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Set out the instruments available for monetary policy

CFA® Level I · Economics · Monetary Policy · EC.7.b

The idea

The policy rate is the central instrument, influencing short-term market rates and from there borrowing costs across the economy. Open market operations buy and sell securities to steer rates toward the target. Reserve requirements set the minimum banks must hold, constraining lending, though many jurisdictions now rely on them little. Where rates approach zero, quantitative easing purchases longer-dated assets to compress yields further out the curve, and forward guidance attempts to move long rates by shaping expectations of the future path of policy.

A practice question

From the question bank, with the reason each wrong option is wrong.

What is the principal tool of monetary policy in normal conditions?

  1. The policy interest rate — correct
  2. The income tax rateWhy not: A fiscal instrument, set by the legislature rather than the central bank.
  3. Government spendingWhy not: Also fiscal, and the other half of what a treasury controls.

Setting the short-term policy rate transmits through market rates to borrowing costs across the economy. Taxation and spending are fiscal instruments.

A harder one

What is quantitative easing intended to achieve?

  1. Raising short-term rates above zeroWhy not: The opposite of its purpose: it is reached for because short rates are already as low as they can usefully go.
  2. Lowering longer-term yields when the policy rate is already near zero — correct
  3. Reducing the government's budget deficitWhy not: The central bank buys securities in the market. The deficit is set by spending and taxation.

With the short rate at its floor, buying longer-dated assets is a way to keep easing by compressing yields further along the curve.

The hardest tier

How does forward guidance work without any immediate change in the policy rate?

  1. By changing reserve requirements automaticallyWhy not: Reserve requirements are a separate instrument and are not moved by a statement about future rates.
  2. By directly setting long-term interest ratesWhy not: Long rates are set in the market. Guidance influences them through expectations rather than by decree.
  3. By shaping expectations of future policy, which are embedded in long rates today — correct

A long rate is roughly an average of expected future short rates plus a premium. Credibly changing the expected path therefore moves long rates now, which is why the commitment's credibility is the whole mechanism.

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