Monetary Policy and Money Markets in Europe

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Monetary Policy and Money Markets an European perspective Abel M. Mateus Banco of Portugal Board Member (MPC) Executive Director for Monetary Operations and IT (1992-1998)

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An efficient money market is an absolute prerequisite for a well functioning bond market

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We will present what in our view is an optimal monetary policy framework, considering monetary theory, the state of the art of CBs, based on experience of European central banks Today, the SECB comprises ECB and NCB So, these models will correspond better to NCB just before the euro started

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OutlineFramework for Monetary Policy Money market infrastructure Money market operations Criteria for market efficiency Treasury/MOF and Central Bank relationship Market surveillance

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OutlineFramework for Monetary Policy Money market infrastructure Money market operations Criteria for market efficiency Treasury/MOF and Central Bank relationship Market surveillance

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Basic principles (based on the recent advances in optimal monetary policy models and the European Monetary Union experience)Independent Central Bank (setting objectives, politically independent, free from government pressure, Board Members cannot be dismissed, accountability) Clearly defined nominal anchor Central Bank has complete freedom and all the instruments required to attain objectives Prohibition of government credit and buying directly bonds from the government All these rules should be enshrined on the Constitution and/or Central Bank Charter

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Monetary Policy RulesInflation targeting Inflation depends on real interest rate Real interest rate depends on nominal interest rate and inflation expectations Nominal interest rate can be manipulated thru bank reserves P=a. (Real Interest Rate, GDP-Normal GDP) Exchange rate targeting Policy pursued by most of EU countries in the 1990s, Interest Rate Parity

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Monetary ProgrammingMacroeconomic Forecasting Exercise (IS-MR, AD-IA) Or, more traditionally, fix intermediate monetary aggregates (LM compatible with MR) Control of bank reserves to reach a certain monetary aggregate, compatible with a given interest rate

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Central Bank InstrumentsSetting key interest rates Money market interventions thru repo and reverse repo operations Money market interventions thru open market operations Money market interventions thru foreign exchange markets Set bank reserve requirements

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Central Bank Interest Rate Structure Permanent Credit FacilityRepo ratePermanent Absorption Facility

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Framework for Monetary Policy Money market infrastructure Money market operations Criteria for market efficiency Treasury/MOF and Central Bank relationship Market surveillance

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Money market infrastructureRTGSDepository, Electronic Registrar and Clearing SystemCentral Bank System for Auctions, MP Control and Market SurveillanceInterbank Money Market

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In most of the EU countriesAll this platforms should be integrated and its functioning and integrity are responsibility of Central Bank or agencies that depend directly on Central Bank

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Portuguese caseSITEM is an electronic system for auctioning liquidity between participants and BP(ECB) Brokering liquidity among participants (handles all call market) Keeps track of all operations,e.g. informs participants of operations condition and warns of date of payment Informs of market conditions, rates and indices linked to RTGS, settlement of all operations is a central registrar and clearing/settlement for TBs. Other paper is registered at CVM linked to these systems in real time.

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Framework for Monetary Policy Money market infrastructure Money market operations Criteria for market efficiency Treasury/MOF and Central Bank relationship Market surveillance

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Regular money market intervention at beginning of reserve period Following closely market indicators (interest rate in spot markets for different terms), excess supply/demand of liquidity Following closely exchange rate developments If needed, non-regular interventions in the money markets

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Basic: good bank reserve programming Problem: Treasury operations in some European countries: Single Treasury account at CB in others: Treasury accounts with commercial banks

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Money and exchange rateMoney market and Exchange rate management SHOULD GO HAND IN HAND In countries that give some importance to exchange rate stability, even more important than quantitative planning of monetary aggregates is

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Interest Rate ParityUncovered interest rate parity: Domestic Interest Rate= International Interest Rate + Expected Devaluation+ Sovereign Risk

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Who should have access to Central Bank liquidity windows?All banking institutions (that can take deposits or make loans of liquidity) should have access to Central Bank liquidity window Moreover, all institutions that are subject to minimum reserve requirements

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Conditions for participating in CB liquidity windowsFully compliant financial institution (RTGS, brokerage and/or dealership regulations) Be solvent and financially sound (supervisory institution certified) Signs a contract with Central Bank with rights and responsibilities Is subject to surveillance and timely audits by Money Market Department staff

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Most of European countries have abandoned rediscounting (too much risk taking, and risk assessment) - only France maintains important window Bulk of operations with Treasury Paper (mainly Tbills) But more recently, in order not to bias preference for public paper: use top grade corporate bonds

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Problem of risk assessment of paperRisk assessment is easy for TBs: usually very small hair cuts Hair cuts would be higher for long term bonds (10 year Tbonds) But id usually difficult to compute hair cuts for corporate bonds due to lack of liquidity (30% haircut was common in this case) At BP we have developed an interesting model valuation

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Framework for Monetary Policy Money market infrastructure Money market operations Criteria for market efficiency Treasury/MOF and Central Bank relationship Market surveillance

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Efficient money marketFull market mechanisms, transparent and with frequent transactions Not excessive volatility of market interest rates, and market interest rates reflecting CB targeting But it should respond to shocks in real and monetary markets, as well as inflationary expectations Adjustment more thru quantity than price Settlement risk reduced to a minimum and well defined distribution

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Efficient and secure market infrastructure Market reference rates frequent and easily available Very small spreads in Interbank rates Articulation between wholesale and retail money markets Fluidity between money, foreign exchange and bonds markets Excellent market stability and surveillance

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Last Updated: 8th March 2018

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