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This paper has benefitted from, and the authors appreciate, the comments of R. Freeman, Y. Horiguchi, K. Johnson, D. Kohn, J. Marquez-Ruarte, D. McDonald, K. Riechel, and G. Tavlas.
The demand and supply curves for reserves are continuously subjected to small, day-to-day, frequently offsetting shocks which the monetary authorities in the G-5 countries typically accommodate. The following analysis involves shocks that are large enough and are sustained long enough that they may affect the monetary authority’s ability to achieve its objectives.
For a discussion of how financial innovation during the 1980s has generated increased shocks to the demand for money, see Bank for International Settlements (1984).
Market operations are primarily open market operations (i.e., conducted in markets with varied participants and various financial instruments) in the United States, Germany, France, and the United Kingdom. In contrast, market operations in Japan are conducted largely in the interbank market, i.e., only between banks.
In the 1970s, financial intermediaries in France provided more than 80 percent of the funds raised by domestic nonfinancial sectors. In 1986, this amount declined to less than 40 percent.
For a more detailed description of these developments in France as well as other major industrialized countries, see Raymond (1987).
M2 consists of currency, checking accounts, and savings accounts available at sight. M3 consists of M2 plus nonnegotiable time deposits and foreign currency deposits.
The 5- to 10-day repurchase agreement is similar to the Lombard facility in Germany.
On average, repurchase tenders are invited each week. They need not, however, result in the net addition of reserves to the banking system as the allocation in the new tender may be insufficient to offset the drainage of reserves caused by the expiration of previous repurchase agreements.
See Table 3. The reserve requirement ratios are changed infrequently; for example, during the last two years, they were changed in January and July of 1987 and in May of 1988.
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.
The reasons for the shift from the central bank money stock to M3 are discussed in detail in Bundesbank (1987). M3 comprises currency in circulation plus sight deposits, time deposits for less than four years, and savings deposits at statuatory notice.
The Central Bank Council consists of the President and Vice-President of the Bundesbank, the members of the Directorate, and the Presidents of the Land Central Banks (regional offices of the Bundesbank).
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. On this point, see Bundesbank (1987), p. 97.
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.
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, over DM 100 million), and the origin of deposits. See Table 3.
The Bundesbank’s Lombard facility provides short-term loans to banks against the collateral of certain Government and public sector securities.
The increased recourse to securities repurchase operations was attributable primarily to the marked shift in the balance of payments to sizeable 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 through a reduction in required minimum reserves, an expansion in the rediscount quota, and 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 which the banks held in large quantity. The historical evolution of securities repurchase operations and their basic modality are discussed in more detail in Bundesbank (1983), Bundesbank (1985), and Dudler (1986).
Eligible securities comprise fixed interest securities (both domestic and foreign) which 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.
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.
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.
The call rate is the interest rate charged in the interbank market for the overnight loan of reserves between banks.
An interesting attempt is made to analyze the policy implementation process and its transmission mechanism by Neumann (1988).
The extensive financial and foreign exchange liberalization occurred against the background of fundamental changes in the structure of the Japanese economy during the 1970s. Until the first oil crisis, the Japanese domestic financial system had been predominantly characterized by the channelling of funds from the household sector, with a high saving ratio, through the banking system to the corporate sector which demanded investment funds. For this reason, the banks’ asset portfolios had consisted largely of loans to corporations. However, in the wake of the first oil price shock, two fundamental changes emerged in the structure of Japanese economy and its flow of funds. First, the Japanese Government began to run large deficits in its operations in 1975 in an effort to counteract the recession that year, financing them with large issues of government bonds. Second, the growth of the Japanese economy sharply decelerated, as did the investment activity by the corporate sector, reducing its once predominant demand for domestic saving. As a result, the proportion of indirect financing was drastically reduced, and the government and foreign sectors began to absorb larger shares of domestic saving.
Broadly defined money consists of M2 (currency plus demand, savings, and time deposits) plus certificates of deposit. Since the third quarter of 1978, the Bank of Japan has announced its quarterly projections of the average outstanding M2 plus certificates of deposit for the next quarter in terms of year-over-year growth rates. Hutchison (1986) and Ito (1988) have questioned whether these projections are in fact targets, but instead would be viewed as forecasts that reflect the current level of economic activity, not policy goals of the Bank of Japan.
The call rate is an interest rate in the short-term interbank money market. The bill discount rates are discount rates on various bills of short maturities traded in the interbank money market.
Gensaki transactions are repurchase agreements usually involving government securities.
The quotation system in which the Bank of Japan had been setting the rates was discontinued in 1978.
See below for a description of this ratio.
See Cargill (1986) for a discussion of the impact of financial market liberalization on the implementation of monetary policy.
In November 1988, some changes were introduced in the maturity structure of the interbank money markets in order to encourage increased interest rate arbitrage between the interbank and open money markets and to maintain the effectiveness of monetary control by the Bank of Japan. The maturities of collateralized commercial bills were extended on the short end to one week; thus their maturities now range from one week to six months, compared with one to six months previously. The maturities of collateralized call trading have been limited to overnight to one week, compared with slightly longer previous maturities of overnight to three weeks. On the other hand, the maturities of uncollateralized call trading have been lengthened to a range of overnight to six months. These changes were intended to enable the Bank of Japan to intervene in the interbank money markets through purchasing operations of commercial bills mainly in the maturity range of one to three weeks, compared with the range of one to three months previously.
The official discount rate was reduced to a post-war low in February 1987 and was increased in May 1989.
This relationship can be derived by rearranging the balance sheet of the Bank of Japan.
This formulation of monetary policy provides a link between foreign exchange intervention and money market intervention; it in effect implies automatic sterilization of the reserves either generated or eliminated through official foreign exchange intervention.
The reserve progress ratio is usually measured as the deviation from the average because individual banks judge their actual reserve position in relation to the average daily requirement as a standard. For a fuller explanation of the reserve progress ratio, see Kanzaki (1988).
In early 1989, for example, with the current discount rate of 2.5 percent and the call rate of around 3.70 percent, the effective interest rate on loans for two days or less exceeded the call money rate.
These bills include commercial and industrial bills, trade bills, promissory notes, export and import bills, bills of exchange, etc.
The Bank of Japan began operations in short-term government bills in 1981, but the market is not yet deep enough to permit large purchase operations in this instrument.
See Takagi (1986) for a discussion of this point.
This view of the principal objective of monetary policy was conveyed by Bank of England officials in an interview in July 1988.
£M3 comprises notes and coin in circulation with the public plus all sterling deposits (including certificates of deposit) held by the U.K. private sector with U.K. banks.
MO is defined as all notes and coin in circulation with the public plus banks’ till money and banks’ operational balances with the Bank of England. The annual average target growth range for FY 1989 has been set at 1-5 percent.
These are liabilities that the Bank of England deems eligible for rediscounting; they are described in more detail below.
The Bank of England judges applications for eligibility according to three basic criteria: first, the bank must maintain a broadly based and substantial acceptance business in the United Kingdom; second, its acceptances must command the finest rates in the market for bills that are not considered “eligible;” and third, in the case of foreign-owned banks, British banks must enjoy reciprocal opportunities in the foreign owners’ domestic market.
If the Bank were to decide to increase recourse to straight-forward lending, it could reestablish the minimum lending rate, which served as the benchmark interest rate for several years before the procedural changes of 1981. Before then, the Bank of England generally auctioned relatively large amounts of Treasury bills—usually £500-600 million worth each week. Whenever it proved necessary to inject liquidity into the system, the Bank would buy these bills back at a rate that was set by formula in relation to the average auction rate. When the Bank of England decided not to meet the demand for liquidity in this way, the discount houses would be forced to borrow from the Bank of England at the more costly “minimum lending rate.” This rate served as the key benchmark interest rate and changing it had major political as well as economic implications. In 1981, the U.K. authorities switched to what was seen as a system that would be more sensitive to market mechanisms and overcome the “bias to delay” in adjusting interest rates that was inherent in the existing system (Coleby 1986). The weekly allocation of Treasury bills was cut back to about £100 million and the Bank of England increased the amount of other commercial and local authority bills that it would purchase as well as Treasury bills to relieve shortages. It was provided that when the discount rates offered by the discount houses for these bills fell outside an unpublished band of rates that were deemed consistent with the Bank’s monetary policy objectives, those discount houses would have to borrow from the Bank at a rate that was only determined on the day of the borrowing. The Bank of England, however, explicitly retained the possibility of reintroducing a fixed minimum lending rate, and indeed it did so on January 1985 for a short period in an effort to bring some stability to rather volatile market conditions.
Ml consists of currency, travelers checks, demand deposits, and other checkable deposits. M2 is Ml plus savings accounts, money market deposit accounts, general purpose and broker/dealer money market mutual funds, small (less than $100,000) time deposits, overnight repurchase agreements, and overnight eurodollars issued to U.S. residents by foreign branches of U.S. banks. M3 is M2 plus large time deposits, institution-only money market mutual funds, term repurchase agreements, and term eurodollars issued to U.S. residents.
See Axilrod (1985), Heller (1988), and Wenninger (1986). While this relationship has been called into question, it appears that the Federal Reserve continues to have confidence in the longer-term relationship between growth in the monetary aggregates and the rate of inflation. See, for example, Heller (1988), p. 422.
Reserve requirements are also in principle an instrument of policy. While changes in reserve requirements do release or absorb reserves, and hence, could be used to affect the reserve positions of depository institutions, only limited use is now made of reserve requirements in the short-run implementation of monetary policy.
Matched sale-purchase transactions are conducted only in Treasury bills, while repurchase agreements may be conducted in the entire range of Treasury securities.
The federal funds rate is the interest rate in the overnight interbank market on deposits at the Federal Reserve which depository institutions with reserve deficiencies borrow from institutions with excess reserves.
The directive from each FOMC meeting is made public on the Friday following the succeeding FOMC meeting. The directives for 1988 are summarized in Table 6.
Total reserves equal borrowed plus nonborrowed reserves, or equivalently, required plus excess reserves.
See Thornton (1986), pp. 9-12. However, the relationship between borrowing and the federal funds rate is not completely stable and has exhibited permanent shifts. When these were perceived to have occurred, frequently formal adjustments to the targeted level of borrowed reserves have been made. Most recently this occurred in late 1988. See footnote 1 on page 49.
Johnson (1988b) provides a Wicksellian interpretation, viz., that inflationary pressures will be moderated as market interest rates rise relative to the “natural” interest rate.
See footnote 1 on the following page.
In an addendum to the minutes of the FOMC meeting held on November 1, 1988 (released on December 16, 1988), it was noted that, subsequent to the FOMC meeting of November 1, depository institutions had reduced their demands on the discount window as adjustment plus seasonal borrowing had declined, falling significantly below the level anticipated at the November 1 meeting. The Federal Reserve Bank of New York, however, adjusted the reserve paths to incorporate a lower level of borrowing so that the federal funds rate would continue to trade in its previously established range. Such a combination of events may indicate that the Federal Reserve has begun to place less emphasis on the borrowed reserves objective and more on maintaining the federal funds rate at a particular level.
Thornton (1986) and Batten and Thornton (1984) have found that discount rate changes, when they are announced, have a statistically significant impact on the federal funds rate, the three-month Treasury bill rate, and the trade-weighted index of the foreign exchange value of the dollar. Both studies concluded that this “announcement effect” indicated that market participants interpreted a discount rate change as signalling a change in the stance of monetary policy.
For example, in announcing the increase in the discount rate on August 9, 1988, the Federal Reserve stated that the action was taken to reduce inflationary pressures. Moreover, it is clear from the minutes of the FOMC meeting held August 16, 1988, that the Committee intended the discount rate increase to signal a tightening of policy.
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).