Mr. Tomás J. T. Baliño https://isni.org/isni/0000000404811396 International Monetary Fund
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Mr. William E. Alexander
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In implementing monetary policy, a central bank can act in two ways: directly through its regulatory powers, or indirectly through its influence on money market conditions as the issuer of central bank money (currency in circulation and balances with the central bank). The term “direct” refers to the one-to-one correspondence between the instrument (such as a credit ceiling) and the policy objective (such as domestic credit).
In implementing monetary policy, a central bank can act in two ways: directly through its regulatory powers, or indirectly through its influence on money market conditions as the issuer of central bank money (currency in circulation and balances with the central bank). The term “direct” refers to the one-to-one correspondence between the instrument (such as a credit ceiling) and the policy objective (such as domestic credit).
This distinction between direct and indirect monetary instruments can operate in two ways:
Influencing market conditions does not exclude the possibility that the central bank targets certain key interest rates or quantities of credit (or sets those pertaining to its own credit facilities). Instead of direct controls, the market mechanism allows participants in the money markets to adapt to the settings of one of these parameters.
Indirect instruments are also referred to as market-based instruments, as they generally change the supply of bank reserves through transactions with banks and nonbanks at market-related prices on a voluntary basis. Different market-based instruments can be distinguished by the specific markets in which the monetary operations are carried out. But even though these instruments are called indirect and market based, they also involve a minimum degree of regulation to govern the conditions of their use: the eligible counterparties, the auction form, and the form of payment at settlement. Within this framework, however, it is the market forces that, through the use of indirect instruments, affect changes to central bank money.
Tables 1 and 2 describe the characteristics of various direct and indirect instruments of monetary policy and summarize their advantages and disadvantages. The most common types of direct instruments are interest rate controls and bank-by-bank credit ceilings, along with directed lending by central banks. There are three main types of indirect instrument: open market operations, reserve requirements, and central bank lending or discount operations. 1
Direct Instruments of Monetary Policy—Overview
Direct Instruments of Monetary Policy—Overview
| Instruments | Advantages | Disadvantages | Issues in Design and Operations | Experience and Assessment |
|---|---|---|---|---|
| Interest rate controls | Contain the effects of noncompetitive pricing when entry into banking is limited. Limit adverse selection problems, particularly when information on borrowers is scarce or banking supervision is weak. Often resorted to when authorities cannot achieve a target interest rate through market means or when longterm rates are a policy objective. | Allocation of financial resources not based on price mechanism; ceiling easily circumvented by shifting bank deposits into assets yielding market rates (such as foreign exchange) or into goods. Lead to administrative rationing of credit. Floors or ceilings encourage disintermediation or nonbank intermediation. Ceilings make borrowing appear less costly, which encourages overuse of capital. | Design can involve fixing interest rates or spreads. | Various controls are still used in some countries and were used even in industrial countries until the late 1980s. Increasingly ineffective as markets and financial instruments develop. Effectiveness requires a credible enforcement system. |
| Ban k-by-bank credit ceilings | Can deliver effective control over bank credit if reserve money creation is otherwise controlled. Can minimize loss of monetary control during transition to indirect instruments when transmission mechanism is uncertain. | Because credit ceilings are not market determined, they progressively distort the allocation of bank resources. Can lead to disintermediation and ultimate loss of effectiveness. Difficult to implement if there are many banks and if there are capital inflows. | Quotas may depend on capital, existing credit, and existing deposits. Secondary trading of unused credit quotas introduces elements of market allocation and mitigates distortions. | Used in Western Europe until late 1980s; still used in some African and Asian countries and in transition economies. Supply of base money must be consistent with money demand; otherwise instrument leads to buildup of excess reserves, thereby creating incentives for evasion. |
| Statutory liquidity ratios | By providing captive demand for qualifying assets (typically government debt), ratios reduce cost of borrowing for issuer of these instruments. | Distort competition by imposing constraints on banks’ asset management. Distort pricing of securities and stifle secondary trading. Can lead to disintermediation and reduce government fiscal discipline, thereby losing effectiveness as means to control money. | Design involves choosing eligible securities, eligible maturities, and averaging methods, either of requirement, base, or both. | Still used in many countries, but mainly for prudential reasons and, more recently, to provide captive demand for government papers. Used as a monetary policy instrument only to the extent that proceeds from sale of securities are under the control of the central bank. This is typically not the case. May be helpful in short-term liquidity management when proceeds of security sales are sterilized (Singapore). |
| Directed credits | Method of distributing central bank credit mostly used to finance particular sectors. In principle, they provide direct control over aggregate central bank credit to the banks. | Credit allocation process is discretionary. Misallocation of resources is possible. May be used to direct credit to public enterprises, thus reducing direct budgetary impact. | Design involves setting a mechanism to allocate credit and to ascertain ultimate use of funds. Usually credit does not require collateral. Occasionally extended through special rediscount facility. | Used in many transition economies. Because of fungibility, they are unlikely to be effective in directing resources. Costly in terms of resource allocation. |
| Bank-by-bank rediscount quotas | Place a floor under interbank rates and thereby improve transmission of interest rate changes. Otherwise, used mostly to rediscount (at preferential rate) paper of particular sectors and provide liquidity to particular banks. | Below-market discount rate can discourage development of interbank money market if use of facility is not limited. Fungibility undermines assessment and control of funds’ destination if instrument is used primarily to direct credit. | Need mechanism to allocate refinance quotas and review quality of eligible paper | Used in industrial countries on a limitedaccess basis where discount rate is below interbank rate (Germany and United States), and elsewhere to provide incentives to lend to particular sectors (Tunisia and China). Discount rate is highly visible rate and can be effective in signaling policy changes. |
Direct Instruments of Monetary Policy—Overview
| Instruments | Advantages | Disadvantages | Issues in Design and Operations | Experience and Assessment |
|---|---|---|---|---|
| Interest rate controls | Contain the effects of noncompetitive pricing when entry into banking is limited. Limit adverse selection problems, particularly when information on borrowers is scarce or banking supervision is weak. Often resorted to when authorities cannot achieve a target interest rate through market means or when longterm rates are a policy objective. | Allocation of financial resources not based on price mechanism; ceiling easily circumvented by shifting bank deposits into assets yielding market rates (such as foreign exchange) or into goods. Lead to administrative rationing of credit. Floors or ceilings encourage disintermediation or nonbank intermediation. Ceilings make borrowing appear less costly, which encourages overuse of capital. | Design can involve fixing interest rates or spreads. | Various controls are still used in some countries and were used even in industrial countries until the late 1980s. Increasingly ineffective as markets and financial instruments develop. Effectiveness requires a credible enforcement system. |
| Ban k-by-bank credit ceilings | Can deliver effective control over bank credit if reserve money creation is otherwise controlled. Can minimize loss of monetary control during transition to indirect instruments when transmission mechanism is uncertain. | Because credit ceilings are not market determined, they progressively distort the allocation of bank resources. Can lead to disintermediation and ultimate loss of effectiveness. Difficult to implement if there are many banks and if there are capital inflows. | Quotas may depend on capital, existing credit, and existing deposits. Secondary trading of unused credit quotas introduces elements of market allocation and mitigates distortions. | Used in Western Europe until late 1980s; still used in some African and Asian countries and in transition economies. Supply of base money must be consistent with money demand; otherwise instrument leads to buildup of excess reserves, thereby creating incentives for evasion. |
| Statutory liquidity ratios | By providing captive demand for qualifying assets (typically government debt), ratios reduce cost of borrowing for issuer of these instruments. | Distort competition by imposing constraints on banks’ asset management. Distort pricing of securities and stifle secondary trading. Can lead to disintermediation and reduce government fiscal discipline, thereby losing effectiveness as means to control money. | Design involves choosing eligible securities, eligible maturities, and averaging methods, either of requirement, base, or both. | Still used in many countries, but mainly for prudential reasons and, more recently, to provide captive demand for government papers. Used as a monetary policy instrument only to the extent that proceeds from sale of securities are under the control of the central bank. This is typically not the case. May be helpful in short-term liquidity management when proceeds of security sales are sterilized (Singapore). |
| Directed credits | Method of distributing central bank credit mostly used to finance particular sectors. In principle, they provide direct control over aggregate central bank credit to the banks. | Credit allocation process is discretionary. Misallocation of resources is possible. May be used to direct credit to public enterprises, thus reducing direct budgetary impact. | Design involves setting a mechanism to allocate credit and to ascertain ultimate use of funds. Usually credit does not require collateral. Occasionally extended through special rediscount facility. | Used in many transition economies. Because of fungibility, they are unlikely to be effective in directing resources. Costly in terms of resource allocation. |
| Bank-by-bank rediscount quotas | Place a floor under interbank rates and thereby improve transmission of interest rate changes. Otherwise, used mostly to rediscount (at preferential rate) paper of particular sectors and provide liquidity to particular banks. | Below-market discount rate can discourage development of interbank money market if use of facility is not limited. Fungibility undermines assessment and control of funds’ destination if instrument is used primarily to direct credit. | Need mechanism to allocate refinance quotas and review quality of eligible paper | Used in industrial countries on a limitedaccess basis where discount rate is below interbank rate (Germany and United States), and elsewhere to provide incentives to lend to particular sectors (Tunisia and China). Discount rate is highly visible rate and can be effective in signaling policy changes. |
Indirect Instruments of Monetary Policy—Overview
1 Reserve requirements have elements of both a direct and an indirect instrument. This paper follows conventional central bank usage and classifies them as indirect instruments.
Indirect Instruments of Monetary Policy—Overview
| Instruments | Advantages | Disadvantages | Issues in Design and Operations | Experience and Assessment |
|---|---|---|---|---|
| Reserve requirements 1 | Help to induce demand for reserves and therefore enhance predictability of reserve demand. An increase in reserve requirements can be useful in one-off sterilization of excess liquidity, or otherwise to accommodate structural changes in demand for reserves. | A high requirement imposes tax on bank intermediation. This can be neutralized through reserve remuneration at market rates. The tax may result in a widening of the spread between lending and deposit rates, which can lead to disintermediation. Not convenient for short-term liquidity management, as frequent changes disrupt bank portfolio management. | Design includes definition and monitoring of requirement base, eligibility of assets, and averaging rules and rate of remuneration. Averaging provides banks with greater flexibility in portfolio management. | Used extensively in some countries, especially in Latin America. Active variation for policy purposes has dropped significantly in industrial countries. |
| Rediscount window | Rediscount rate often can enhance transmission of policy stance through announcement effect as a key rate (France, Germany, and United States). Initial impact is wider than with open market operations, which are limited to central banks’ counterparties in one or a few financial centers. Develops demand for rediscountable paper. May also be useful in circumstances where open market operations are limited due to lack of paper. | Not very convenient for precise base money targeting, since access to window is usually at initiative of banks. Criteria for rediscountable paper and for access to window have often been utilized to implement selective credit policy. | Rediscount rate can be above-market rate to discourage access. In some countries (United States, Japan, Germany), rate is below market and therefore nonprice rationing must be used. Elements of design include eligible paper and access criteria. | Used in many countries as standard instrument for monetary control, although access at initiative of banks can complicate its usefulness for quantity transactions; its effectiveness is largely determined by provisions that regulate access. Also used for moral suasion. |
| Lombard window or overdraft window | Provides facilities for very short-term (collateralized) loans usually priced above any alternative source of funds. Can be key part of payments system arrangements. | See rediscount window above. Disadvantage of preannounced rate facility where access is at discretion of banks. | Lombard requires decision on the part of banks to borrow from central bank with appropriate collateral and other conditions regarding maturity and access. Overdraft occurs automatically and may or may not be collateralized. | Standard facilities in many countries. Lombard rate can be key rate in announcing changes in policy stance. |
| Public sector deposits | Given magnitude of daily government flows in and out of banking system, reallocation of government deposits between the central bank and the commercial banks can be key instrument to offset impact of such flows on short-term liquidity. | Lack transparency. Militate against the development of secondary market for government securities. | Allocation mechanisms needed to ensure equitable distribution among the competing commercial banks. | Used in a few countries (Canada, Malaysia, Germany up to end-1993). Requires close coordination of central bank and treasury. |
| Credit auction | Offers means of pricing central bank credit. Can be used when markets are underdeveloped and interbank reference rate does not exist; establishes benchmark interest rate; allocates credit on market terms. | Central bank is exposed to credit risks that are difficult to assess. Not necessarily convenient for day-to-day management if turnaround/settlement of auction exceeds end of day. Vulnerable to “adverse selection” problem. | Initially, access rules can mitigate credit risk Credit can become progressively collateralized, as quality securities become available. With sufficient collateral available, such operations could also be structured as repo auctions. | Used temporarily in early phases of transition to indirect instruments to shift from directed credit to market allocation. |
| Primary-market sales of central bank paper (open market type operations) | Flexible instrument for short-term liquidity management because issuance is at discretion of central bank, and various auction/tender formats can be used to steer interest rates. If treasury is not willing to accept sufficient interest rate flexibility, central bank papers preserve operational autonomy of central bank. | Central bank may incur losses if large primary issuance is needed to sterilize liquidity. If central bank bills are used in parallel with treasury bills, problems may occur in the absence of strong coordination between the issuing agents. | Management of liquidity can be achieved through staggered primary issuance. Procedures involve decisions on auction system, counterparties, frequency, maturities, and settlement rules. | Used by many countries, particularly when there is a need to separate monetary policy objectives from public debt management objectives. Also used when secondary markets are insufficiently developed to permit open market operations in the secondary market. |
| Primary-market sales of government securities (open market type operations) | Management similar to central bank bill if coordination with treasury is appropriate, as treasury bill emission may need to exceed fiscal funding requirements. Encourage fiscal discipline on the part of government if direct central bank financing is discontinued. | Debt-management objective can conflict with monetary management if treasury manipulates auction to keep funding costs below market. When monetary management relies on primary issuance, high frequency of auctions may hamper secondary market development. | Same as above. Sometimes when the central bank has government securities in its portfolio, reverse repo auctions can be used instead of outright sales in primary markets. | Used in many countries when secondary markets are insufficiently developed to conduct open market operations. |
| Foreign exchange (FX) swaps and outright sales and purchases | In case of deep foreign exchange market but inactive government securities market, swaps can substitute for repo operations in government paper. FX outright sales and purchases may be useful when FX market is more developed than money market. | Central bank can suffer losses if foreign exchange operations are used in attempts to preserve an unsustainable exchange rate. | Need to design appropriate risk-management procedures. | Swaps used on a regular basis by a few countries (Germany, Greece. Malaysia. Switzerland, and Turkey). |
| Secondary-market operations (outright purchases and sales or repo operations) | Can be undertaken on continuous basis; hence provide flexibility, Transparent Enhance market development. Immediacy of response in money market. | Require liquid and deep secondary market, and central bank must have an adequate stock of marketable assets. | Repos have advantage of being automatically reversible, especially well suited for offsetting seasonal fluctuations. | Used by most countries with liquid and deep secondary markets. |
1 Reserve requirements have elements of both a direct and an indirect instrument. This paper follows conventional central bank usage and classifies them as indirect instruments.
View TableIndirect Instruments of Monetary Policy—Overview
| Instruments | Advantages | Disadvantages | Issues in Design and Operations | Experience and Assessment |
|---|---|---|---|---|
| Reserve requirements 1 | Help to induce demand for reserves and therefore enhance predictability of reserve demand. An increase in reserve requirements can be useful in one-off sterilization of excess liquidity, or otherwise to accommodate structural changes in demand for reserves. | A high requirement imposes tax on bank intermediation. This can be neutralized through reserve remuneration at market rates. The tax may result in a widening of the spread between lending and deposit rates, which can lead to disintermediation. Not convenient for short-term liquidity management, as frequent changes disrupt bank portfolio management. | Design includes definition and monitoring of requirement base, eligibility of assets, and averaging rules and rate of remuneration. Averaging provides banks with greater flexibility in portfolio management. | Used extensively in some countries, especially in Latin America. Active variation for policy purposes has dropped significantly in industrial countries. |
| Rediscount window | Rediscount rate often can enhance transmission of policy stance through announcement effect as a key rate (France, Germany, and United States). Initial impact is wider than with open market operations, which are limited to central banks’ counterparties in one or a few financial centers. Develops demand for rediscountable paper. May also be useful in circumstances where open market operations are limited due to lack of paper. | Not very convenient for precise base money targeting, since access to window is usually at initiative of banks. Criteria for rediscountable paper and for access to window have often been utilized to implement selective credit policy. | Rediscount rate can be above-market rate to discourage access. In some countries (United States, Japan, Germany), rate is below market and therefore nonprice rationing must be used. Elements of design include eligible paper and access criteria. | Used in many countries as standard instrument for monetary control, although access at initiative of banks can complicate its usefulness for quantity transactions; its effectiveness is largely determined by provisions that regulate access. Also used for moral suasion. |
| Lombard window or overdraft window | Provides facilities for very short-term (collateralized) loans usually priced above any alternative source of funds. Can be key part of payments system arrangements. | See rediscount window above. Disadvantage of preannounced rate facility where access is at discretion of banks. | Lombard requires decision on the part of banks to borrow from central bank with appropriate collateral and other conditions regarding maturity and access. Overdraft occurs automatically and may or may not be collateralized. | Standard facilities in many countries. Lombard rate can be key rate in announcing changes in policy stance. |
| Public sector deposits | Given magnitude of daily government flows in and out of banking system, reallocation of government deposits between the central bank and the commercial banks can be key instrument to offset impact of such flows on short-term liquidity. | Lack transparency. Militate against the development of secondary market for government securities. | Allocation mechanisms needed to ensure equitable distribution among the competing commercial banks. | Used in a few countries (Canada, Malaysia, Germany up to end-1993). Requires close coordination of central bank and treasury. |
| Credit auction | Offers means of pricing central bank credit. Can be used when markets are underdeveloped and interbank reference rate does not exist; establishes benchmark interest rate; allocates credit on market terms. | Central bank is exposed to credit risks that are difficult to assess. Not necessarily convenient for day-to-day management if turnaround/settlement of auction exceeds end of day. Vulnerable to “adverse selection” problem. | Initially, access rules can mitigate credit risk Credit can become progressively collateralized, as quality securities become available. With sufficient collateral available, such operations could also be structured as repo auctions. | Used temporarily in early phases of transition to indirect instruments to shift from directed credit to market allocation. |
| Primary-market sales of central bank paper (open market type operations) | Flexible instrument for short-term liquidity management because issuance is at discretion of central bank, and various auction/tender formats can be used to steer interest rates. If treasury is not willing to accept sufficient interest rate flexibility, central bank papers preserve operational autonomy of central bank. | Central bank may incur losses if large primary issuance is needed to sterilize liquidity. If central bank bills are used in parallel with treasury bills, problems may occur in the absence of strong coordination between the issuing agents. | Management of liquidity can be achieved through staggered primary issuance. Procedures involve decisions on auction system, counterparties, frequency, maturities, and settlement rules. | Used by many countries, particularly when there is a need to separate monetary policy objectives from public debt management objectives. Also used when secondary markets are insufficiently developed to permit open market operations in the secondary market. |
| Primary-market sales of government securities (open market type operations) | Management similar to central bank bill if coordination with treasury is appropriate, as treasury bill emission may need to exceed fiscal funding requirements. Encourage fiscal discipline on the part of government if direct central bank financing is discontinued. | Debt-management objective can conflict with monetary management if treasury manipulates auction to keep funding costs below market. When monetary management relies on primary issuance, high frequency of auctions may hamper secondary market development. | Same as above. Sometimes when the central bank has government securities in its portfolio, reverse repo auctions can be used instead of outright sales in primary markets. | Used in many countries when secondary markets are insufficiently developed to conduct open market operations. |
| Foreign exchange (FX) swaps and outright sales and purchases | In case of deep foreign exchange market but inactive government securities market, swaps can substitute for repo operations in government paper. FX outright sales and purchases may be useful when FX market is more developed than money market. | Central bank can suffer losses if foreign exchange operations are used in attempts to preserve an unsustainable exchange rate. | Need to design appropriate risk-management procedures. | Swaps used on a regular basis by a few countries (Germany, Greece. Malaysia. Switzerland, and Turkey). |
| Secondary-market operations (outright purchases and sales or repo operations) | Can be undertaken on continuous basis; hence provide flexibility, Transparent Enhance market development. Immediacy of response in money market. | Require liquid and deep secondary market, and central bank must have an adequate stock of marketable assets. | Repos have advantage of being automatically reversible, especially well suited for offsetting seasonal fluctuations. | Used by most countries with liquid and deep secondary markets. |
1 Reserve requirements have elements of both a direct and an indirect instrument. This paper follows conventional central bank usage and classifies them as indirect instruments.
Open market operations are broadly defined as the purchase or sale of financial instruments by the central bank, either in the primary market (open market type operations) or in the secondary market (full open market operations). Instruments commonly used for this purpose include treasury bills, central bank bills, or prime commercial paper. Reserve requirements oblige some types of financial institutions to hold a specified part of their portfolio in reserve money (currency or deposits with the central bank). Central bank lending facilities are typically short term and can take a variety of forms; in general, they involve the rediscounting of high-quality financial assets such as treasury bills, collateralized lending through Lombard facilities, or the extension of credit through auctions.
Using indirect instruments, the central bank has the capability of determining the supply of reserve money. 2 This affects the banks’ liquidity position, as long as they have to settle their payments obligations across the books of the central bank and provided that they do not have unlimited access to nonpenal funding at the central bank. The effect on banks’ liquidity positions results in adjustments to bank, interbank, and money market interest rates to re-equilibrate the demand and supply of reserve balances. Because this chain of events is mediated by the financial markets, the central bank determines overall systemic liquidity, but the market distributes it. The impact of changes in liquidity will be absorbed by those most willing and able to absorb it; for example, purchases of treasury bills are a voluntary sacrifice of liquidity but can be encouraged by appropriate (market) pricing.
