowcasting
A key tool used by central banks is nowcasting.
• Like forecasting, but predicting current period’s data, not future!
• Idea: we have data on some releases for the current period - can we infer
slow releases (e.g., GDP)?
• Take all data that is available for current month/quarter, use historical
relationships to predict data yet to be released.
• Nowcasts are typically dynamic factor models using many series.
• Factor models are a dimensionality reduction tool to express a big dataset
in terms of a few (unknown) underlying time series.
• Some quickly released data (unemployment claims, labour market
reports) becomes very important.
Factor models
More formally, factor models express the data, Xt , as
Xt = ΛFt + ut ,
where dim(Xt ) ≫ dim(Ft ).
This looks like a simple regression model - except Ft is latent (unobserved).
The simplest way to estimate Λ and Ft is to find the uncorrelated factors that
explain as much variation in Xt as possible.
This is called principal components analysis. What does each principal
component do?
How many factors/principal components?
• Scree plots or information criterion
Estimated F̂t for fixed date t change depending on the sample used. Why?
Reference: Stock and Watson (2016). “Dynamic Factor Models,
Factor-Augmented Vector Autoregressions, and Structural Vector
Autoregressions in Macroeconomics” in Handbook of Macroeconomics.
Financial data
While macroeconomic data is only available with a delay, financial data is
produced continuously.
• Challenge: financial markets aren’t a key part of the central bank’s
mandate.
• Used correctly, financial data can be informative for relevant variables.
• Informs about lending conditions, which are relevant for interest rate
decisions.
• Various derivatives reflect inflation expectations.
• Yield curve reflects expectations of future economic conditions.
Data during the pandemic
The pandemic exacerbated the challenges facing central banks.
• Recessions typically build over time - not over a week!
• In March 2020, policymakers needed data and they needed it immediately
- not in late April (GDP)!
• Not only was the decline abrupt, the duration was short.
• Data on real activity was needed at a higher frequency and needed with
virtually no lag.
• Virtually no traditional data on real activity satisfied these requirements.
The Weekly Economic Index
In March 2020, we developed the Weekly Economic Index (WEI) to address
these challenges.
• While official data is monthly/quarterly, unconventional data is
sometimes daily/weekly.
• Built a panel of 10 non-standard series at daily/weekly frequency
(consumer activity, industrial production, labour market).
• Most series available within 5 days of end of the week.
• High-frequency data is very noisy, but common factor is more reliable.
• WEI measured weekly fluctuations and nowcast GDP well during 2020.
Summary
Today we’ve discussed the basics of monetary policy and some contemporary
challenges:
• Policy at the zero lower bound
• Threats to independence
• Mandate evolution
• The pandemic and persistent inflation
• Real-time assessment using low-frequency data
Next time, we will change gears: focus on the econometric tools needed to
assess whether monetary policy is effective.
