January 11, 2017    4 minute read

A Short History And Future Of Monetary Policy

Central Banking    January 11, 2017    4 minute read

A Short History And Future Of Monetary Policy

Although the Swedish are said to have opened the first central bank, it is the Bank of England (which opened in 1694) that most clearly showed the potential for such institutions. Over the next few centuries after its foundation, the Bank of England would see several political changes that would alter its powers. One of the most important was the Bank Charter Act of 1844, which gave the bank a monopoly on the issue of bank notes. This was a historical moment that would change monetary policy – not only in England but across the developed world.

The Impact Of Monetary Policies

Monetary policy is the process and tool by which a country’s monetary authority controls the supply of money. It is often used in pursuit of reaching inflation targets, real interest rate targets, employment levels and growth to ensure price stability and confidence.

Usually, central banks control the supply of money by manipulating interest rates, via their function as lender of last resort. Lowering interest rates is known as an expansionary monetary policy. In difficult economic climates, such as that of 2008, central banks across the world dramatically have typically lowered interest rates in a relatively short period of time. In turn, these lower bank lending rates reached consumers. The subsequent borrowing boosted demand and helped increase domestic growth, which helped to alleviate some of the symptoms from peaking stock market volatility and sharp declines in consumer sentiment.

On the other hand, monetary authorities sometimes wish to reduce consumer demand. In this case, they may increase interest rates; this is known as a contractionary monetary policy.

The Relationship With Inflation

At first glance, the relationship between bond prices and monetary policies may seem relatively straight forward. One may assume that as interest rates go up, demand for bonds goes down, whose prices fall and whose yields go up – and vice versa. However, it is important to note that although the latter is true in principle, in reality it is only the case when discounting all other aspects of monetary policy. Monetary policy does not just relate to controlling interest rates but has several other approaches too. In summary, these are inflation targeting, price level targeting, monetary aggregates, exchange rate targets, and mixed policy.

Although several of these had more significance in previous years, they all influence current policy to some extent, albeit some more than others. Therefore, the important distinction to make is that although interest rates rise, it does not necessarily mean bond yields increase – and vice versa. This is because loosening monetary policy, or lowering interest rates (where one might expect rising bond prices), may, in reality, lead to inflation or higher inflation expectations. If the latter turns out to be true, then rising inflation levels will result in falling, not rising, bond prices.

The Short And Long-Term Effects

To consider the effects of monetary policies on their bond yields, investors must also consider the long and short term effects of changes in monetary policy. For example, there is a sharp distinction to be made between overnight interest rates, which the bank has direct control over, and long-term market rates which are more unpredictable. Taking a look at a yield curve for this would show how it steepens as the difference in short and long-term rates of interest increases. At its flatter points, the difference between the two rates is reduced.

Over the past two decades, a common trend of this yield curve has been an upward slope. Interest rates are currently at historical lows, and expectations are that they will go up in the near future, as they have recently begun to. These expectations of continued expansionary monetary policy are likely to increase market interest rates in the short to medium term, and more so in the long term as indicated by the steepening yield curve.

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