The policy rate and the macro-prudential policy tool shall counteract each other in order to prove fruitful.

Here is the third commentary of the series. In the previous commentary, I summarized the monetary policy commonly applied before the global crisis which I called “the classical policy.” Then, I drew a monetary policy framework I called “the new policy”, which is voiced frequently both in theory and practice.  The new policy suggests how central banks have to set the value of at least two policy tools: the policy rate and macro-prudential policy tool.

Extreme risk-taking in periods of economic growth
The rationale for macro-prudential policy tools can be explained as such: in periods of rapid economic growth, the perception that thing will always go well and triggers the risk-taking activities. This tendency has to be restrained. On the contrary, in periods of slow growth and economic contraction in particular, risk appetite comes to halt and needs to be boosted. There are policy tools devised for this purpose as required reserve ratio or credit reserve ratio. It is expected that increasing any or both of these two ratios would reduce financial risk appetite and vice versa.

The policy rate is decided by bureaucrats, that is, central bank officials. In order for the policy rate to fulfill its purpose, that is, converge output to potential, inflation to the target and the level of financial risks to normal, it has to influence the demand for domestically produced goods, the real exchange rate and inflationary expectations. One prerequisite to this end is that the policy rate has to affect the interest rate in the short-term interbank market, which I will call the “short-term market rate” or the “market rate.” The policy rate has to affect the market rate so that it can in turn influence the longer-term interest on credits, demand deposits and bonds.

With this perspective, the value of the short term market rate has to be close to the policy rate. Central banks ensure this using a corridor-like interest rate system: central bank announces a lending and a borrowing interest rate. Lending interest rate corresponds to the upper limit of the corridor and represents the interest rate a bank in temporary shortage of liquidity agrees to give to the central bank in exchange for short-term borrowing. Borrowing interest rate corresponds to the lower limit of the corridor and represents the interest rate a bank in temporary surplus of liquidity agrees to take in exchange for depositing the excess fund amount to the central bank. The policy rate is set at or in between the upper and lower limit. Until May 20, 2010 the policy rate of the CBRT and the borrowing rate (the lower limit) were the same. From this point on (until the mid – late 2011) the CBRT set the policy rate at the same level with the weekly lending rate (repurchase rate).  The policy rate is maintained within the corridor since the central bank is ready for lending at the upper limit and borrowing at the lower limit (problems about warranty are neglected)

The CBT raised reserve requirements with consecutive decisions
One critical point must be kept in mind when implementing this new monetary policy: the policy rate and the macro-prudential policy tool shall counteract each other in order to prove fruitful. This problem was unfortunately witnessed in Turkey between October 2010 and June. The need for a new institutional regulation stems basically from this problem in practice. The Central Bank of Turkey has successively increased the required reserve ratio as a macroprudential policy tool with the aim to lower the risk of financial instability stemming from rapid credit growth. This policy attempt, however, encountered a dilemma, which I will tell on Saturday.

This commentary was published in Radikal daily on 26.01.2012