The implementation of monetary policy in industrial countries: a survey

Abstract

In recent years monetary policy operating procedures have continued to evolve in the light of changes in the structure and workings of financial markets as well as in the broader economic and political environment. Since the mid-1980s, central banks have further strengthened the market-orientation of policy implementation, cut reserve requirements, widened the range of available instruments, increased the flexibility of liquidity management, sharpened the focus on interest rates as operating targets, improved the transparency of policy signals and shortened the maturity of interest rates serving as the fulcrum of policy. While these trends have resulted to some extent in a continuation of the process of convergence dating back to at least the 1970s, significant differences still exist across countries. This paper reviews current monetary policy implementation procedures within a common framework in order to highlight similarities and remaining differences across countries. It also provides some information about their evolution in recent years and suggests possible explanations for the main forces underlying the observed changes.

Introduction

Operating procedures are the least conspicuous facet of monetary policy. Much academic and public attention is devoted to the ultimate objectives and strategic aspects of policy. Questions such as "should price stability be the sole ultimate goal?" or "should the central bank adopt a monetary, exchange rate or inflation target?" invariably steal the thunder. In contrast, not much thought is normally given to issues relating to day-to-day or month-to-month implementation of policy and to the corresponding choices regarding operating objectives, tactics and specific instruments. A keen interest in these issues remains generally limited to central bankers and the market participants most directly concerned, particularly those active in money markets.

While to some extent understandable, this relative neglect is unfortunate for a number of reasons. First, it breeds the perception that operating procedures can be taken for granted. Yet ensuring that the central bank has adequate control over monetary conditions is no easy task. Secondly, it encourages the view that operating procedures are of no consequence. Yet the strategic aspects of policy need to be supported by an appropriate operating framework. Moreover, the way in which policy is implemented can have significant implications for the organisation and functioning of money and even capital markets as well as for asset price volatility. Thirdly, it risks giving rise to potential misconceptions among parts of the academic profession. Possible examples include the view that the monetary base is the key concept in the determination of interest rates; that reserve requirements are necessary, or predominantly used, for monetary control; that the marginal demand for bank reserves can be thought of as a function of the volume of deposits; or that the central bank controls interest rates by mechanically supplying a certain volume of funds to meet a generally well-behaved demand for monetary base or bank reserves. Finally, a proper understanding of operating procedures could throw light on the ultimate power of the central bank to affect monetary conditions, on its source, changing characteristics and reach in the wake of the profound changes taking place in the financial environment.

As a result of this relative neglect, a great deal has been written on the evolution over the last decade or so of views regarding the appropriate ultimate objectives for monetary policy or its strategic aspects. What has been less appreciated is that the changes in operating procedures have been equally substantial, having been driven by much the same forces, viz. the significant changes that have taken place in the structure of financial markets as well as in the broader economic and political environment. In particular, since the 1980s to varying degrees central banks in industrial countries have sharpened the focus on interest rates as operating objectives, shortened the maturity of interest rates serving as the fulcrum of policy, strengthened the market orientation of policy implementation, increased the flexibility of liquidity management and improved the transparency of policy signals. In the process, they have cut reserve requirements and widened the range of available instruments. While these trends have to some extent carried further a process of convergence dating back at least to the 1970s, significant differences still exist across countries.

Against this background, the present paper reviews current monetary policy implementation procedures in fourteen industrial countries within a common framework in order to highlight similarities and remaining differences across countries. It also provides information about their evolution in recent years and suggests possible explanations for the main forces underlying the observed changes. As the analysis draws heavily on the responses to a factual questionnaire sent to the central banks concerned in the second half of 1996, the information contained in the main text and various tables reflects the situation in September 1996. Since then, considerable further changes have taken place in some countries, notably the United Kingdom and the Netherlands; these are summarised separately in Annex V. As these modifications have tended to narrow cross country differences further, the main body of the paper provides a richer spectrum of possible frameworks.

The paper is organised as follows. Section I outlines the conceptual framework underpinning the analysis. Section II offers a very brief overview of existing arrangements, focusing only on the main defining features of national set-ups. Section III examines in more detail the characteristics of the demand for bank reserves, treating separately cases in which this is primarily determined by settlement balance needs and those in which reserve requirements still play a major role. Sections IV and V then analyse the supply of bank reserves, broadly defined. Section IV deals essentially with liquidity management issues, that is, with how central banks go about meeting the demand for bank reserves through adjustments in the supply. It looks in particular at the forecasting process and at the basic features and functions of discretionary market operations and standing facilities. Section V, by contrast, examines the communication strategies through which central banks attempt to influence and guide market rates. In this context, signalling mechanisms and tactics are considered in some detail. The conclusions summarise the key points emerging from the analysis.

A number of annexes complement the paper. Annex I provides some statistics on sources and uses of bank reserves. Annex II presents some additional information on reserve requirements. Annex III discusses how operating procedures are adapted and perform at times of severe exchange rate pressure, when they are tested to the full. Annex IV considers the implications for policy implementation of the emergence of electronic money and of the general shift towards real-time gross settlement (RTGS) currently under way. Annex V updates the information contained in the main text to cover changes in operating procedures since autumn 1996. Annex VI describes the conceptual design of the operating framework chosen for stage three of European economic and monetary union.