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How does monetary policy impact inflation?

In this segment we focus on the macro economy to understand how a central bank might

use its ability to adjust policy interest rates to guide inflation in the economy.

The set of channels through which monetary policy impacts the economy and inflation,

are called the monetary policy transmission mechanisms.

The central bank sets a target for the short term interbank rate.

The interbank rate and the expectations of the near term

policy stands at the central bank determine money market rates.

Money market rates are central to the operation of the financial system.

The effects of monetary policy will be felt in various financial markets.

These financial markets will then spill over into

the real economy by impacting the good demand for goods and services.

We will explore three major transmission mechanisms.

Policy interest rates will affect the interest rate on bank loans.

In the Asia Pacific region,

bank lending is a dominant source of financing for private sector investment.

Thus, monetary policy will impact investment through bank lending.

We call this the interest rate channel.

Expectations of the future path of interest rates will impact

long term bond rates which will also finance investment spending.

This is called the expectations channel.

Interest rates will also spill over to stock markets and real estate markets.

The resulting impact on asset prices

and household wealth can affect consumption spending.

We call this the asset price channel.

After viewing this segment,

you should be able to; one,

identify the channels of the monetary policy transmission mechanism.

As we have seen in a previous module,

changes in the policy rate will have an immediate impact on money market rates.

This will also impact the costs of funds for banks.

When banks can borrow money cheap with money markets,

they will have less need for deposits from retail customers.

This reduces the market deposit rate.

When banks have access to cheap funding,

competition will reduce market loan rates.

This slide shows the central bank policy rate in Japan which is set by the Bank of Japan.

In the late 1980s a policy rate was raised to

six percent before persistently cutting interest rates to near zero.

Money market rates closely tracked the policy rate over the last 40 years.

We see that time deposit rates fall money market rates.

The prime lending rate is

a benchmark bank loan rate while

the prime lending rate in the housing loan rate fall and parallel,

lending rates are typically higher due to credit risk.

A similar phenomenon is observed in Korea.

We see deposit rates and commercial bank loan rates follow the policy rate.

Low interest rates make borrowing to finance

housing cheaper and corporate investment more profitable.

This should stimulate aggregate demand,

which in turn has a dampening effect on consumer price inflation.

As seen above, the central bank's policy tightening and

easing cycles lasts for periods of up to several years.

This is likely to affect not only current money market rates,

but also expectations of future interest rates.

Consider if the policy rate sets

the one year interest rate which we call, (i) subscript one.

The market will also develop expectations of

the future path of one year interest rates for the next number of years.

Consider the path of expected interest rates covering the next T years.

Take the average of the interest rate,

compare that with the interest rate for a bond with maturity of two years.

Define (i) subscript t as the interest rate for a bond with maturity of T years.

The logic of the expectations theory of the term structure,

suggests that the long term bond rates tend to gravitate toward

market expectations of the average future path of short term interest rates.

The average of these interest rates is the average interest you would earn if

you put money into one year bonds for T years.

If investors didn't care about risk or diversification,

they would put money into the highest yielding asset.

If long term rates were higher than the average of short term rates,

then investors would rush into long term bonds

pushing down rates as bond issuers found they had many customers.

If interest rates and long term bonds were too low relative to this benchmark,

they would leave this market and bond insurers would need to offer higher interest rates.

Market forces will push the long term interest rate toward this benchmark.

The yield curve indicates the relationship between the maturity of

debt securities and the associated interest rates.

This graph shows the interest rate of Korean government notes

with maturity of one to three and five years,

and longer term bonds with maturity of 10,

20, 30 and even 50 years.

The yield curve indicates the expectation of

interest rates in the near term and the far term.

Data from Korean bond markets illustrates the expectations theory.

We see that persistent changes in policy rates have

a direct impact on longer term government bond rates.

The near term yield curve is an indicator of future policy focus on the recent few years.

Since the Bank of Korea began an easing cycle in the summer of 2014,

bond rates follow the policy rate downward until the middle of

2016 when bond rates move noticeably above the policy rate.

Why? One explanation is that bond markets were expecting

a subsequent tightening of interest rates which occurred in November 2017.

What does this imply for expectations of future monetary policy?

Consider the near term yield curve for March 9th 2017,

one year interest rates are 1.87%,

two year interest rates are 2.21% and three year interest rates at 2.29%.

If the two year interest rate is the average of the one your

interest rate this year and next year,

then we can calculate the expectation of the one year rate next year

as twice the two year rate minus the one year rate today.

If the one year rate is 1.87%,

and the two year rate is 2.21%,

this indicates that the expectation of the one year rate on March 9 2019 would be 2.56%.

Likewise, the three year interest rate would be

an average of one year rates over the next three years.

Thus, simple algebra would say that the market's expectation of the interest rate on

March 9th 2020 can be calculated as

three times the three year rate minus a one year rate,

minus one year rate expected to prevail on March 9th 2019.

We have already solved for the latter.

So we can calculate the prevailing interest rate for two years from now at 2.45%.

On the surface, the Bank of Korea's policy action in

November 2017 raised the policy rate by 25 basis points.

But perhaps more importantly this changed

the market's expectation of the future path of interest rates to an even greater degree.

For corporate borrowers who tend to issue debt

with maturities over a range of several years,

the impact of monetary policy and expectations and

that's on longer term interest rates may be more important.

Lower interest rates and bonds make corporate finance cheaper and

encourage investment spending increasing aggregate demand.

We call the impact of monetary policy on expectations of

future interest rates longer term bonds and thus investment, the expectations channel.

Keep in mind longer term bonds may be exposed to

unforeseeable future risk and thus

investors usually tend to ask a small premium to hold them.

So the expectation theory may not hold true exactly.

However, we still see that the expectations theory offers insight into

the dynamic effects of monetary policy of long term interest rates.

This slide shows the importance of the corporate bond market and

bank lending relative to the size of the economy in the Asia Pacific region.

Korea has a relatively large corporate bond market.

So the expectations channel might have significant effects on demand through bond rates.

Bank lending is still much more important though even in Korea.

The Asia's bond markets have been growing rapidly.

Keep in mind that in most regional economies bank lending is still

a far larger source as of financing for private sector investment.

There is one additional aspect of

the expectations channel which is the impact of future policy on future inflation.

When borrowers consider financing,

they will take into account both the interest rate and expected future inflation.

Consider a corporation that borrows money at interest rate (i) to build a factory.

The factory will start producing goods in the future.

If inflation over the course of the loan is high,

the prices of the goods the factory produces will

be high relative to the cost of building

the factory reducing the real costs of

repaying the loan and making borrowing more attractive.

So borrowers naturally compare the interest rate to

expected inflation measured by the real interest rate.

In this sense the monetary policy raises expectations of future inflation,

It also reduces the real interest rates and helps to stimulate borrowing.

Likewise, when the central bank communicates increased interest rates,

this can also increase expectations of future interest rates.

We have seen channels through which interest rates impact inflation.

Future interest rates will by the same token affect future inflation.

Expectations of increasing interest rates should dampen expectations of future inflation.

Lower future inflation will increase today's real interest rate.

In turn high real interest rates will also reduce demand,

the output gap and inflation today.

That's why we see that the expectations channel helps to

reinforce the effect of the interest rates on

aggregate demand and therefore on consumer price inflation.

Consider one additional channel for monetary policy.

When interest rates and deposits changes,

investors adjust their portfolio of wealth.

When deposit rates are unattractive,

investors may switch to stocks or real estate increasing stock and real estate prices.

Consider this famous example of the effect of

monetary policy and asset prices from Japan.

During the late 1980s,

The Bank of Japan reduced a policy rate from 5 percent to

2.5 percent and kept it at this low level for several years.

Over this easing cycle the Tokyo stock market almost triple.

When the Bank of Japan responded to the overheating cycle by raising policy rates,

the stock market fell back to Earth.

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Higher asset prices make consumers feel wealthier and can help drive consumer spending.

So we see that policy rates directly move financial markets.

But the effects on bank interest rates,

long term bonds and asset markets will all have

an impact on spending patterns and thus on inflation.

Amidst all the external events destabilizing demand and

potentially unemployment inflation and corporate profits,

there is an additional channel monetary policy

that could be used to offset other factors.

To reiterate, if central banks raise interest rates this will dampen demand.

This reduces the output gap which has slowed

down core inflation and thus headline inflation.

The central banks reduce interest rates,

this will increase the output gap which should stimulate

core inflation and thus headline inflation.

In the next module will also consider

the exchange rate channel which offers one more channel

for monetary policy to effect demand

potentially strengthening the role of policy stabilization.

Well, let's leave that for later.

Now that we've completed this segment,

you should be able to: one,

identify the channels of the monetary policy transmission mechanism.

So how does the monetary policy impact inflation?

In this segment, we've seen the channels through which

monetary policy affects economic activity and inflation.

The most direct channels were the interest rates channel

and several channels include the impact on asset prices,

or the impact of expected future interest rates on long term bonds.

Each of these will impact the level of demand for goods and

services which puts demand side pressure on inflation.

Monetary policy is thus one additional demand factor that can guide inflation.

Now that we've seen how that central bank can go about guiding inflation,

let's take a look at a monetary policy framework in which

the central bank will set a specific target for inflation called Inflation Targeting.