RDP 8502: Meeting on Monetary Issues Summary of Discussion

Instruments and implementation of monetary policy

Discussion of the mechanics of the implementation of policy centred on the role of the money base. The money base (sometimes known as high-powered money) is generally described as the domestic liabilities to the private sector of the Central Bank. In Australia, the base is defined in Table A.1 of the Reserve Bank's Bulletin as “holdings of notes and coin by the private sector plus deposits of banks with the Reserve Bank and Reserve Bank liabilities to the non-bank private sector.” SRD deposits account for around 25 per cent of the money base while currency on issue accounts for virtually all the remainder.

One view of the role of the base, described by some as the “text-book” view, was that the Reserve Bank should control the money base and thereby exert control over the monetary aggregates. Participants who held this view saw the money base as an appropriate operating objective of monetary policy. Daily market operations could seek to control the supply of the base and this, in turn, would control the growth of the monetary aggregates through the so-called “money multiplier”. This approach assumed a relatively constant, or at least predictably changing “multiplier”. Views differed on the empirical issues here, identifying an area for further work. A related issue was the question of a more appropriate definition of the money base.

The alternative view questioned the usefulness of the money base as an operating objective of monetary policy. Participants who held this view recognised that there was a link between movements in the base and monetary aggregates, but this relationship was not causal. Currency, the main component of the base, was demand-determined and not subject to control in anything but the long run. Similarly, SRDs were directly linked to the growth in trading bank deposits but this need not imply a direction of causation. The direction of causality was, in fact, from bank deposits to the base, as SRDs are determined by the average level of deposits in the previous month. On this view, the Central Bank cannot, in the short run, withhold money base; it can only affect the price at which it is made available. Under current institutional arrangements, it was incorrect to view the Bank's operations as working on the money base and through it on the broader monetary aggregates. Rather, the money base was better regarded as simply another monetary aggregate.

To an extent, this debate was academic. It was generally agreed that any strict attempt at controlling the money base – with whatever changes to institutional arrangements might be required to produce that control – would result in marked volatility in interest rates. It was, therefore, appropriate for the authorities to take this into consideration in conducting market operations to secure appropriate outcomes for all the monetary aggregates (including the money base). In this sense, it was generally agreed that the supply of money base was better regarded in the short-run as demand-determined, but at a price set in the market place (which will be influenced by the setting of monetary policy).

“Reintermediation” and “increased intermediation”

Discussion then turned to the guidance that monetary theory could provide about policy responses during a period of rapid financial deregulation. There was an initial discussion of terminological matters. The word “reintermediation” has been given two meanings. The first is a move from direct to intermediated sources of financing. The second refers to a shift in the pattern of financing between intermediaries – in the present environment, primarily from non-bank financial intermediaries (NBFIs) to banks. On this definition, “increased intermediation” would refer to the process whereby there was a shift in the pattern of financing from direct sources to intermediaries generally. In line with current practice in Australia, the second set of definitions were used in discussion at the meeting.

It was generally agreed by participants that the lifting of controls on banks (and the entry of new banks) would increase the demand for bank deposits and reduce the demand for deposits at non-bank financial intermediaries. This would reflect the fact that banks could offer better terms and provide a wider range of products than they could in the past – factors which may also contribute to money demand instability discussed in the next section. All other things equal, borrowings by NBFIs would, therefore, grow more slowly than they otherwise would have.

In a “text book” world characterised by a stable money multiplier and in which the Central Bank sought strictly to control the quantity of the money base, reintermedition would not be reflected in a corresponding increase in bank deposits and M3. Rather, growth in M3 would be unchanged while growth in broad money would be reduced. By maintaining the same money base objective, the Central Bank would produce an unintended tightening in policy, given that the tendency for M3 to grow more quickly would be due to reintermediation and not to an increase in the overall demand for credit.

It was recognised that the “text book” world was an oversimplification as a description of current circumstances. It was generally agreed that the appropriate policy response to reintermediation would be to accept faster expansion of bank deposits and, therefore, in the money base. Specifically, with demand for M3 boosted by the effects of deregulation, faster than normal growth of M3 and the money base should be allowed. This had, in fact, been the case over 1984/85 with growth in M3 of around 17-1/2 per cent and in the money base of 15 per cent (on a June-to-June basis). It was also recognised, however, that considerable care had to be taken to avoid inadvertently accomodating inflationary credit demands.

One implication of reintermediation is that observed growth in M3 would not be a reliable indicator of underlying monetary conditions. If the effects of reintermediation on M3 were unpredictable or uncertain, it would be important to look at broader monetary and credit aggregates to guage better the growth of total financing. In these circumstances, broad money would be a superior indicator than M3 because it subsumes the effects of a shift of financing from NBFIs to banks. However. growth in broad money would also be affected if there was a shift of financing from direct sources to intermediaries generally. It was observed that growth in broad money in 1984/85 had been higher than expected on the basis of past relationships.

The Bank had recently introduced an aggregate which included both direct and intermediated sources of financing – Liabilities of the Non-Finance Sector (“L”). This aggregate seeks to capture all inter-sector lending to the private non-finance sector and to governments. However, intra-sector financing and internal financing are not included. It was agreed that further work should be done in this area. In particular, data on direct financing were currently available with a long lag and were not complete.

It was also conjectured that deregulation might even change the relationship between total financing (including direct financing) and nominal GDP. This would be another reason why movements in broad money could be higher than expected on the basis of past relationships.

The demand for money

An important pre-requisite for monetary “targeting”, or even the provision of useful “projections”, is that the demand for money be stable, or at least predictable, over time. The structural changes occurring in the financial system at present may lead to instability in conventionally estimated money demand functions.

The paper on this subject discussed at the meeting simply updated some previous Australian money demand studies to examine their performance over the past few years. All of the equations considered exhibited some over-prediction in 1983/84 and under-prediction in 1984/85. It was conjectured that over-prediction in 1983/84 was due to the strong surge of economic growth, which the “activity” variable in the equations (typically current period GDP) was not properly capturing. For 1984/85, when the growth rate of M3 was greater than that predicted by the equations, it was argued that the major cause was “reintermediation”.

It was pointed out that there were many technical problems with single equation estimates of the demand for money. It was also agreed that the prediction errors evident in 1983/84 and 1984/85 did not generally fail strict statistical criteria – that is, the errors in these years were not significantly larger than previous errors. Indeed, it was surprising how well the equations had stood up over time. However, one participant submitted evidence of further work that suggested statistically significant underprediction of M3 had occurred in the first half of 1985.

The updated equations suggested that a prediction of growth in M3 in 1984/85 based on historical experience would have been markedly lower than the growth that actually occurred. This also tended to be true (but was less obvious) for preliminary equations for broad money. Participants agreed that further work was desirable for equations for broad money and (as data permitted) even broader measures of financing.

Indicators of the setting of policy in the current environment

In the past, movements in M3 have provided useful information to policy-makers and the community in general about the degree of firmness of policy. However, it was generally agreed that the monetary aggregates have recently been affected by structural change. Hence it was argued that the authorities should rely more heavily on other indicators. In particular, the response has been to examine a wide range of financial and economic indicators – the so-called “check list” – when setting policy. This “check list” of indicators includes, inter alia, all the monetary aggregates; interest rates; the exchange rate; the external accounts; the current performance and outlook for the economy, including movements in asset prices, inflation, the outlook for inflation and market expectations about inflation.

This approach was generally accepted as being appropriate in the present circumstances. Interpretation of the list would obviously require considerable judgement. For example, the indicators would often give mixed signals. It would also be necessary to take account of lags in the operation of policy.

It was also suggested that, although interest rates should not be targeted, short-term interest rates could be used as one important indicator of the stance of policy. This reflected the view that interest rates are an important means through which policy changes are transmitted to monetary aggregates and financial markets more generally. The role of other variables, including the exchange rate, was also canvassed in this context.

Several views were put on the question of whether or not a monetary target or projection should be announced by the authorities during a period of rapid structural change in financial markets. It was generally agreed that both the money base and M3 would be affected to a sizable but uncertain extent by reintermediation and would, therefore, not be appropriate candidates for the purposes of a projection. (It was suggested that the base was also being distorted at the present time by the impact of changes to the payments system, automatic teller machines, the introduction of new coinage and the entry of new banks.)

Broad money might be the aggregate least affected during this period which could be monitored regularly and with only a short lag. One problem would be that broad money is not amenable to close control in the short-term by changes in monetary policy. Even if these problems could be ignored, there would clearly be a trade-off between the benefits of announcing a monetary projection against the costs and uncertainties of setting a range for an aggregate which might prove to be inappropriate as a result of structural change or other unexpected developments. Participants generally were of the view that an early return to the publishing of monetary projections would not be desirable.

Finally, the view was put that the current “check list” approach was, in effect, a form of nominal GDP targeting and that a formal nominal GDP target could be considered. Particular problems with this approach were that data on GDP were available only with a substantial lag and were often subject to sizable revisions. Nominal GDP could also be influenced by many factors other than monetary policy and its “controllability” would therefore be even less than that of broad money.

Participants also discussed the setting of monetary policy when the transitory effects of deregulation had passed. There were different views about when this might be. It was noted that some structural changes may only be beginning now and that further major distortions to monetary aggregates could occur. If this were the case, current problems with the aggregates may continue in the immediate future.

Information and the market

It was noted that financial markets have become accustomed to a numerical indication of policy over the ensuing year – in the form of a conditional projection of M3 growth. One advantage of this approach was that it provided markets with a relatively simple guide to the stance of policy. It was observed that at the time of the suspension of the M3 projection for 1984/85 there was an increase in market uncertainty about the stance of policy. To overcome this uncertainty, the Bank had increased the flow of information to the market. Despite this, some argued that this additional information had not satisfied all legitimate demands in this area. This suggested that the market sought more information and/or a better explanation of what the Central Bank is doing. An alternative view was that the market would never be satisfied, no matter how much information was provided by the authorities. It was also suggested that uncertainty was greatest at the time of the dropping of the M3 target but that many market participants may now have adjusted to the new regime.

There was also discussion of the form that any additional information about policy could take. The pros and cons of a return to the announcement of conditional projections were again canvassed. It was also suggested by some participants that the Bank could extend the information it provided on expected developments in major financial and economic variables, including GDP, prices and monetary aggregates. This information should not be seen as defining the aims of monetary policy. Rather, it would indicate to the market the Bank's outlook for the economy, given the stated stance of policy. Participants agreed that there should be regular comment on the stance of policy.

PARTICIPANTS

Discussion was based on three papers already in the public domain and one working paper prepared specially for the meeting (attached). The meeting was chaired by P.D. Jonson.

Participants at the meeting were:

Professor V.E. Argy (Macquarie University)

Dr A.W. Blundell-Wignall (EPAC)

Dr J. Carmichael (Reserve Bank)

Mr D.W. Challen (EPAC)

Mr K.T. Davis (University of Adelaide)

Mr B.L. Gray (Reserve Bank)

Dr C.I. Higgins (Treasury)

Mr P.D. Jonson (Reserve Bank)

Dr G.C. Lim (University of Melbourne)

Mr I.W. Little (Reserve Bank)

Mr I.J. Macfarlane (Reserve Bank)

Mr A.M. Mohl (Reserve Bank)

Mr A.J. Oster (Treasury)

Dr R.W. Rankin (Reserve Bank)

Mr S.T. Sedgwick (Prime Minister and Cabinet)

Professor I.G. Sharpe (University of Newcastle)

Professor T.J. Valentine (Macquarie University)

Dr J.M. Veale (Reserve Bank)

The papers discussed were:

Davis. K.T., “Australian Monetary Policy: Recent Experience and Some Current Issues”. Conference of Economists, Sydney, May 1985

Mohl. A.M., “Changing Patterns of Financing”, Reserve Bank of Australia, Bulletin, May 1985

Valentine. T.J., “Recent Australian Monetary Policy”, Bulletin of Money Banking and Finance, No. 3, 1983/84

Veale. J.M., Boulton, L.F. and Tease, W. “The Demand for Money in Australia: A Selective Survey and Some Updated Results”.