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    The search for a new monetary policy (4)

    Fatih Özatay, PhD28 January 2012 - Okunma Sayısı: 978

    If the steps taken to launch the reserve requirement policy had not disturbed the policy rate mechanism, we would not have cared about this non-functionality.

    I am continuing with the fourth commentary of the series. I called the prevalent pre-crisis monetary policy the “classical policy.” Then, I drew the framework of a “new policy” addressed frequently in both theory and practice though there is no common agreement on it. 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.

    One critical point must be kept in mind when implementing this new monetary policy: the policy rate and the macro-prudential policy tool shall not counteract each other in order to prove fruitful. This problem was unfortunately witnessed in Turkey between October 2010 and June 2011. The need for a new institutional regulation stems basically from this problem in practice. The Central Bank of Turkey (CBT) 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.

    The first point to take into account in order to comprehend this dilemma is that, the average maturity of demand deposits was low already (then varying around 50 days). By increasing required reserve ratio, the CBT would seize a relatively higher proportion of bank deposits, with the aim to lower the credit supply of banks. The second point to keep in mind is that in order for the policy rate set in the context of the inflation targeting regime to serve its purpose, short-term market interest rate has to be close to the policy rate in value. To this end, the CBT has to lend banks short-term liquidity as much as they demanded.

    Did the policy work?

    As a third point, please focus on the answer of the following question: Would banks offset the fall in deposits via borrowing from the CBT so that the credit supply does not shrink? If banks decide not to lower the credit supply, the answer would be, yes. This was exactly what we witnessed in practice. Reserve requirements, the liquidity banks have to keep at the CBT and the amount the CBT has to lend to banks in order to keep the policy rate and the market rate close to each other (OMO) increased almost at par starting with October. In October 1, 2010 required reserves and OMO stood at 22.4 billion Liras and 16.3 billion Liras, respectively. By the week starting on February 25, 2011 the figures were 45.7 billion Liras and 29 billion Liras. On June 3, 2011, the figures reached 70.8 and 60.1 billion Liras, respectively. In July, required reserves remained constant whereas OMO increased a bit further.

    Parallel movement

    I think these figures are enough to prove the point that the two variables moved in parallel with each other. The CBRT has withdrawn liquidity from banks on the one hand but right after returned this amount back by lending to banks. Pace of growth of credit supply did not change until June 2011 as also admitted in a number of CBT documents and presentations (for example Briefing to Bank Economists, 1 November 2011, slides eleven and twelve; 2012 Monetary and Exchange Rate Policy, paragraph five). These documents reveal that the upwards trend in credit supply growth began to be reversed only after the Banking Regulation and Supervision Agency (BRSA) decisions of June 2011. In other words, the macro-prudential tool the CBT chose (required reserve ratio) did not work, but the one the BRSA used (changes in credit reserve ratio) did to some extent.

    The critical point is that, if the steps taken to launch the macro-prudential policy tool had not disturbed the policy rate mechanism, we would not have cared about this non-functionality. But this was not the case. What was the problem? What did the CBT do wrong? I will cover these during the last commentary of the series.

    This commentary was published in Radikal daily on 28.01.2012