Abstract

The Bundesbank Act of 1957 stipulates that the fundamental task of the central bank is to safeguard the currency by regulating “the amount of money in circulation and of credit supplied to the economy,” which has been considered a principal prerequisite for maintaining a high level of employment and adequate economic growth over the medium term. Since 1974, this broad objective has been pursued within a framework of monetary targeting in which the growth of key monetary aggregates has been regulated in accordance with a target set for each year.16 Until recently, the intermediate target was established in terms of the central bank money stock17 in view of its closer relationship with developments in nominal income and its limited responsiveness to cyclical movements in short-term interest rates, compared with more narrowly defined monetary aggregates. In early 1988, however, the central bank money stock was replaced by M3 as the intermediate target variable, mainly because of unexpected shifts in currency demand in response to changes in interest rates that had not been experienced by M3.18

Objectives and Intermediate Targets

The Bundesbank Act of 1957 stipulates that the fundamental task of the central bank is to safeguard the currency by regulating “the amount of money in circulation and of credit supplied to the economy,” which has been considered a principal prerequisite for maintaining a high level of employment and adequate economic growth over the medium term. Since 1974, this broad objective has been pursued within a framework of monetary targeting in which the growth of key monetary aggregates has been regulated in accordance with a target set for each year.16 Until recently, the intermediate target was established in terms of the central bank money stock17 in view of its closer relationship with developments in nominal income and its limited responsiveness to cyclical movements in short-term interest rates, compared with more narrowly defined monetary aggregates. In early 1988, however, the central bank money stock was replaced by M3 as the intermediate target variable, mainly because of unexpected shifts in currency demand in response to changes in interest rates that had not been experienced by M3.18

In the Bundesbank’s view, interest rates are also an important monetary indicator but they are not subject to any specific targets because of their uncertain relationships with nominal income and the limited extent to which they can be controlled, especially given the highly open economy of the Federal Republic of Germany. Nevertheless, the maintenance of some short-run stability in interest rates has been a major objective of the Bundesbank. Over the longer term, however, interest rates are subject to constant review in light of developments in the monetary aggregates and exchange rates, and actions are taken to guide them to an appropriate level consistent with the overall monetary policy objectives.19

The Central Bank Council of the Bundesbank establishes an annual target for the growth of M3 for each year, which is announced in December of the preceding year.20 Key macroeconomic considerations in determining the annual target are the economy’s growth potential and expected “unavoidable” (or exogenous) increases in prices. Some short-term factors are also considered, such as possible changes in capacity utilization, developments in the foreign exchange value of the deutsche mark, and the velocity of circulation; the latter is perceived to represent changes in the demand for money reflecting both cyclical factors and structural changes in the financial sector.21 The Central Bank Council reviews the monetary target in the middle of each year in light of macroeconomic developments during the first half of the year.22 It also reviews biweekly monetary developments and the conduct of monetary policy. At these meetings, the members consider the latest economic and financial developments, re-examine the appropriateness of the current monetary policy stance, and adjust the short-run policy stance if necessary. If the Council adopts any major policy changes, these are announced at a press conference immediately following a Council meeting.

Instruments and Operating Procedures

The Deutsche Bundesbank has a variety of policy instruments it can use at its discretion to achieve its intermediate monetary target. These consist for the most part of indirect controls that are designed to manage banks’ reserve positions and are classified by the Bundesbank into two categories: interest rate or liquidity policy instruments, depending on whether their primary objective is to influence interest rates directly or indirectly through changing the availability of bank reserves. Prior to the early 1980s, the banks’ longer-term reserve demands were regulated primarily through adjustments in the terms of refinancing at the Bundesbank (changes in the access limit to refinancing at the Bundesbank’s discount window as well as the discount rate),23 minimum reserve requirements,24 and open market transactions in long-term government bonds. These measures were supplemented by short-term policy measures, especially adjustments in the access limit to the Lombard facility, which functioned as a “safety valve” to meet banks’ temporary reserve demands on a daily basis.25

Since the early 1980s, however, open market operations under securities repurchase agreements have become the principal vehicle for short-term reserve management. Consequently, the Lombard facility has become a marginal source of reserves through which the Bundesbank acts as a lender of last resort.26 These open market operations involve the purchase by the Bundesbank of eligible securities from banks for a specified period, with an understanding that the banks will repurchase these securities at the end of the period.27 The timing and frequency of such operations, the duration of the repurchase period, the amount of funds to be provided to the banking system, and the rate of interest charged on the funds are decided according to liquidity considerations and policy guidelines set by the Central Bank Council. The decision is generally based on the Bundesbank’s estimates of banks’ reserve positions over the next several months, given its current policy stance.

Open market operations under securities repurchase agreements were conducted at approximately monthly intervals from 1983 to 1985, but these operations have become more frequent since then, mainly reflecting their increased importance as a short-term intervention instrument as well as changes in the policy stance of the Bundesbank. In 1987, for example, these operations took place three times a month except for January and November, when they were limited to once and twice a month, respectively. These operations are now typically conducted each week. The maturity of repurchase agreements has generally been 28 days and 35 days, but it has been as short as 4 days or as long as 63 days. A securities repurchase agreement is typically offered one day before a preceding repurchase agreement expires.

Because securities repurchase operations take place under a tender system, the amount of additional reserves provided to the banking system can be measured easily.28 There are three types of tender schemes, namely, a volume tender, an interest rate tender, and a combination tender composed of both (a two-tranche tender scheme). For a volume tender, the Bundesbank sets the rate of interest (“the repurchase rate”) for the repurchase agreements; banks are then asked to bid for the amount of securities that they wish to sell to the Bundesbank. The total amount of funds provided by the Bundesbank is generally a portion of the total bids made by the banks (generally below 50 percent); the exact ratio of actual purchases to total bids differs for each securities repurchase agreement in accordance with the Bundesbank’s policy stance at the time. Funds are allocated to individual banks on the basis of a uniform allocation ratio, with each individual bank’s bid being reduced in proportion to the overall actual purchase/bid ratio.

For an interest rate tender, the banks are requested to submit bids containing both the amount of securities they wish to sell and the repurchase rate. Prior to September 1988, for each interest rate tender, a minimum repurchase rate was quoted by the Bundesbank, and banks were allowed to make several bids with different repurchase rates. Funds were allocated at a uniform repurchase rate equal to the rate at which the marginal bid was accepted (Dutch auction method). All bids above the uniform rate were fully met, while those at the uniform rate were reduced if required. The interest rate tender scheme was revised in two respects in September 1988. Under the new interest rate tender, the quotation of a minimum repurchase rate by the Bundesbank has been suspended and the allocation of funds is now made on the basis of the different repurchase rates bid by banks instead of a uniform repurchase rate; this is tantamount to the adoption of the U.S. auction method. These revisions were aimed at alleviating a general upward bias in repurchase rates under the Dutch auction method, as banks, especially small banks, tended to bid more aggressively to ensure a sufficient allocation of funds to them.

It is important to note that the amount of reserves provided to the banking system under securities repurchase agreements is ultimately decided at the Bundesbank’s discretion irrespective of the type of the tender scheme employed. However, volume tenders generally provide the Bundesbank with a more direct mechanism for guiding short-term interest rates to the particular level it wishes to achieve and in signaling its policy stance to the market. The choice between the two alternative tender schemes thus depends partly on the extent to which the Bundesbank directly seeks to achieve a specific interest rate.29 For example, from January to October 1987, both tender schemes were used to the same extent, but the volume tender became the sole vehicle for securities repurchase agreements from October 1987 to mid-1988 when the Bundesbank maintained interest rates at a fairly low level following the October 1987 stock market crash. In September 1988, the Bundesbank reintroduced a two-tranche tender with two different maturities at the time of a gradual tightening of monetary policy: a shorter maturity tranche (34 days) was offered under a volume tender and a longer maturity tranche (62 days) was offered under the new interest rate tender. During 1989, the Bundesbank employed all three types of tender schemes, but relied primarily on volume tenders when it desired to guide interest rates. Table 5 gives details of the Bundesbank’s repurchase transactions during 1989.

Table 5.

Deutsche Bundesbank: Repurchase Transactions, 1989

(In millions of deutsche mark)

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Source: Deutsche Bundesbank, Monthly Report, various issues.

Allotment at individual bid rates within the spread.

Repurchase rates, especially those set under an interest rate tender, have been closely related to prevailing money market rates and are typically between the Bundesbank’s two official interest rates—the discount rate at the bottom and the Lombard rate at the top. This contrasts markedly with the period prior to early 1985 when repurchase rates had typically been higher than both the discount and the Lombard rates. In general, the Lombard rate is now set at a level that is usually 2 percentage points above the discount rate and is typically higher than short-term interbank rates to ensure that the Lombard facility will be used only for exceptional liquidity shortages. Consequently, repurchase rates have replaced the Lombard rate as the key indicator of the Bundesbank’s policy stance. Moreover, repurchase rates are also an important barometer (both to the market and to the Bundesbank) of money market conditions and hence serve as an anchor for key money market rates. Reflecting this close relationship with the repurchase rate, key money market rates, especially the call rate30 and the three-month interbank rate, which are usually slightly higher than the repurchase rate, are also typically within the band set by the discount and the Lombard rates.

While open market operations under securities repurchase agreements contribute significantly to satisfying banks’ short-term reserve demands, they do not necessarily completely smooth out daily fluctuations in banks’ reserve positions and interest rates. This is partly because the allotment of reserves to the banking system under each security repurchase agreement typically occurs no more frequently than weekly and is decided on the basis of the Bundesbank’s expectations of future demand and supply conditions. In order to avoid excessive daily fluctuations in interest rates, the Bundesbank’s repurchase operations are supplemented by a number of other reversible fine-tuning measures. These measures include the sale of short-term treasury bills, open market operations under foreign exchange swap or repurchase agreements, the shift of public authorities’ central bank deposits to the banking system, and the provision of Lombard loans.

The Bundesbank’s decision to use these policy instruments is heavily influenced by the sources and types of disturbances facing the money market. The sale of treasury bills with short maturities (normally three days) is designed to absorb excess liquidity and prevent an abrupt fall in short-term rates (especially the call money rate); these treasury bills are sold at a rate usually about ¼ of 1 percentage point below repurchase rates. Open market operations under foreign exchange swap agreements also have been frequently used to neutralize an excessive expansion in domestic reserves, especially that resulting from international capital inflows. These operations are conducted in a manner similar to those for securities repurchase agreements except that they involve U.S. dollars rather than domestic securities. The spot and forward exchange rates that are used for these operations follow prevailing market rates at the time of the transactions. The typical maturity is three months, and the amount of the transactions is determined by the Bundesbank. The shift of public authorities’ central bank deposits to the banking system has generally been aimed at offsetting temporary reserve shortages in the banking system, particularly those associated with large tax payments; ongoing market interest rates are charged on those deposits shifted to the banking system. Finally, the Lombard facility continues to be available for the short-term provision of borrowed reserves, although at a penalty interest rate.

Identifying Changes in Policy

In pursuing policy objectives, the particular use of policy instruments is continually adjusted in response to exogenous economic and financial shocks. The process of policy adjustment to altered economic conditions generally varies, depending on the type and degree of these shocks.31 A key feature of the adjustment process is that the Bundesbank’s policy action is generally aimed at influencing both interest rates and the availability of bank reserves. Policy adjustments are made essentially through a process that requires the gradual adjustment of not only interest rates but also the amount of reserves in order to generate desired monetary conditions. Any adjustments of the key intervention rates (the discount rate, the Lombard rate, and the repurchase rate) provide important information concerning policy changes undertaken by the Bundesbank. At the same time, the amount of reserves provided to the banking system under repurchase agreements constitutes another important signal concerning the Bundesbank’s policy stance. In general, therefore, the overall direction of the policy stance can be judged from both the action taken with regard to the key intervention rates and the availability of reserves.

16

For a more detailed discussion of monetary targeting, see Deutsche Bundesbank (1987), pp. 79—104.

17

The central bank money stock is defined as currency in circulation and banks’ minimum required reserves on their domestic liabilities. The central bank money stock differs from the monetary base in that it is computed on the basis of constant January 1974 required reserve ratios and excludes the minimum required reserves on nonresident deposits and banks’ excess reserves.

18

The reasons for the shift from the central bank money stock to M3 are discussed in detail in Deutsche Bundesbank (1988). M3 comprises currency in circulation plus sight deposits, time deposits for less than four years, and savings deposits at statutory notice.

19

See Deutsche Bundesbank (1987), especially p. 81 and p. 102.

20

The Central Bank Council consists of the President and the Vice-President of the Bundesbank, the members of the Directorate, and the Presidents of the Land Central Banks (regional offices of the Bundesbank).

21

See Deutsche Bundesbank (1987), especially pp. 93—97.

22

In an earlier period of monetary targeting, the review generally resulted in narrowing the target range for the remainder of each year to half of the original target range (either the top half or the bottom half), even if no revision was made to the overall annual target. See Deutsche Bundesbank (1987), p. 97.

23

Adjustment of the discount rate is generally aimed at signaling changes in the stance of monetary policy rather than at controlling borrowing at the discount window to a desired level; the latter objective is achieved by adjusting the access limit to the discount window.

24

Minimum reserve requirements are applicable to both resident and nonresident bank deposits. The minimum requirement rate is differentiated according to the type of deposits (sight deposits, time deposits, and savings deposits), the amount of deposits (less than DM 10 million, DM 10 million to DM 100 million, and over DM 100 million), and the origin of deposits. See Table 3.

25

The Bundesbank’s Lombard facility provides short-term loans to banks against the collateral of certain government and public sector securities.

26

The increased recourse to securities repurchase operations was attributable primarily to the marked shift in the balance of payments to sizable deficits during the late 1970s and the early 1980s and the consequent growing need to meet banks’ reserve demands through central bank credit. Under these circumstances, the Bundesbank initially tried to meet such demand by reducing the required minimum reserves, expanding the rediscount quota, and by other traditional measures. However, the supply of central bank credit to the banking system through these channels was constrained by the already low required reserve ratios, the limited scope for a further substantial expansion in the rediscount quota because of a relatively small amount of bills held by commercial banks for rediscount, and the excessive use of the Lombard facility which was designed to meet only temporary liquidity needs as a fine-tuning measure. These developments led the Bundesbank to rely more extensively on open market operations, buying and selling a diverse range of securities that the banks held in large quantity. The historical evolution of securities repurchase operations and their basic modality are discussed in more detail in Deutsche Bundesbank (1983 and 1985) and Dudler (1986).

27

Eligible securities comprise fixed interest securities (both domestic and foreign) that are officially quoted on the German stock exchange and are accepted as collateral for Lombard loans; medium-term notes issued by the Federal Government, the Federal Railways, the Federal Post Office, and the Land Governments; and treasury discount paper with a remaining maturity of less than one year.

28

The tender system was introduced in March 1980. Banks are requested to submit their bids by 3:00 p.m. on the day for which a tender is set and funds are credited to their accounts at the Bundesbank the next day. Banks participating in securities repurchase agreements are required to maintain special open security deposit accounts (“disposition accounts”) at the Land Central Banks to facilitate the smooth transfer of ownership of securities.

29

However, the extent to which this objective is achieved also depends on appropriate fine-tuning measures being taken along with securities repurchase agreements. See the discussion below.

30

The call rate is the interest rate charged in the interbank market for the overnight loan of reserves between banks.

31

See Neumann (1990) for an interesting attempt to analyze the policy implementation process and its transmission mechanism.

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