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The channels of transmission of monetary policy

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					                        The channels of transmission of monetary policy∗

                                                  Juan Antonio Morales
                                                  President of the Central Bank of Bolivia


I would like to comment on the difficulties of establishing a domestic monetary policy in

countries in transition from the nominal anchor of exchange rate targeting to inflation

targeting cum flexible exchange rates. Before reaching full-fledged inflation targeting, the

channels of monetary policy, it will be argued, are likely to be weak. A related but

unanswered question concerns the appropriate timing to move to full-fledged inflation

targeting, and hence the length and characteristics of the transition period.



In countries where there is a large degree of de facto dollarization, which implies to a

significant extent a hard peg, there is little connection between monetary policy in domestic

currency and financial markets. This lack of connection is reflected, inter alia, in very

volatile money market rates in domestic currency, very distant from the rates in dollars, the

prevailing currency in financial markets. Arbitrage conditions between the two currencies

are seldom met and the interest rate spreads tend to be very volatile.



After abandoning the exchange rate anchor, monetary independence has to recover and a

whole new monetary policy has to be constructed, including the guidance of expectations

by a credible central bank. Institutional development is not an easy matter and often the


∗
 Comentarios expuestos en el Segundo Seminario de Alto Nivel del Eurosistema y de los Bancos Centrales
Latinoamericanos. Río de Janeiro, 26 de Noviembre de 2004.
legal support for central banking is inadequate, despite the proclaimed independence. In

addition, financial markets are shallow, with underdeveloped capital markets and with most

of the financing of domestic investment granted by banks. Recurrent fiscal weaknesses

cause large placements of public debt and banks’ portfolios are overloaded with

government paper. It is not hard to see that the channels of transmission of monetary policy

are going to be weak, when they are not entirely inexistent.



Especially in countries that in the past have experienced high inflation, dollarization has

been part and parcel of the reconstruction of their financial systems. This is an important

point to keep in mind: financial development has been closely related to dollarization.

Again, with financial development highly anchored in a foreign currency (and the attendant

foreign institutions) the conventional channels of monetary policy are either weak or work

in unexpected ways with regard to conventional theory.



My comments are very much based on my Bolivian experience, although Bolivia is by no

means a typical Latin American economy. She is a poor counterpart of the more mature

emerging economies in the region. Yet, for analysis, Bolivia provides and extreme

illustration of the roadblocks that plague many countries in their way from exchange rate

anchors to other types of nominal anchors. As important, Bolivia has escaped financial

collapse, despite her lack of monetary independence, her intermediate exchange rate regime

and very difficult fiscal and political conditions




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An independent monetary policy is needed to give sense to the transmission mechanisms.

In turn the conditions for an independent monetary policy can be very demanding. If we

focus specifically on the traditional channels of transmission of monetary policy:

    -   the interest rate channel

    -   the exchange rate channel

    -   the credit channel

    -   the expectations channel,

we can see why they work languidly:



The interest rate channel. Given the difficulties of establishing the term structure of interest

rates, the monetary policy interest rate has a very limited reach, at best to the interbank

market. The weak transmission originates in the shallowness of financial markets and the

uncertainties in the inflation rate, which can be low but its variance may be still high. Also,

the volatility of inflation makes difficult to gauge the real interest rate.



In addition, financial uncertainty is usually high and the bond markets are rather illiquid,

leading to high and variable risk premia. In particular, in Bolivia, bank lending rates seem

determined mainly by risk premia. The expectations mechanism in the determination of the

term structure of interest rates cannot work in this context.



Also the fact that inflation is not the main focus of attention of financial markets has a

bearing on the formation of the yield curve. In the developed financial markets of industrial

countries, it is well known that with lower expectations of inflation and hence lower

expected future interest rates, long term interest rates would be lower today. However, even


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in mature emerging markets, the transmission of changes in interest rates takes a relatively

long and variable amount of time to materialize across the economy.



It is very unlikely that the policy interest rate would affect in a significant way the interest

rate of long term bonds, or the financing of capital goods or even of housing. The problem

is compounded when de facto dollarization is widespread, where the term structure of

deposit and bond interest rates is mainly determined by the U.S. market rather than in the

domestic market. However, in econometric studies in my country it has been found that the

interest rate of the 13-week Treasury bill in dollars Granger causes other longer-term

interest rates in foreign currency, including the interbank rate.



The exchange rate channel. Also this channel works weakly in an emerging economy in

transition from exchange rate anchoring to inflation targeting cum flexible exchange rates.

It is well known that the exchange rate, being an important transmission mechanism, will

normally enter in the policy evaluation models of small open economies. Exchange rate

movements passes-through to the inflation rate, requiring thus strong reactions of the

interest rate in the policy function, which may unduly affect financial markets. Policy

reactions to exchange rate shocks are typically strong, and in inflation targeting economies,

the response is usually stronger than to the inflation rate and the output gap. Also exchange

rate movements have a direct bearing on the solvency of the banks, if there is liability

dollarization. Given these conditions, the monetary authority will try to keep exchange rate

movements within narrow limits. There will be a pervasive “fear of floating”.




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Ironically and notwithstanding what has been said, the exchange rate has become a main

monetary instrument (that can be a close substitute of a monetary policy rule) in my

country. With the exchange rate we follow a special “Taylor rule”, in the sense that our

monetary rule is exchange rate based, rather than interest-rate based. In the Bolivian

incomplete crawling rate system the rate of crawl adjusts to gaps in inflation, economic

activity and the real exchange rate.



The credit or lending channel. It is either narrow or when it works it does somewhat

unconventionally. Banks are the most important players in the financial systems of most

Latin American countries. Their loans are very imperfect substitutes of bonds as source of

finance and moreover banks are unable to insulate their supply of credit from reductions in

deposits, induced in part by changes in monetary policy. One could expect then a very

strong lending channel that gives extra push to the effects of monetary policy on aggregate

demand. Yet, this may not be the case because expansions and contractions of domestic

money have a limited impact when most of the lending is in dollars. Also, dollar deposits

are very volatile and prone to runs when economic or political conditions deteriorate.



Of course, there is the possibility of conducting a monetary policy in dollars, as we do in

Bolivia, but this unusual. There is also the intriguing possibility to consider three types of

assets in the banks’ portfolio: loans in dollars, loans in domestic currency and bonds. Prima

facie, these assets are imperfect substitutes and hence monetary movements in domestic

currency may have, after all, consequences both in the dollar lending of banks and the

overall size of credit by banks.




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The balance sheet effects of the lending channel may also be weak or perverse. Monetary

policy in domestic currency per se hardly affects the price of assets, either financial or real

like housing, which in many Latin American countries are priced in dollars. No major

changes in creditworthiness may ensue changes in domestic money. However, monetary

policy, to the extent that it is conducive to exchange rate depreciations, while restraining

inflation, could have vast and unsettling balance sheet effects as the real price of assets

denominated in dollars will increase as well as of dollar denominated liabilities. With a

highly leveraged private sector, moreover with dollar debts concentrated in non tradable

sectors, an expansionary monetary policy may end being contractionary and reducing the

level of lending.



On the other hand, the net wealth of depositors in the banks may increase by the amount of

the real depreciation hence real cash balances increase and work their way through

conventional IS-LM effects.



The expectations channel. After leaving the exchange rate as a monetary anchor, the

expectations channel has to be created from scratch. The public’s attention will continue to

stay on the exchange rate for a long time while inflation, unless it is very high, commands

relatively low interest. The central bank’s commitment to low inflation takes time build and

to be internalised by domestic financial markets and the public at large, given their

traditional focus on the exchange rate. The time required will be the longer the weaker the

fiscal situation and, for small open economies, if there are contagion effects from disorders

elsewhere.




                                                                                             6
Conclusions.



Without significant reductions in the levels of dollarization, the possibility of an

independent monetary policy, under the assumption that it is desirable, is small. The

manoeuvring        space for monetary policy in domestic currency in the presence of

widespread de facto dollarization is very narrow and, as important, it is perceived by the

public as marginal. The main negative features of dollarization are first, that it leaves the

country essentially without a monetary policy and second, that it can be a source of

financial instability to the extent that there are currency mismatches.



Dollarization appears so resilient because of the weakness of fiscal, financial and monetary

institutions. While actual inflation has been low for many years, there are still in the public

expectations of abrupt exchange rate depreciations and ensuing high inflation. Payments

dollarization, which has a bearing on financial dollarization, has increased because of

network effects.



The manifestations of an acute “peso problem” appear not only in the high spreads between

interest rates in domestic currency and dollars for most financial operations (although not

for all) but also in the reluctance of financial institutions to receive deposits or grant credits

in domestic currency.



Unless the credibility of fiscal and monetary institutions is greatly and lastly strengthened,

dollarization that implicitly carries imported credibility will persist. Laws that assure the

independence of central banks, a floating exchange rate (with all the risks it entails during


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the transition) and market-friendly mechanisms like the introduction of bonds linked to

inflation and advantages in taxation and regulation for assets denominated in domestic

currency may help to revert dollarization, but the thrust has to be on confidence.



The bank lending channel can be a very powerful channel of transmission of monetary

policy enhancing the latter’s effect on aggregate demand, at least for a while, but provided

again that dollarization is reduced. Meanwhile, ways and means for smooth functioning of

the banking system have to be sought emphasizing prudential regulations and including

rules of internalization by the banks of the costs of dollarization.



Notwithstanding the limitations faced by the central banks of emerging economies, they

can still have non negligeable impacts on expectations, and ultimately on prices and the

level of activity, by following predictable rules and communicating very clearly both their

commitment to low inflation and their reaction function.




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