Abstract

The procedures for implementing monetary policy in the five countries examined here exhibit numerous common features; the dissimilarities that exist do not appear to be fundamental, but rather are attributable primarily to differences in institutional conditions.78 It should be noted, however, that this conclusion could not have been drawn if this paper had been written ten years ago. Especially in France and Japan, the implementation of monetary policy has evolved considerably from primary reliance on quantitative credit controls to intervention in financial markets to influence the availability and the price of reserves of the banking system. While the change has not been quite as dramatic in the Federal Republic of Germany and the United Kingdom, the convergence among the five to market-oriented procedures is nonetheless clear and marked.

The procedures for implementing monetary policy in the five countries examined here exhibit numerous common features; the dissimilarities that exist do not appear to be fundamental, but rather are attributable primarily to differences in institutional conditions.78 It should be noted, however, that this conclusion could not have been drawn if this paper had been written ten years ago. Especially in France and Japan, the implementation of monetary policy has evolved considerably from primary reliance on quantitative credit controls to intervention in financial markets to influence the availability and the price of reserves of the banking system. While the change has not been quite as dramatic in the Federal Republic of Germany and the United Kingdom, the convergence among the five to market-oriented procedures is nonetheless clear and marked.

The monetary authorities in the five countries use a monetary aggregate as an intermediate target of policy and have established target ranges for the growth of the chosen aggregate or aggregates. The aggregates targeted vary from the very narrow (MO, the monetary base) in the United Kingdom to the very broad (M3) in Germany. With the exception of the United Kingdom, which has moved from targeting a very broad aggregate (M3) to a very narrow one, the monetary authorities in the four other countries have tended to de-emphasize narrow aggregates as targets during the 1980s in favor of broader ones. This change in focus to broader aggregates has been motivated primarily by the increased uncertainty concerning the link between narrower monetary aggregates and the ultimate objectives of policy, typically real gross national product and inflation, that has evolved during the 1980s.

Moreover, most authorities have adopted a more eclectic approach in formulating monetary policy by expanding the range of variables that they monitor to include economic indicators, especially the exchange rate, other than monetary aggregates. For example, the U.S. Federal Reserve has noted publicly that it places importance on indicators other than the monetary aggregates, and during the past several years it has altered its policy stance several times even when the growth of the aggregates was within their targeted ranges. Similarly, the Deutsche Bundesbank eased its policy stance in the fall of 1987, although the growth of its targeted aggregate was well above the established target band, and it tightened policy in early 1989 in response to downward pressure on the deutsche mark. The Bundesbank also tolerated growth in the targeted monetary aggregate in excess of the target band in recent years. The Bank of England also has at times taken account of the deutsche mark-pound sterling exchange rate in the formulation of monetary policy, while France’s membership in the EMS necessarily requires the Bank of France to direct policy on many occasions at maintaining the French franc-deutsche mark exchange rate within the EMS narrow band. Finally, the Bank of Japan has stated that even though it emphasizes the money supply, it is not “blind to other indicators.”79

Regardless of which variables are important for the formulation of monetary policy, short-term interest rates play a major role in the operating procedure in each country. First, short-term interest rates are a major influence on the demand for money and therefore are very important in achieving the path desired for growth in the aggregates. Second, even if target ranges for growth in the monetary aggregates are regarded more as a guide than an objective, changes in short-term interest rates have a direct impact on economic activity. Thus, changes in interest rates generated by the central bank will ultimately be transmitted to the economy, either dampening or quickening the pace of economic activity. In other words, given the increased uncertainty regarding the link between monetary aggregates and economic activity, short-term interest rates have at times been considered intermediate targets as well as operating instruments.

While the monetary authorities in the five major industrial countries tend to moderate excessive fluctuations in short-term interest rates, they do not aim at controlling interest rates inflexibly. On the contrary, the operating procedures in these countries generally allow short-term rates to be primarily market-determined while, at the same time, permit monetary authorities to influence the range within which these rates fluctuate. Each monetary authority sees the need for interest rates to adjust expeditiously to reflect new economic developments but also recognizes the importance of maintaining some discretionary control over interest rate movements to avoid excessive volatility. In this regard, it is clear from their actions that these five monetary authorities generally attempt to accommodate, at least initially, changes in credit demand so as to prevent large movements in short-term interest rates. However, over the medium term they typically review such action and then guide interest rates to levels consistent with their overall monetary policy stance.

Given the prominent role played by interest rates in the short-run implementation of monetary policy in these countries, it should not be surprising that changes in policy stances are typically signaled by changes in short-term interest rates. These signals, however, cannot be identified with the same degree of precision in each country. The policy intentions of the monetary authorities in France, the Federal Republic of Germany, and the United Kingdom are readily discernible. In France, the intervention rate and the rate on five- to ten-day repurchase agreements establish a range within which the market-determined call money rate tends to fluctuate. In Germany, the discount rate and the Lombard rate determine a similar range for the call money rate. Thus, any change in the stance of monetary policy in either France or Germany will be accompanied by a change in one or both of these interest rates that are set by the authorities. Changes in the intentions of the monetary authorities in the United Kingdom are manifested somewhat differently but are equally transparent. The Bank of England typically supplies reserve shortages or absorbs reserve surpluses on a day-to-day basis at the prevailing interest rate. When the Bank of England alters its policy stance, it will adjust the dealing rate below which it is not prepared to buy bills, and if insufficient bills are offered at that rate, the discount houses are obliged to borrow from the Bank of England at an interest rate different from that currently prevailing in the interbank market.

In the United States and Japan, monetary policy changes are not as readily apparent. Each of the monetary authorities administers a discount rate but changes it only infrequently. Instead, policy changes are reflected primarily by movements in largely market-determined rates—the call rate in Japan and the federal funds rate in the United States—which the monetary authorities influence through market operations. These rates, however, also move in response to developments other than monetary policy changes and therefore the movements that are unrelated to policy changes must be filtered out from interest rate fluctuations in the United States and Japan before policy inferences can be drawn. However, the short-run behavior of these rates is not so volatile as to preclude the identification of increases or decreases that deviate significantly from the range of recent movements. Nonetheless, this requires some interpretation of interest rate movements; consequently, it may take market participants several days in the United States and possibly even longer in Japan to ascertain policy changes, while changes are more easily identified in the other three countries.

The monetary authorities in these five countries implement monetary policy by regulating the supply of reserves to the banking system, which in turn indirectly influences short-term interest rates. Each of the authorities employs either open market or interbank market operations as its major instrument in reserve management. Repurchase or matched sale-purchase agreements are used most frequently in market operations in France, the Federal Republic of Germany, and the United States. These reversed security transactions provide an effective mechanism for temporarily absorbing reserves from or supplying reserves to the banking system, thereby giving the monetary authority the ability to fine-tune the adjustment of bank reserves and interest rates and also the flexibility to respond quickly to unexpected developments affecting these variables.

While reversed security transactions are employed by the monetary authorities in each country, their relative importance varies somewhat. The Federal Reserve considers most of its open market operations as defensive, that is, as designed to offset temporary autonomous fluctuations in reserves; it therefore makes almost exclusive use of reversed security transactions that usually last for only 1 day and never for more than 15 days. Reversed security transactions are also the primary instrument for the implementation of monetary policy in Germany and France, but are used somewhat differently than in the United States. The Federal Reserve uses its relatively short maturity repurchase agreements both to smooth daily autonomous fluctuations in reserves and to regulate reserves in order to achieve its medium-term policy objectives. In contrast, the Deutsche Bundesbank and the Bank of France direct their repurchase agreements, which are characteristically of longer maturity than in the United States (usually 10 to 20 days in France and 28 to 35 days in Germany), only at providing sufficient reserves to achieve their medium-term policy objectives, not to smooth daily fluctuations. Autonomous daily fluctuations in reserves are smoothed with other instruments, for example, foreign exchange swaps or repurchases or day-to-day repurchase agreements at prevailing market interest rates.

Reversed security transactions do not play a major role in the implementation of policy in either Japan or the United Kingdom. The Bank of Japan has only recently entered into repurchase agreements, and the Bank of England employs repurchase agreements primarily to meet peak seasonal reserve demands. Instead, both monetary authorities conduct market operations primarily by the outright purchase or sale of securities. Even though the Bank of England mostly purchases and sells outright, however, it prefers to conduct its operations in bills with maturities of only 7 to 33 days. Thus, these operations are quite similar to the longer maturity repurchase agreements employed by the Bundesbank and the Bank of France.

In general, the role of the discount window for short-term reserve management has declined during the 1980s, as open or interbank market operations have become the major instrument used to influence the supply of reserves in the banking system. Discount window credit (or its equivalent) is now generally a marginal source of funds. In Japan, although interbank market operations are the major policy instrument, the discount window plays a substantially more important role in the daily management of reserves than in the other four countries. As the discount rate is usually below market interest rates, the Bank of Japan must ration discount window credit. Moreover, the Bank can recall discount window loans at its discretion. That is, the Bank can either extend or withdraw lending at its option. The Bank uses this extremely flexible facility to smooth daily fluctuations in the banking system’s reserve position. The effective discount rates in the Federal Republic of Germany and France (the Lombard rate80 and the rate on five- to ten-day repurchase agreements, respectively) are penalty rates. That is, these rates are kept above existing short-term market rates, thereby penalizing depository institutions that borrow from the central bank. Consequently, depository institutions in these two countries typically consider discount window credit only as a last resort. In the United States, the discount rate is typically below short-term market rates, and vigorous nonprice-rationing procedures are used to raise the effective cost of borrowing from the central bank and thereby limit the access of depository institutions. In the United Kingdom, the Bank of England does not maintain an official discount window. It does, however, lend occasionally to the discount houses, usually at rates different from those currently prevailing in the market in its daily operations; in doing so, it can signal its policy changes to financial markets. It should be noted that the diminished role of the discount window has not necessarily reduced the policy relevance of the discount rate. On the contrary, changes in the discount rate in each of these five countries are interpreted by market participants as indicating a change in the stance of monetary policy.

Finally, it is clear from the preceding analysis that the monetary authorities of the five major industrial countries attempt to influence short-term interest rates in their implementation of monetary policy. This paper has described the procedures employed by these monetary authorities so that changes in policy stances can be identified. As these changes are typically manifested in changes in key short-term interest rates and to the extent that interest rate developments affect the behavior of exchange rates, this analysis should facilitate ascertaining more readily and in a more timely manner changes in monetary policies across the five countries and their exchange rate implications.

78

Similar conclusions were drawn by Kneeshaw and Van den Bergh (1989).

79

See Shimamoto (1983), p. 82.

80

The rediscount facility in Germany provides a source of longer-term liquidity. However, because the discount rate is below market rates and the amount of rediscount credit available to banks is restricted by quotas, the rediscount facility is not typically used for short-term reserve management. See Dudler (1986).

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