The Relevance Of The Monetary Policy Rate In The Monetary Transmission Mechanism

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THE RELEVANCE OF THE MONETARY POLICY RATE IN THE MONETARY TRANSMISSION MECHANISM

(AUGUST 2012)

1.???????Introduction and Background

In May 2007 the Bank of Ghana formally adopted inflation targeting (IT) as the framework for stabilizing prices within the economy. Since then, significant progress has been made in developing the policy framework as well as the institutions and markets that underpin its implementation money and capital markets have been developed, there is a framework for forecasting liquidity, and a broad range of instruments with which to conduct monetary policy is available.??????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????

The monetary policy tool of the BOG is the monetary policy rate (MPR) the rate at which commercial banks can borrow from the central bank and it is set at a level that is consistent with meeting the BOG s inflation target. The MPR, thus, is expected to communicate the stance of monetary policy and act as a guide for all other market interest rates.

The monetary transmission mechanism the process by which monetary policy decisions affect the real economy and inflation operates through several channels.

When monetary policy tightens, for example, and market interest rates rise, the financial position of firms may weaken either because of an increase in their interest payments which reduces their net cash flows or because of a fall in the value of their assets and thus collateral causing the terms of credit that they face (the cost of external funds) to rise. This is the balance sheet channel .

Monetary policy changes may also affect the supply of credit, particularly by commercial banks. Because banks rely on demand deposits as an important source of funds, monetary policy tightening, by reducing the aggregate volume of bank reserves will also reduce the availability of bank loans. When a significant number of firms and households rely on banks as a major source of financing, then a reduction in loan supply will depress aggregate spending and reduce total output and price. This is the bank lending channel .

In conventional macroeconomic models, the primary mechanism believed to be at work in the transmission of monetary policy is the interest rate channel . In this case, an increase in the MPR, for example, is expected to directly impact on some short-term wholesale market interest rate (the interbank interest rate the rate at which banks borrow from each other or Treasury bill interest rates) and then transmitted to retail market interest rates bank lending and deposit rates. Assuming that prices remain fixed for some period of time, the increase in the nominal market interest rates would translate into an increase in real (inflation adjusted) market interest rates and, hence, an increase in the real cost of capital. This, in turn, would result in a reduction in overall consumption and investment spending (i.e. a decline in aggregate demand) such that total output and prices would fall.

The effectiveness of the monetary transmission mechanism is important for the credibility of monetary policy the relevance of the MPR in determining market interest rates and hence the level of economic activity and prices.

In the present exercise we examine the channels through which changes in the MPR pass through to impact on the lending rates of banks. Specifically, we examine pass through to two intermediate money market variables the interbank interest rate and 91-day Treasury bill rate and assess their individual and joint impact on the lending rate. We also examine any lags in the transmission mechanism.

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CEPA
CENTER FOR POLICY ANALYSIS
THE RELEVANCE OF THE MONETARY POLICY RATE IN THE MONETARY TRANSMISSION MECHANISM
(AUGUST 2012)
CEPA: The relevance of the MPR in the monetary transmission mechanism Page 1
1. Introduction and Background
In May 2007 the Bank of Ghana formally adopted inflation targeting (IT) as the framework for stabilizing prices within the economy. Since then, significant progress has been made in developing the policy framework as well as the institutions and markets that underpin its implementation ? money and capital markets have been developed, there is a framework for forecasting liquidity, and a broad range of instruments with which to conduct monetary policy is available.
The monetary policy tool of the BOG is the monetary policy rate (MPR) ? the rate at which commercial banks can borrow from the central bank ? and it is set at a level that is consistent with meeting the BOG?s inflation target. The MPR, thus, is expected to communicate the stance of monetary policy and act as a guide for all other market interest rates.
The monetary transmission mechanism ? the process by which monetary policy decisions affect the real economy and inflation ? operates through several channels.
When monetary policy tightens, for example, and market interest rates rise, the financial position of firms may weaken ? either because of an increase in their interest payments which reduces their net cash flows or because of a fall in the value of their assets and thus collateral ? causing the terms of credit that they face (the cost of external funds) to rise. This is the ?balance sheet channel?.
Monetary policy changes may also affect the supply of credit, particularly by commercial banks. Because banks rely on demand deposits as an important source of funds, monetary policy tightening, by reducing the aggregate volume of bank reserves will also reduce the availability of bank loans. When a significant number of firms and households rely on banks as a major source of financing, then a reduction in loan supply will depress aggregate spending and reduce total output and price. This is the ?bank lending channel?.
In conventional macroeconomic models, the primary mechanism believed to be at work in the transmission of monetary policy is the ?interest rate channel?. In this case, an increase in the MPR, for example, is expected to directly impact on some short-term wholesale market interest rate (the interbank interest rate ? the rate at which banks borrow from each other ? or Treasury
CEPA: The relevance of the MPR in the monetary transmission mechanism Page 2
bill interest rates) and then transmitted to retail market interest rates ? bank lending and deposit rates. Assuming that prices remain fixed for some period of time, the increase in the nominal market interest rates would translate into an increase in real (inflation adjusted) market interest rates and, hence, an increase in the real cost of capital. This, in turn, would result in a reduction in overall consumption and investment spending (i.e. a decline in aggregate demand) such that total output and prices would fall.
The effectiveness of the monetary transmission mechanism is important for the credibility of monetary policy ? the relevance of the MPR in determining market interest rates and hence the level of economic activity and prices.
In the present exercise we examine the channels through which changes in the MPR pass through to impact on the lending rates of banks. Specifically, we examine pass through to two intermediate money market variables ? the interbank interest rate and 91-day Treasury bill rate ? and assess their individual and joint impact on the lending rate. We also examine any lags in the transmission mechanism.
2. Monetary Policy Transmission and the Effectiveness of the Monetary Policy Rate
The transmission from the MPR to the wholesale market interest rates
The time paths (from November 2009 to May 2012) of the MPR and market interest rates are shown in Charts 1 ? 3 below.
Chart 1a is a plot of the MPR and interbank interest rates over time. It shows a general positive association between the MPR and the interbank interest rate, implying that the interbank interest rate is responsive to changes in the MPR such that an increase or decrease in the MPR could result in a corresponding change in the interbank interest rate in the same direction.
CEPA: The relevance of the MPR in the monetary transmission mechanism Page 3
Chart 1a: Nominal MPR and Interbank Interest Rate (%, p.a.)
Source: Based on data obtained from the BOG website
CEPA has attempted to capture this observed positive correlation between the two rates in a simple regression model. The interbank interest rate used represents an average over a one month period.
Estimates from the model show that, on average, there is almost a full pass through from the MPR to the interbank interest rate. That is, the BOG is able to almost perfectly impact the interbank interest rate contemporaneously ? i.e. within the month of the change in the MPR. It is important to note that one month in financial markets is a long enough period of time to observe a significant impact of the MPR on the interbank rate. Also, the MPR remains fixed for two month periods. The finding of a contemporaneous effect should, thus, not be too surprising.
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Chart 1b: Nominal MPR and 91-Day Treasury Bill Rate (%, p.a.)
Source: Based on data obtained from the BOG website
Changes in the MPR can also have an impact on the 91-day T-bill interest rate. Here, we derive the monthly 91-Day T-bill rate as an average of the weekly T-bill rates in a particular month and plot it, along with the MPR, over the period of interest in Chart 1b.
The chart shows that there is again a strong positive correlation between the MPR and the 91-Day T-bill rate. CEPA?s estimated model confirms this positive correlation and shows that, on average, a change in the MPR is also almost perfectly passed through to the 91-Day T-bill rate within the month.
The transmission from the wholesale market interest rates to the retail lending rate
Given the findings above ? that changes in the MPR strongly impact both the interbank and 91-day Treasury bill interest rates ? we next investigate the impact of monetary policy on bank lending rates. Lending rates differ both over time and across banks. As such, the monthly lending rate that we use here reflects an average over a one month period for all banks.
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CEPA: The relevance of the MPR in the monetary transmission mechanism Page 5
Through the interbank and 91-day T-bill rates changes in the MPR ultimately impact the lending rate. Charts 2a and 2b show graphical representations of the relationship between the lending rate and the interbank interest rate and 91-Day T-Bill rate respectively. The graphs show a general positive relationship between the two pairs of interest rates ? i.e. over the specified time period the rates tend to trend downwards.
Chart 2a: Nominal Interbank Interest Rates and Bank Lending Rates (%, p.a.)
Source: Based on data obtained from the BOG website
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Chart 2b: Nominal 91-Day Treasury-Bill Interest Rates and Bank Lending Rates (%, p.a.)
Source: Based on data obtained from the BOG website
Estimates by CEPA?s model show positive and statistically significant influences of both changes in the interbank interest rate and changes in the 91-Day T-bill rate on changes in the lending rate. Yet, while both interest rates are important for determining the average bank lending rate to businesses and individuals, the influence of the 91-Day T-Bill rate is larger and more significant. We find that, on average, roughly 23 percent of a change in the interbank interest rate is passed through to the lending rate; while, on average, about 77 percent of a change in the 91-Day T-bill rate is passed through to the lending rate. This finding is not surprising given the time span of the analysis and the short period during which the MPR and the interbank interest rate followed divergent paths.
The effectiveness of the monetary transmission mechanism
Overall, our findings suggest that the MPR is an effective tool of monetary policy and that it remains relevant for assessing the monetary policy stance of the BOG. Changes in the MPR
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impact both the interbank and 91-day Treasury bill rates; which in turn impact the average lending rate of banks.
Between November 2011 and January 2012, Chart 1a, there was a deviation in the direction of the interbank interest rate from the MPR (a sharp drop in the interbank rate against the stability of the MPR) which raised questions about the relevance / effectiveness of the MPR as a monetary policy tool. The concern is valid given that during this period the average lending rate declined slightly despite a stable MPR and a mildly rising 91-day T-bill rate. Our findings show, however, that the observed deviation was too brief to have had a statistically significant effect on the MPR?s relevance as an indicator of the monetary policy stance of the BOG.
The fall in the interbank interest rate was the result of large excess reserves in the banking system. Evidence of this liquidity overhang can be seen in the high (above the mandatory 9 percent of total deposits) and rising reserve ? to ? deposit ratio depicted in Chart 3a and in the rising currency ? to ? deposit ratio shown in Chart 3b.
Chart 3a: Bank Reserves ? to ? Domestic Deposit Ratio
Source: Based on data obtained from the BOG website
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Chart 3b: Currency with the Non-Bank Public ? to ? Domestic Deposit Ratio
Source: Based on data obtained from the BOG website
Because of the high cost of OMO and the limited resources of the Central Bank to conduct OMO effectively, these excesses were inadequately sterilized by the BOG. Indeed, additional liquidity was further injected into the system as a result of the only partial rollover of maturing OMO securities.
To manage the excess reserves in the banking system, the BOG resorted to the use of the cheaper repo ? with a rate of 5 percent. This, however, is an instrument meant for smoothening temporary fluctuations in liquidity. As such, it was an inappropriate tool for managing what was essentially a structural problem and in any case it still left a large amount of excess reserves in the system. That banks were willing to lend to the BOG at such low rates rather than lend to SMEs goes to show the high perception of risk associated with our SMEs ? the backbone of jobs especially for the youth.
While the divergence in the interbank interest rate has been shown to have not significantly affected the relevance of the MPR; efforts must be made to ensure a better alignment of the
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interbank market interest rate with the MPR. This would require that the BOG is adequately resourced, through provisions for OMO in the budget, to perform its role effectively.
3. Conclusion
Our work has shown that over the period of study the MPR has remained relevant as an indicator of the monetary policy stance of the BOG. This is in spite of the temporary divergence of the MPR from the interbank rate that was caused by the failure of the BOG to adequately mop-up excess liquidity in the system.
In the wake of the continued rapid depreciation in the cedi, the BOG started tightening monetary policy; raising its policy rate three times thus far this year from 12.5 percent in January to 13.5 percent in February, 14.5 percent in April, and 15 percent in June. Additional measures have also been taken to tackle the excess liquidity problem. These have included the reintroduction of BOG bills, the requirement that mandatory reserves on foreign currency deposits be held in cedis, the provision of cedi cover for vostro balances of deposit money banks, and the reduction in the net open position of banks.
Market interest rates have responded positively to these measures. However, greater reliance on market-based policies, rather than administrative measures, is needed to ensure a more effective sterilization of the excess liquidity in the system; while preserving the role of the MPR. Additionally, there must be greater complementarity between fiscal and monetary policy; with fiscal policy supporting efforts on the monetary front. This calls for enhanced and credible fiscal discipline, particularly in this election year. The wider cash deficit projected in the supplementary budget raises the net domestic financing requirement of the Government. This is likely to lead to a rise in interest rates and the need for upward revision of the MPR at the next meeting of the Monetary Policy Committee (MPC). Indeed, unless the currency crises is quickly brought to an end, the MPC may have to consider meeting monthly to maintain the role of the MPR as the relevant indicator of monetary stance.

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