Monetary policy instruments and transmission mechanism

Transmission of monetary policy
The Central Bank largely implements its monetary policy by affecting interest rates in the money market, primarily through the yield in its transactions with credit institutions. In implementing its monetary policy, the Bank needs to assess the impact of its actions on the economy, its overall size, channels of transmission and timing. Following the adoption of a formal inflation target this has become even more important. Since the Central Bank has the exclusive right to issue money in the economy, i.e. base money which comprises notes and coin in circulation and the financial institutions' deposits at the Central Bank, it can have extensive influence on the determination of interest rate in financial markets and in the economy as a whole, by adjusting the interest rate on short-term loans to financial institutions.

Interest rates
The Central Bank only provides short-term lending to credit institutions (see later). Central Bank interest rates on these loans therefore have the most immediate impact on other short-term interest rates in the money market. Through price formation in financial markets the effect is then transmitted across the whole interest rate spectrum, i.e., the rates of interest on securities and loans of different maturities. By influencing interest rates, monetary policy then has an effect on the savings and expenditure decisions of individuals and businesses. It should be borne in mind that interest rates in effect represent the price of money. When individuals or businesses make a decision as to whether or how much they want to allocate to savings or consumption and investment at any time, they compare the reward (i.e. the rate of interest) that they receive for deferring their outlays and the benefit they earn from consuming immediately. Thus interest rates have an effect on demand, both private and public consumption, and capital formation, which ultimately exerts an effect on prices.

Under normal circumstances a rise in the Central Bank policy rate results in higher interest rates on savings and outstanding short-term loans, as well as long-term loans with variable interest rates. This causes a reduction in the disposable incomes after interest payments of households and businesses which have outstanding net debts. They are then unable to maintain the same expenditure on consumption and investment as before, except by incurring further debt or drawing upon savings, which in both cases are more expensive than before. Likewise, monetary policy has an effect on the cost to businesses and households of financing new projects. All things being equal, higher interest rates therefore reduce expenditure by individuals and businesses on consumption and investment.

Impact on credit system
An important part of the transmission mechanism of monetary policy takes place through the credit system. The extent to which credit institutions can offer individuals and businesses favourable rates of interest is partly determined by the rates of interest that they have to pay on the funds they borrow from the Central Bank. Besides reducing demand for credit, all things being equal, higher lending rates can also cut back the supply of credit. This may happen as a result of greater lending risk. The reason is that the net wealth of individuals is reduced (see later), the market value of businesses falls and their cash flow worsens. At worst, the consequence could be bankruptcies and loan losses.

Impact on exchange rate
Another important channel for transmitting monetary policy is through its impact on the exchange rate of the króna. If interest rates on domestic securities are higher than on comparable foreign ones, they become more attractive, other things being equal. By increasing the interest rate spread between domestic and foreign assets, the Central Bank can encourage a capital inflow or reduce an outflow, i.e., spur demand for the króna. Under normal conditions a rise in interest rates prompts an exchange rate appreciation (or less depreciation than otherwise), contributing towards lower import prices which, all things being equal, has a direct effect towards reducing inflation. Since changes in the exchange rate alter the relative prices of domestic and foreign goods and services, and thereby the competitive position of domestic companies vis-à-vis foreign ones, they exert an effect on external trade and domestic demand. An appreciation makes imported goods and services relatively cheaper, channelling demand out of the domestic economy. Demand for domestic production contracts, which all things being equal should also lead to lower inflation.

Impact on asset prices
Central Bank policy rates also have an effect on asset prices, e.g. equity prices and housing prices, and therefore on the wealth formation of households and businesses. As a rule, a rise in the policy rate brings down equity prices: firstly since the income flow which the share price measures is now discounted at a higher rate of long-term interest than before; secondly because demand for bonds grows at the expense of equities when bond yield rises, and thirdly since higher interest rates may cause an increase in corporate financial expenses, thereby reducing their profits, out of which dividends to shareholders are paid. Likewise, the cost of housing finance goes up, reducing demand for it. Less demand, in turn, causes housing prices to rise slower or even drop. Falling equity and housing prices reduce the wealth of individuals, which in turn reduces their propensity and ability to borrow, and thereby their propensity and ability to spend. A fall in share prices also reduces the market value of firms relative to the replacement cost of capital, making it relatively more expensive to issue new equity to finance new investments.

Expectations
Finally, monetary policy has an impact on the public's expectations about, for example, the pace and certainty of future economic growth and inflation. Changes in expectations affect the behaviour of financial market participants and elsewhere in the economy, including individuals' expectations about their employment prospects and expectations of corporations on future sales and profits. A rise in the policy rate may be interpreted as signalling that the Central Bank identifies the need to cool the economy in order to achieve its inflation target. Thus growth prospects decline in the wake of an interest rate rise, but the likelihood of price stability improves. If the monetary policy action is credible it should cut back inflation expectations and support the Bank's effort to maintain stable prices.


International studies suggest that the impact of monetary policy actions on domestic demand is generally first felt after roughly half a year and that it has largely been transmitted after one year. The impact on domestic inflation generally begins to be felt after around a year and has largely been delivered some 1½-2 years after the Central Bank interest rate rise. In principle the transmission mechanism appears to follow the same pattern in Iceland.

It should be underlined, however, that the transmission mechanism may change from one time to another, and considerable uncertainty surrounds it, both the ultimate scale of the impact and the lag between changes in Central Bank policy rates and their effect on the economy. It is likely that the effectiveness of monetary policy largely depends on its impact on expectations and confidence, further underlining the importance of a credible and transparent monetary policy.Monetary policy instruments. The Central Bank's main instrument is its interest rate (policy rate) on loans to the financial undertakings against collateral. These loans are a common form of central bank lending in many parts of the world. Trading involves the lender, i.e., the Central Bank, purchasing securities with a condition that the borrower will buy them back on a specified day. (Once called "repurchase agreements")  The incentive for such transactions is the credit institutions' need for short-term liquidity. Central banks can take advantage of this need to influence market interest rates. In Iceland the Central Bank holds weekly auctions of 7-day repos. Credit institutions are required to put up qualified securities as collateral, i.e., securities carrying a treasury guarantee and with active market making on Iceland Stock Exchange. Auctions can be either in terms of fixed prices, i.e. when the Central Bank offers to buy an unlimited amount of securities at a specified yield, or the total amount of agreements on offer is announced and the return is determined by market conditions, at least within certain limits. Fixed-price auctions have been the rule so far in Iceland.

Other market actions. While repos are the Central Bank's main instrument for influencing interest rates, it can also trade in the securities market on its own initiative. Such trading is confined to treasury-guaranteed paper and is rare. On its own initiative the Bank can also conduct foreign exchange market operations, i.e., buy and sell currencies. Intervention of this kind has become rarer after the exchange rate target was abandoned. The Central Bank only conducts foreign exchange market operations if it considers that they will serve its inflation target, or if excessive volatility threatens to jeopardise financial stability.

Besides its market actions, the Central Bank provides credit institutions with a number of on tap facilities, i.e. deposit and lending formats that can be used at their discretion within certain limits. These facilities also play an important role in fine-tuning interest rate decisions and prevent excessive swings in overnight lending rates in the interbank market:

• Current accounts are deposits of credit institutions' undisposed assets. They serve as settlement accounts for netting between deposit money banks and in interbank trading, including trading with the Central Bank. Interest rates on these accounts form the floor for overnight interest rates in the interbank market.
• Certificates of deposit with a maturity of 90 days are sold at the request of credit institutions. Although unlisted, these securities qualify for repo transactions. Their role is to create a floor for three-month money market yields. This format has remained virtually unused in recent years.
• Required reserves are obligatory for credit institutions which are not dependent on the treasury budget authorisation for their operations. The required reserves base is the balance sheet total less equity and interbank liabilities at the end of the preceding month. The required reserves ratio is 1½% for the part of the required reserves base which is tied for one year or more, and 4% for the remainder. The average deposit in the account shall reach the specified required deposit amount during the maintenance period, which is from the 21st of each month to the 20th of the following month.
• Overnight lending is provided at the request of credit institutions and secured with the same collateral that qualifies for repo transactions. Overnight interest rates form the ceiling for overnight rates in the interbank market.

References
Thórarinn G. Pétursson: The transmission mechanism of monetary policy, Monetary Bulletin 2001/4

Yngvi Örn Kristinsson: Implementation of monetary policy and Central Bank instruments, Monetary Bulletin 2000/4