1

FINA 6222FB
SELECTED TOPICS IN FINANCE:
MACRO INVESTMENT STRATEGY
MONETARY POLICY DECISIONS –
INTERPRETATION AND PREDICTION
Dr. Paul M. Kitney
Term 3, 2021-22
 Motivation – Role of Monetary Policy 2

in Determining Asset Prices

• Monetary policy decisions impact the money supply and directly
affect the performance of government & corporate bond markets
• Monetary policy decisions impact interest rate differentials
between countries, affecting the direction of FX markets
• Monetary policy decisions impact equity market valuations via the
Gordon Growth model, affecting both the required rate of return
and the growth rate of dividends
• Monetary policy impacts real assets such as real estate,
commodities, and precious metals markets by impacting the
relative expected return of these asset markets
• Monetary policy is therefore the most important policy to
understand for anyone involved in an investment process in
ANY asset class
 3

Monetary Policy and Gold Prices

• In the financial media gold prices are often linked to: a)
geopolitical risk (i.e. when there is war or a crisis); b) bond yields
(rising bond yields increase the opportunity cost of holding gold);
c) inflation hedge; and d) as a substitute for fiat currency (e.g. the
USD).
• Statistically, there is support for bond yields, inflation and the USD
explaining gold price movements. All of these factors are
influenced by Fed’s and other central bank’s monetary policy.
• For example, very easy monetary policy boosts inflation, QE
lowers bond yields, and lower real bond yields weaken the USD.
This is and environment when Gold tends to perform well as an
asset class.
 4

GOLD – USD CORRELATION

• There is a negative correlation between gold and the USD

• Gold is often seen as a substitute for fiat currency
• When the US eases monetary policy sufficiently to weaken
the USD, it tends to boost gold prices
 5

GOLD – 10YR BOND CORRELATION

• There is a negative correlation between gold & 10 year bond yields

• As an “alternative currency” the opportunity cost of holding gold
rises with interest rates
• Fed QE keeps bond yields down, supporting gold prices
 6

GOLD – INFLATION CORRELATION

• There is a positive correlation between gold & US inflation

• Higher inflation lowers the value of money (fiat currency) and
raises the value of it’s alternative – Gold (or crypto)
• Clearly Gold reacts inversely to real bond yields, which are
clearly being driven lower by Fed policy now.
 7

CENTRAL BANK
TOOL BOX
 8

Conventional Monetary Policy Tools

• During normal times, the Federal Reserve uses three tools of

monetary policy—open market operations, discount lending, and
reserve requirements—to control the money supply and interest
rates, and these are referred to as conventional monetary policy
tools.
 9

Inside the Fed: Using Discount Policy

to Prevent a Financial Panic

• To prevent the collapse of the financial sector, the Chairman of the

Board of Governors announced before the market opened on
Tuesday, October 20, the Federal Reserve System’s “readiness to
serve as a source of liquidity to support the economic and financial
system.” In addition to this extraordinary announcement, the Fed
made it clear that it would provide discount loans to any bank that
would make loans to the securities industry. The outcome of the
Fed’s timely action was that a financial panic was averted
 10

Relative Advantages of the Different

Monetary Policy Tools
• Open market operations are the dominant policy tool of the Fed
since it has complete control over the volume of transactions,
these operations are flexible and precise, easily reversed, and can
be quickly implemented.
• The discount rate is less well used since it is no longer binding for
most banks, can cause liquidity problems, and increases
uncertainty for banks. The discount window remains of
tremendous value given its ability to allow the Fed to act as a
lender of last resort.
 11

On the Failure of Conventional Monetary

Policy Tools in a Financial Panic

• When the economy experiences a full-scale financial crisis,

conventional monetary policy tools cannot do the job, for two
reasons.
• First, the financial system seizes up to such an extent that it
becomes unable to allocate capital to productive uses, and so
investment spending and the economy collapse.
• Second, the negative shock to the economy can lead to the zero-
lower-bound problem.
 12

Nonconventional Monetary Policy Tools

During the Global Financial Crisis
• Liquidity provision: The Federal Reserve implemented
unprecedented increases in its lending facilities to provide liquidity
to the financial markets
• Discount Window Expansion
• Term Auction Facility
• New Lending Programs
• Large-scale asset purchases: During the crisis, the Fed started three
new asset purchase programs to lower interest rates for particular
types of credit:
• Government Sponsored Entities Purchase Program
• QE2
• QE3
 13

Expansion of the Fed Balance Sheet,

2007–2014
 14

Nonconventional Monetary Policy Tools

During the Global Financial Crisis
• Quantitative Easing Versus Credit Easing
• During the global financial crisis, the Federal Reserve became
very creative in assembling a host of new lending facilities to
help restore liquidity to different parts of the financial system.
• Forward Guidance
• By committing to the future policy action of keeping the
federal funds rate at zero for an extended period, the Fed
could lower the market’s expectations of future short-term
interest rates, thereby causing the long-term interest rate to
fall.
 15

Unconventional Policy - Forward

Guidance – June 2020
 16

Unconventional Policy – Credit

Market Purchases – March 2020
 17
Markets – March 2020
VIX – Volatility Index North American Investment Grade CDS

Source: Bloomberg, Daiwa. Note: Data as of 13 March 2020, Weekly Source: Bloomberg, Daiwa
Note: Data as of 13 March 2020; Weekly; We use CDX IG CDSI GEN 5Y as an indicator

S&P 500 China Sovereign 5-Year CDS

Source: Bloomberg, Daiwa. Note: Data as of 13 March 2020; Weekly; We use CHINAGOV
Source: Bloomberg, Daiwa. Note: Data as of 13 March 2020, Weekly
CDS USD SR 5Y D14 CORP as an indicator
 18

Nonconventional Monetary Policy Tools

During the Global Financial Crisis

• Negative Interest Rates on Banks’ Deposits

• Setting negative interest rates on banks’ deposits is supposed
to work to stimulate the economy by encouraging banks to
lend out the deposits they were keeping at the central bank,
thereby encouraging households and businesses to spend
more. However, there are doubts that negative interest rates
on deposits will have the intended, expansionary effect.
 19

Inside the Fed: Fed Lending Facilities

During the Global Financial Crisis

• During the global financial crisis, the Federal Reserve became very
creative in assembling a host of new lending facilities to help
restore liquidity to different parts of the financial system.
• Loans to AIG
• Loans to JP Morgan
• TAF, TALF, TSLF
• PDCF, AMLF, CPFF, MMIFF
 20

CENTRAL BANK
OBJECTIVES
 21

The Price Stability Goal and the

Nominal Anchor
• Over the past few decades, policy makers throughout the world
have become increasingly aware of the social and economic costs
of inflation and more concerned with maintaining a stable price
level as a goal of economic policy.
• The role of a nominal anchor: a nominal variable, such as the
inflation rate or the money supply, which ties down the price level
to achieve price stability
 22

Time Inconsistency Problem

• Policy makers, particularly those influenced by politics, may pursue
more expansionary monetary policy, attempting to boost short-
run output
• Workers and firms see this expansionary policy and raise their
expectations on wages and prices, driving wages and prices up.
• The result is higher inflation without higher output/employment
on average – the short-term policy is inconsistent with the long-
term objective
• Policy makers should avoid discretion as they will have a better
result if they follow their long-term objective of controlling
inflation
• Time inconsistency problem may be solved by adopting a more
predictable policy framework, based on rules rather than
discretion. eg. Taylor Rules.
 23

Other Goals of Monetary Policy

• Five other goals are continually mentioned by central bank
officials when they discuss the objectives of monetary policy:
1. High employment and output stability
2. Economic growth
3. Stability of financial markets
4. Interest-rate stability
5. Stability in foreign exchange markets
Should Price Stability Be the Primary 24

Goal of Monetary Policy?

• Hierarchical versus Dual Mandates:
• Hierarchical mandates put the goal of price stability first, and
then say that as long as it is achieved other goals can be
pursued
• Dual mandates are aimed to achieve two coequal objectives:
price stability and maximum employment (output stability)
• Price Stability as the Primary, Long-Run Goal of Monetary Policy
• Either type of mandate is acceptable as long as it
operates to make price stability the primary goal in the long
run but not the short run.
 25

Inflation Targeting
• Public announcement of medium-term numerical target for
inflation
• Institutional commitment to price stability as the primary, long-
run goal of monetary policy and a commitment to achieve the
inflation goal
• Information-inclusive approach in which many variables are used
in making decisions
• Increased transparency of the strategy
• Increased accountability of the central bank
 Inflation Targeting 26

• New Zealand (effective in 1990)

• Inflation was brought down and remained within the target most of
the time.
• Growth has generally been high, and unemployment has come down
significantly.
• Canada (1991)
• Inflation decreased since 1991; some costs in term of unemployment
• United Kingdom (1992)
• Inflation has been close to its target.
• Growth has been strong, and unemployment has been decreasing.
 27

Inflation Rates and Inflation Targets for New Zealand,

Canada, and the United Kingdom, 1980–2017
 28

Inflation Targeting
• Advantages:
• Does not rely on one variable to achieve target
• Easily understood
• Reduces potential of falling in time-inconsistency trap
• Stresses transparency and accountability
• Disadvantages:
• Delayed signaling
• Too much rigidity
• Potential for increased output fluctuations
• Low economic growth during disinflation
 29

Inside the Fed: Ben Bernanke’s

Advocacy of Inflation Targeting

• While a professor at Princeton, Bernanke, in several articles and in

a book co-written with Mishkin, argued that inflation targeting
would be a major step forward for the Federal Reserve and would
produce better economic outcomes, for many of the reasons
outlined earlier. When Bernanke took his position as a governor of
the Federal Reserve from 2002 to 2005, he continued to advocate
the adoption of an inflation target.
 30

Lessons for Monetary Policy Strategy

from the Global Financial Crisis

1. Developments in the financial sector have a far greater impact on

economic activity than was earlier realized.
2. The zero-lower-bound on interest rates can be a serious problem.
3. The cost of cleaning up after a financial crisis is very high.
4. Price and output stability do not ensure financial stability.
 31

READING
CENTRAL BANK
POLICY MOVES
 The Taylor Rule 32

Federal funds rate target =

inflation rate  equilibrium real fed funds rate
1/2 (inflation gap) 1/2 (output gap)

• An inflation gap (current inflation minus target rate) and an output gap

• Output gap is an indicator of future inflation – deviation of current output

from potential (long-term) output.
 The Taylor Rule 33

• Taylor Principle – Central Bank should increase interest rates by more than the
increase in inflation to stabilize inflation. Suppose not, if the inflation rises by 1
percentage point, and the nominal policy rate rises by 50 bp. Then the real interest
rate will have decreased by 50 bps. This stimulates demand, via investment and
boosts inflation, not stabilize it.

• Taylor rule satisfies the Taylor Principle as a 1 percentage point

increase in inflation leads to a 1.5% increase in the policy rate.

• Taylor rule is a predictable approach which avoids the Time Inconsistency Problem

• Taylor rule reflects the US Fed’s Dual Mandate

 34

The Taylor Rule for

the Federal Funds Rate, 1960–2017

Source: Calculations with Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/PCECTPI;
https://fred.stlouisfed.org/series/GDPC1; https://fred.stlouisfed.org/series/GDPPOT;
https://fred.stlouisfed.org/series/DFFGDPC1.
 What Data is Influential in Monetary 35

Policy Decisions
• In the US, clearly data linked to variables in the Fed’s policy reaction
function (Taylor Rule) need to be followed closely – output gap
(approximated by the gap between the NAIRU and the current
unemployment rate, inflation, inflation expectations and the inflation
gap

• Follow the FOMC meeting minutes which tell us how closely the Fed is
following monetary policy principles, such as the Taylor Principle
 Approximating the Output Gap 36

16.0
14.0
12.0
10.0
8.0
6.0
4.0
2.0
0.0
Mar-07 Jul-08 Nov-09 Mar-11 Jul-12 Nov-13 Mar-15 Jul-16 Nov-17 Mar-19 Jul-20 Nov-21

US Unemployment Rate (%) NAIRU (%)

• NAIRU (Non-Accelerating Inflation Rate of Unemployment) is the long-

run steady state or natural rate of unemployment.
• Full employment (approximation of positive output gap) is when
unemployment is below the NAIRU
• (Currently the output gap (approximated by unemployment rate –
NAIRU) has closed. What does the Taylor Rule say?
 Oil Prices Impact Inflation 37

Expectations
• Often in the financial media, rising oil prices are underestimated as a Fed
or other central bank data “trigger” since they are often dismissed as
being “not part of core-CPI”.

• Core CPI in the US and in most countries (not Japan) remove energy
prices from the calculation.

• While it is true the Fed does follow core CPI inflation data more so than
CPI data, the do care a lot about inflation expectations. Why?

• Oil statistically and intuitively explain quite a bit about inflation

expectations formation.
 Oil Prices Impact Inflation 38

Expectations

• This chart tracks WTI % change YoY versus inflation expectations.

• Oil prices impact inflation expectations via the impact on firms expected costs of
production
• Oil is a very important data series to follow to help determine the direction of
inflation expectations and Fed policy
 39

Monetary Policy Flexibility

Source: Daiwa, Bloomberg. Note: Data as of 3 January 2020

• In regional markets, where data sources are as rich as in the US, we follow
the policy rate, inflation and the real rate to determine conventional
monetary policy flexibility
 Factors in Reading Central Bank 40

Decisions
• Understand the mandate or objectives of the central bank in the country
you are following.
• Does it follow an inflation targeting approach, that means its decisions
are made by factors that influence inflation and where inflation is relative
to target?
• Does it have a dual mandate? In which case factors that impact
unemployment are equally as important as inflation
• Does the central bank have a hierarchical mandate? What is the emphasis
on other factors. For example India has a loose inflation target, that is not
institutionally supported. Inflation may be the top priority but at times
other factors may be almost as relevant as inflation, like currency stability
or budget issues.