Monetary Policy

• The actions of a central bank, currency board, or other regulatory committee, that determine the size and rate of growth of the money supply, which in turn affects interest rates.
  

 

• is the process of managing a nation's money supply to achieve specific goals—such as constraining inflation, achieving full employment or more well-being. Monetary policy can involve setting interest rates, margin requirements, capitalization standards for banks or even acting as the lender of last resort or through negotiated agreements with other governments.
  

Types of Monetary Policy

In practice all types of monetary policy involve modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base currency is called operations. Constant market transactions by the monetary authority modify the liquidity of base money and this impacts other market variables such as short term interest rates, the exchange rate and the domestic price of spot market commodities such as gold. Open market operations are undertaken with the objective of stabilizing one of these market variables. The distinction between the various types of monetary policy lies primarily with the market variable that open market operations are used to target. Targeting being the process of achieving relative stability in the target variable.

 

Monetary Policy:	Target Market Variable:	Long Term Objective:
Inflation Targeting	Interest rate on overnight debt	A given rate of change in the CPI
Price Level Targeting	Interest rate on overnight debt	A specific CPI number
Monetary Aggregates	The growth in money supply	A given rate of change in the CPI
Fixed Exchange Rate	The spot price of the currency	The spot price of the currency
Gold Standard	The spot price of gold	Low inflation as measured by the gold price
Mixed Policy		Usually interest rates	Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting Inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as a harmonized consumer price index).

Inflation Targeting

Under this policy approach Inflation is defined as the rate of change in the CPI. It requires

that a basket of consumer prices is monitored and from these prices a CPI (Consumer Price Index) defined.

For example the target might be to keep increases in the CPI index between 2 and 3% per year. The specific Inflation rate objective is achieved through periodic adjustments to an interest rate target. The interest rate target generally refers to the interest rate at which banks lend to each other over night for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.

The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.

Changes to the interest rate target are done in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target.

Price Level Targeting

Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move.

Something like price level targeting was tried in the 1930s by Sweden, and seems to have contributed to the relatively good performance of the Swedish economy during the Great Depression. As of 2004, no country operates monetary policy based on a price level target.

Monetary Aggregates

In the 1980s several countries used an approached based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.

This approach is also sometimes called monetarism.

Whilst most monetary policy focuses on a price signal of one form or another this approach is focused on monetary quantities.

Fixed Exchange Rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. Base money is bought and sold by the central bank on a daily basis to achieve the target exchange rate. This policy somewhat abdicates responsibility for monetary policy to a foreign government.

This type of policy is used by China. The Chinese yuan is managed such that its exchange rate with the United States dollar is fixed.

Gold Standard

gold is kept constant by the daily buying and selling of base currency. This process is called open market operations

.The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index".

Today this type of monetary policy is not used anywhere in the world, although a form of gold standard was used widely across the world prior to 1971. For details see the Bretton Woods system. Its major advantages were simplicity and transparency.

Mixed Policy

A mixed policy approach is usually in practice most like "inflation targeting". However consideration is also given to other goals such as unemployment and market bubbles.

This type of policy is used by the United States.

Monetary Policy Tools

Monetary Base

Monetary policy can be implemented by changing the size of the monetary base. This directly changes the total amount of money circulating in the economy. In the United States, the Federal Reserve can use open market operations to change the monetary base. The Federal Reserve would buy/sell bonds in exchange for hard currency. When the Federal Reserve disburses/collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base. Note that open market operations are a relatively small part of the total volume in the bond market, thus the Federal Reserve is not able to influence interest rates through this method.

Reserve Requirements

The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loan able funds. This acts as a change in the money supply.

Discount Window Lending

Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. The lended funds represent an expansion in the monetary base. By calling in exisiting loans or extending new loans, the monetary authority can directly change the size of the money supply.

Interest Rates

Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can only directly set the Federal Funds Rate. This rate has some effect on other market interest rates, but there is no direct, definite relationship. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By altering the interest rate(s) under its control, a monetary authority can affect the money supply.

Overview of Pakistan economy and monetary policy stance(2005):

Pakistan's economy performed exceptionally well during FY05 with a record growth estimated at 8.4 percent in two decades. The growth is broad based as all segments of the economy contributed significantly to GDP growth. Manufacturing sector showed a growth of 12.5 percent against the target of 10.2percent while Agriculture sector expanded by 7.5 percent against the target of 4percent. Services sector also exceeded its performance target by 1.7 percent to show a growth of 7.9 percent. Credit absorption by the private sector has been in the region of Rs.400 billion for the first time in the credit history of the private sector despite rising interest rates. The SME sector also significantly benefited from record credit expansion as its credit absorption has risen toRs.71.4 billion during July-May FY05. may not be taken as a source of concern because it has primarily emanated from production-oriented imports like oil, machinery and raw materials. It has been the sustainability of worker's remittances at around $4 billion a year that has contained the overall balance of payments deficit to mere $933 million during FY05 and thereby has prevented foreign reserves from depletion

Plans

 

To sum up, Pakistan's economy is projected to perform well during FY06. The growth momentum built up last year is expected to continue with economic growth projected at 7 percent and inflation targeted at 8 percent. Manufacturing sector is projected to grow by 11 percent, while agriculture sector is expected to expand by 4.8 percent. To achieve these targets, monetary expansion is targeted at 13 percent with the credit to the private sector growing

at 20 percent (Rs.330 billion). Monetary expansion has been kept marginally below the nominal GDP growth target to reduce monetary overhang and bring inflation down to a reasonable level. The acceleration in interest rates since April 2005 is expected to depress inflationary pressures and help achieve the. inflation target of 8 percent by the end of the current fiscal year. Other factors expected to help contain inflation include:

 

• The increased supply of domestically produced goods and services as a result of continued and rapid GDP growth;
  
• Capacity expansion and BMR in key industries;
  
• Improved food supplies from substantial growth of 17.3 percent in the production of major crops last year supplemented by duty-free imports of 11 essential food/commodities from neighboring countries;
  
• Further improvement in fiscal discipline through the enactment of Fiscal Responsibility and Debt Limitation Law along with sustained
  improvement in financial position of PSEs and decline in revenue deficit;
  
• Expectation of stable exchange rates on the back of sizable foreign reserves and sustained annual inflows of workers' remittances and FDI;
  
• Increased productivity and efficiency of textile industry and ongoing expansion in automobile, electronics and cement industries;
  

Monetary and Credit Trends(initiatives)

The monetary expansion continued unabated despite periodic rises in interest rates during FY05. SBP continued to facilitate growth initiatives as it ensured interest rate hikes at a gradual pace through to March 2005. The policy of gradual interest rate hike substantially added to the

stock of reserve money as it expanded by 16.6 percent (Rs.128.5 billion) during July-25 June FY05, in part due to shifting of some of the government debt away from banks to the SBP.

Therefore, the stock of broad money also expanded by 16.5 percent (Rs.411.3 billion) as the net domestic assets (NDA) of the banking system grew by 19.5 percent (Rs.371.2 billion) largely due to record credit distribution to the private sector (Figure 1). The share of NDA in monetary expansion stood at 90.3 percent while net foreign assets (NFA) of the banking system increased

moderately by Rs.40.1 billion (Tables 1-2). The balance sheets of banks continued to expand substantially during July-25 June FY05. This primarily occurred on the back of substantial growth of deposits by 15.9 percent (Rs.303.9 billion). Other factors that made the liquidity position of banks even more comfortable included a shift of some of the TB holdings by banks to SBP (Rs.67.0 billion), and retirement of bank credit by PSEs (Rs.17.9 billion). Therefore, the total liquidity of banks rose roughly by Rs.411 billion and this improved the credit performance of banks substantially as the private sector credit off-take rose to an historically high

level of almost Rs.400 billion.

Private sector continued to benefit from relatively low real interest rates, which remained in the negative zone as inflationary pressures outpaced ongoing interest rate hikes recorded in the

first three quarters of FY05. This spurred the demand for cheap bank credit by the private sector and in consequence commercial banks created history by providing ample liquidity to the private sector. Bank credit to the private sector during July-25 June FY05 grew by 30.6 percent

(Rs.390.3 billion) compared with the growth of 30.7 percent (Rs.291.6 billion) in the corresponding period of last year (Figure 2). The distribution of credit to the private sector continued to be broad-based during July-May FY05. The manufacturing sector as usual led the credit utilization and its credit absorption rose by 41 percent to Rs.153.2 billion. The largest recipient of manufacturing loans was textile industry (Rs.91.8 billion) followed by cement industry (Rs.11.3 billion) and petroleum refining industry (Rs.4.7 billion). The scale of consumer loans expanded by 93.1 percent to Rs.80.3 billion and their distribution showed concentration towards auto loans (Rs.37.4 billion) and house building loans (Rs.17.5 billion). Credit absorption

by Construction industry rose to Rs.10.6 billion from mere Rs.331 million last year. Wholesale and retail trade also picked up strongly and loans involved in these rose by 78.2 percent to Rs.30.7 billion. The credit absorption of transport,
storage and communication rose by 164.7 percent to Rs.21.1 billion.

(Plans)

The ongoing credit boom is likely to ease with expected monetary expansion decelerating to around 13 percent during FY06 because of the prospect of rise of interest rates triggered primarily by rising core inflation. However, it is expected that credit to the private sector will still expand by around 20 percent (Rs.330 billion) during FY06 due to substantial rise in the bank deposit base due to record economic growth of 8.4 percent during FY05 and likely continuation of significant inflows of workers' remittances in FY06.

Inflation Trends( initiatives)

The consumer price inflation fluctuated around 9 percent last year despiteinterest rate tightening throughout the year. It was encouraging to see the food price inflation decelerating to 12.5 percent in June 2005 from 14.9 percent at the start of year but it remained on the higher side

primarily due to excessive rises in the prices of eggs, pulses, sugar, milk and potato. Major sources of inflation from the non-food basket were the groups of house rent and, fuel and lighting: they recorded increases of 11.3 percent and 3.7 percent from 9 percent and 2.7

percent, respectively. The major source of concern remained the rising core inflation, which ended at 7.6 percent in June 2005 up from 6.1 percent at the start of the year (Figure 3).

(Plans)

Inflationary pressures are likely to ease during FY06. Food supplies are expected to improve on account of better food crops in FY05 and permission of duty-free import of some essential food items from neighboring countries. Therefore, food inflation is likely to decelerate further. Core inflation is also likely to come down on account of slowdown in aggregate demand due to

higher interest rates. Exchange rates are expected to remain stable on the back of substantial workers' remittances, FDI inflows and foreign reserves and thereby contribute to contain the price inflation of imported goods. Therefore, consumer price inflation is projected to come down at least to 8 percent in FY06.

Interest Rate Trends (initiative)

International financial markets remained subject to interest rate hikes during FY05.

The Fed raised the Federal Funds Rate eight times during the year by 25 basis points each to 3.25 percent since July 2004. The 6-month LIBOR also continued to edge up and showed a rise of 263 basis points to 3.84 percent. The European Central Bank however kept interest rate unchanged in view of weak economic condition in that region. On the domestic front, the inflationary pressures continued to mount with some deceleration in the middle of the year.

In consequence, SBP had to take corrective measures to stay aligned not only with the international financial markets but also to ensure domestic price stability. In the first three quarters of the year, SBP took recourse to the policy of gradual interest rate hikes to avoid its adverse impact on economic growth. However, in April 2005 SBP changed its discount rate policy after a period of two years, and increased its discount rate by 150 basis points to 9 percent and thereby setting the stage for high yields on various government papers and their impending expansionary impact on the bank lending and deposit rates. The increase in the discount rate added momentum to the process of interest rate hikes and in the space of roughly three months, yields on 3-month, 6-month, and 1-year TBs increased quickly by 268 basis points to 7.69 percent, by 230 basis points to 7.99 percent and by 275 points to 8.7 percent, respectively. Prior

To the change in the discount rate policy, it took almost nine months for yields on 3-month, 6-month, and 1-year TBs to rise by 326 basis points to 5.01. Percent, by 346 basis points to

5.69 percent and by 370 points to 5.95 percent, respectively. The rapid upward change in the

Interest rates since April 2005 is also reflected by a large shift in the yield curve

The inter-temporal impact on core inflation of recent rises in key policy rates is expected to unfold in the near term. The average bank lending rate which had risen by 152 basis points to 6.57 percent between July-March FY05 is likely to pick up speed as it has already shown a rise of 109 basis points between April-May FY05.