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Instruments of Central Banking in Failing Economy

Instruments of Central Banking in Failing Economy

Central banks are currently faced with the challenge of guiding respective countries from the current worldwide economic slump down.Officials in these organizations are thus revisiting instruments that have been in application previously in order to achieve breakthrough.This paper argues that central bank instruments that were in place when individual global economies were doing well are still applicable at this time of poor performance.

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All that central bankers need to do is evaluate instruments that are best positioned to lift economic conditions. This could include reversing decisions made previously, especially those that could have caused the current problem. However, central bankers should avoid engaging in practices that could interfere with smooth running of market operations in the name bringing help.

Most importantly, central bankers should ensure that the best practices are applied when implementing respective instruments. Secondly, the officials should ensure that central banking guidelines are followed to the letter. This calls for regular investigation on major participants in national financial markets. Appropriate disclosures by banks and other major players should be done in accordance to the laid rules and regulations. These are attempts to ensure that parties do not engage in activities that could end up worsening the already precarious economic conditions. Laxity in ensuring adherence should be avoided at all costs. Financial market participants should on their part feel obliged to follow the best practices without being followed by respective regulators.

 Central bankers and rest of stakeholders should further understand that the same instruments that were in application during best economic times are also capable of rescuing the economy. The bankers could thus revisit how the instruments were applied before the beginning of boom times and consequently draft similarly efficient application modes. A most important aspect to understand is that central banking instruments are meant to provide market participants with efficient access to sound money (Benhabib, J. & Schmitt, 2006, p. 23). This premise should indeed form a key foundation for application. Secondly, central banks should ensure on improving business environment for players in the financial industry. These two (access to sound money and proper working environment) necessities are all that participants need to make the ailing economy, especially financial industry, start working efficiently again.

Concurrent sections would address how six instruments of central banking (interest rates, open market operations, capital requirements, reserve requirements, exchange requirements, and margin requirements) could once again be used to deliver the economy from the current slow down. Each of the principle and respective applicability would be discussed independently.

Interest rates
Market interest rates are set by central banks in order to control the demand of money in an economy. Low interest rates encourages people to borrow more from financial institutions in order to invests in businesses and income generating assets. On the other hand, higher interest rates encourage people to save more funds in order to receive the attractive interests. Central banks are thus tasked with the responsibility of setting the rates that will please both savers and borrowers. This is a tough balancing market that central bankers have to contend with; especially in today’s failing economy. Central bankers should therefore tweak the rates in accordance to the perceived needs by savers and borrowers, which would form a basis of lifting the economy from the current slump down.

            Central banks achieve the goal of meeting lenders and borrowers interests by lending or borrowing unlimited amounts of funds in the market. In the failing economy, the process should begin by setting a target interest rate that would please participants from either side. Should it happen that current rates are higher than the set target, central bankers should embark on selling bonds to the market in order to force decline in the interest rate. The opposite (buying bonds when target is higher than current rates) when the central bankers are willing to increase interest rates. The central bankers are finally able to set the foundation for economic recovery.

            The interest rate instrument can also be used by commercial banks to borrow from each other through inter-bank rates set by the central bank. Central banks can change the inter-bank rates in order to regulate the amount of currency held by the banks, as well as improve transparency in these transactions. Banks could be borrowing from each other in order to reach the regulated reserve requirements (discussed below). Central banks should therefore ensure understanding reasons behind such arrangements, especially when withy similar principle shareholder, parent company or subsidiaries are concerned. Ensuring transparency on this front would help restore sanity in the industry.

            There are three basic interests rates that can be applied in the process of helping the ailing economy recover. First is the marginal lending rate (or discount rate). This is the rate that institutions, especially financials, can borrow money from the central bank in order to replenish their reserves. This rate is usually lower compared to those in other commercial institutions, which enables borrowers to borrow bigger sums to cater for current needs. This arrangement is especially important in the current poor economic period, as institutions are assured of availability of funds. In the United States, the Federal Reserve Bank has recently opened this facility for struggling player in the country’s mortgage industry, including Fannie Mae and Freddie Mac, the nation’s largest mortgage institutions.

            The second type of applicable interest rate is the marginal refinancing rate, known in the United States as Federal funds rate. Individuals and institutions use this rate to refinance loans. This form of interest rate is of great importance during these times of failing economy. Many individuals in the American housing market are faced with the challenge of paying back their mortgage loans due to higher interest rates on the loans and decline in income as a result of current economic situation.

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The Federal Reserve can therefore reduce main refinancing rates to enable the struggling individuals to eventually pay-off their loans. Changing the rate to levels that can be afforded by individual borrowers would be of great help in restarting their lives once again. The third form of interest rate is the deposit rate, which refers to interest paid to people and institutions that save their funds with respective central banks. Increasing this rate would result to more individuals and institutions saving their money with the central bank. Given that central banks are tasked with the responsibility of raining finds for government’s budget deficits, the funds saved could be used for public projects and social spending targeted at easing financial pains of the current economic conditions, as well as jumpstarting the failing economy. Working with interest rates could thus show effectiveness in times of shining and fading economy.

Open market operations
Open market operations refer to processes used by the central bank to control the amount of money in the economy. This is done through the selling and buying of securities in financial markets. The amount of money in the market determines the level of inflation in respective market, meaning that by changing money in the economy, the central bank can regulate inflation. Inflation is hereby taken to mean rise in the prices of goods and services in the economy. Just like consumers and traders in an economy, central bankers, too, wish to have low and manageable inflation levels that would not inconvenience consumption. Selling government securities in the open market reduces the amount of currency in the economy, because investors would be giving money to the central bank. This reduction in the amount of money in the market tends to reduce inflationary pressures, as people would be lefts with fewer funds to bid-up prices of goods and services. Increase in prices in the current failing economy is not preferable considering that individuals have fewer funds to spend. In this regard, the central bank should in the short run sell securities in order to contain inflationary pressure on the ailing economy. Similarly, buying back securities from investors, both individual and institutions, increases the amount of money in circulation and therefore put inflationary pressure on the economy. The central bank should therefore avoid the temptation of increasing the money supply at this moment, because of hurting the individuals in the ailing economy. In order to stay up with economic demands, central banks keep issuing or buying securities and eventually achieve the manageable inflation levels. The issue of managing inflation is however tricky considering there are other sources apart from increasing money supply. The current increase in the price of oils, foodstuffs and other commodities is especially causing upward pressure on general inflation levels worldwide. Central bankers should therefore have such externality in consideration before embarking on controlling inflation levels.

            The central bank could use open market operations to effect foreign exchange rates. Having a situation where the local currency becomes undervalued leads to increased attractiveness of local products in the international market. For instance, the recent depreciation of American dollar against other major world currencies has resulted to the demand of American products shoring internationally. This is a good thing for local producers as the market for respective products expand. The foreign exchange received can be used to improve respective products so they could face any stiffer competition when global economy improves. Weaker dollar has also resulted to decline in costs of touring American by foreigners, and thus increase foreign exchange flow into the country. There is, however, a downside on this arrangement; the weaker dollar makes imports more expensive and thus robs Americans the opportunity to consumer goods from other nations. Central bankers should thus understand the benefits and costs of respective open market operations as the effects span through various sectors of the economy. Collaboration between different countries’ central banks also becomes an instrument that can still be applied in both good and bad economic times. For instance, countries that have historically invested heavily in American treasuries are worried about further decline of the dollar. Central banks in Japan and China have specifically brought billions of dollars to the United States to try and stabilize the country’s currency (Bruce   & Stacey, 2004, p. 15). It remains to be seen whether their attempts would bear fruits. All in all, applying central banking open market operations regularly and in consideration with a market needs would go into far lengths of helping the economy recover, as well as show effectiveness.

Capital requirements
Central banks require commercial banks to retain certain amount of assets as capital that should not be lending out or be consumed in business operations. The figure is calculated as percentage of total customer deposits, which should under no circumstances, get loaned out or utilized by respective banks. Central banks are also subject to similar guidelines at the international level, though they are not obligated to follow. Keeping a certain percentage as capital reserve helps banks replenish working funds in time of economic crisis. Currently, central bankers should embark on ensuring that all financial institutions are operating on or above the designated capital requirements. This instrument is of help to financial industry as gradual decline of capital requirement towards the designated level indicated an institution in trouble. The arrangement thus helps to keep industry participants to check on themselves without being followed by respective regulators.

            In this arrangement, different class assets are said to have differed values of capital requirements. More secure assets such as treasury bonds are have higher value compared to private bonds. Emphasizing on this matter should be every central bank’s goal, as more banks would become aware of what they need to keep for capital requirement. The central bank has a role to ensure well-sustained capital delinquency in the financial industry, and therefore help escape a situation where banks have lesser capital to run operations in times of need. The central bank should, among other procedures, ensure regular reporting by players in the industry and therefore improve. The central banks’ capital requirements should be maintained at all times given the many purposes played by the funds during economic slow down. The funds could for instance used to assure banks suffering from capital delinquency as well as help government to offset the pains of economic slowdown among the populace.

            Relying on capital requirements to understand capital delinquency is regarded as more effective compared to the popular reserve requirement (Charles C. & Timothy, 2000, p. 9) discussed later in the paper. This originates from the concern of asset inflation in the industry. For instance, reserve requirements are prone to fluctuate more frequently as financial institutions deposits change, meaning that companies can keep on loaning money to customers at its own peril during tough economic periods. Such occurrence can be prevented when capital requirements is used to measure capital delinquency. Here financial institutions cannot loan any more money without having to increase respective amount of core capital, which usually comes from shareholder funds. These instruments thus require shareholders to embark on increasing their bank’s core capital when more moneys are loaned out. In other words, the arrangements make banks to be self-monitor, which is the best measure of avoiding a catastrophe. Reporting regularly to the central bank on respective institution’s capital helps officials to monitor banks performing well and those doing poorly. The central bankers subsequently provide advisory on measures to be taken. Central bankers have historically threatened institutions with take over in the case of failing to meet the set requirements. Individual commercial banks can best avoid falling under the benchmark by setting their own minimum capital requirement way above the one regulated by respective central bank. The self-regulated minimum rate could be set like 5-10 percent above that of the Federal Reserve Bank. The practicing bank could make further ensure on increasing capital when declining toward the self set minimum. Taking such measures ensures being way and above the federal capital requirement rate. The example shows effectiveness of central banking instruments in the failing economy, something that could be taken for granted by critics who argue that it could be the same instruments that caused the current economic conditions.

Reserve requirements
The reserve requirement refers to an instrument demanding that a certain percentage of commercial banks’ deposits be deposited with the central bank or a delegated institution. Some central banks require specific amounts instead of percentage. This requirement has to be fulfilled for any commercial bank to be in operation in many parts of the world. The applicability in the current failing economy cannot be ignored. Most importantly, the arrangement ensures that banks do not provide more loans to customers to the point of eroding the total deposits in their procession. According to Joydeep and Noritaka (2001, p. 21) the instrument was enacted in late 19th century when the banking industry had overextended itself to the point of experiencing bank runs. Depositors in these institutions had felt that banks had loaned out more their money. This is similar what has happened in recent past where banks had been lending more funds as mortgage loans. The hardship to pay those loans has thus exposed financial institutions to bank runs. One bank in California has already been a casualty. However, the reserve requirements serves as a guarantee that depositors’ funds are available despite exposure to bad debts. This is further evidence on the applicability of central banking instruments in the current economic turmoil.

            Having significant potions of commercial banks funds tied as reserve requirements blocs loaning to customers, thus cap credit creation. This arrangement therefore serves as one way of reducing the amount of money in circulation, and thus serve inflationary cap. The current economic situation is wary of any inflationary pressure that could increase the cost of living for the already struggling individuals. Maintaining this instrument at this period is thus one of the most important roles played by the central bank, which is yet another evidence of effectiveness of central banking instruments in a struggling economy. In the absence of this instrument, banks would be tempted to increase respective lending in order to make more profits. This is in consideration that there is market for more loans in the US market despite economic downturn. In addition, the globalization of the financial industry mean that commercial banks could loan funds to individuals, institutions, and governments internationally. This would result to increasing in the amount of dollars in the circulation and thus export American inflation internationally. Finally, what would have been an American problem becomes global and the entire world end up suffering a more serious economic decline. Lower and middle-income nations with less efficient processes of dealing with such pressure would be most hurt by a situation that is not of their own making.

            Commercial banks have, since the 19th century, become accustomed to the importance of reserve requirement in the financial industry. As a result, the banks have been relying on prudence to achieve this goal. Many are the banks that achieve the reserve requirement goal with minimal struggle because of understanding the importance. In fact, individual banks have historically embarked on setting their own private requirements above the federal minimum, which has helped in avoiding conflict with regulators. The instrument has thus been working efficiently in times of descent economic performance end in poor conditions like the current ones. There is no indication of this arrangement’s success fading, which illustrates the unending applicability of central banking instruments in various economic situations. Despite the evidence of most banks adhering to the requirement without pressure, central bankers should keep following up, just in case of laxity among players in the industry. Regular reporting by commercial banks helps in understanding the trend in the industry with regard to following guidelines to the letter, failure of which could reverse success that has taken ages to achieve.

Exchange requirements
The exchange requirements instrument requires traders to deposits foreign currency (gained from exports) to home country central banks. Some traders could take this measure intentionally, without request from central bank officials. The deposited foreign currencies are replaced in the market by local currency. This measure can therefore be said to have a direct impact on money supply in respective economy. However, not many central banks, especially in the developed world, that use this instrument. Traders in these countries embark on depositing their foreign currency with respective central banks in return of treasury securities. The impact on money supply is therefore the same regardless on the party initiating foreign currency deposits. The rate of exchange of is entirely market based, which reduces chances of central bank intentionally determining dollar exchange rates. This, however, changes when there are large amount of foreign currency involved in the exchange. Just like in other market situations, exchanging large amounts of foreign currency into dollars increases the latter’s demand and value. The Federal Reserve Bank could thus choose to keep the foreign currency and sell in piecemeal so as to avoid having unintended impact on the dollar. Officials could, however, choose to exchange the lump some and therefore improve dollar’s value. This is a tough balancing act considering protests from exporters arguing about loss of their exports’ competitiveness in the international market, whereas importers would be enjoying the dollar’s higher purchasing power. Interests of both groups are much important as they represent the wishes of daily participants in the economy. In the current failing economy, this policy looks less effective because exchange rates can only play a minor role in mitigating economic hardships. Federal Reserve officials should indeed let the market determine foreign exchange rates because intervention could end up destabilizing trend to favorable equilibrium.

            In desperate situations, traders holding the exchanged currency could be forced to utilize them in line with central bank guidelines. This has hardly been applied in the developed world since the liberalization of foreign exchange in 1970s and 80s. American traders should thus stay assured that such an arrangement would hardly be forced on them. This shows in impracticability of this instrument in the American economy, which exposes inefficiency. Any attempt by Federal Reserve officials to suggest the use of this instrument would result to major uproar from various stakeholders, including businesspeople, politicians and, most importantly, economists. In short, the Reserve Bank can rarely embark on utilizing this measure.

            The ineffectiveness of this instrument in modern day economics, the central bank still utilizes the system quietly. As described above, the end result is nothing but increase in the supply of money in the American economy and thus expose the already financially burdened consumers with inflationary pressure. The Federal Reserve has various options of reducing the amount of money created from this instrument. For instance, the bank could sell governments bond to individuals and institutions and therefore reduce money supply. The Bank could also embark on intervening in the foreign exchange market either to strengthen or weaken the dollar depending on the market conditions. This instrument indicates that central banks can use instruments to offset negative impacts of some measures. Central bankers thus have ways of reducing the impact of poor decisions made previously. Such a situation could be regarded as a moral hazard in central banks, which leaves questions on their ability to make right decisions in the future. Fact that not many people understand the inner workings of these institutions further affects trust that right decisions would be made. The problem with central bank instruments, notes XXX (Woodford, 2001, p. 33) is the focus on short run goals at the expense of long term ones. Fewer factors are therefore considered when implementing these instruments. Worse, similar mistakes are repeated as one short cited instrument is used to rectify mistakes made previously using other instruments.

Margin Requirements

The abovementioned five instruments are the most common ones applied by central banks worldwide and especially in the west. Most of them have proved effective in ensuring access to sound money in respective economies in good and bad economic times, whereas other have shown to have been overtaken by time. Central banks in differed courtiers have historically developed additional instruments applied to counter various monetary issues, regulate capital markets, or even to limit lending. The margin requirement is an instrument used regulates how companies and individuals can borrow funds against held securities. Usually, the value of securities hedged is way above the amount of loan borrowed, which serves as a cushion in case the securities’ value declines. The Federal Reserve Bank has guidelines on this arrangement. Whether in prospering of failing economy, the margin requirement should be applied equally considering it is an arrangement between two parties. The decline in the value of financial stocks is especially of great concern from various corners. Indeed, individual and institutional investors facing tough economic times could be willing to borrow against falling stocks, considering that it is that banks that would end up loosing. This would result to the creation of increased risk of leverage that should be avoided at all costs, especially considering that it is the same financial industry that has been the cause of current economic dilemma. To deal with possible leverage risks, the Federal Reserve could ensure that stocks being used pass several credit ratings. This measure would help in creating leverage risks through shares of companies that could end up going bankrupt.

Despite the efficiency of this instrument in delivering results, the central bankers at the Federal Reserve should consider that participants in the financial industry understand the risks involved in various products. Many are instances where regulators draft rules that treat participants as beginners who need someone to hold their hands. This result to creation of false mentality that all would be well when participants play by Federal Reserve rules, and therefore expose themselves to even greater risks. It is awkward that same Federal Reserve instruments had been in place when the economy started signs of weakening, but did nothing to reduce the impact yet market participants expect the same instruments to deliver theme from present economic challenges.

The effectiveness of market instruments in during the failing economy is very possible when long-term solutions are sought. This calls for drastic shift from using the instruments to develop short-term solutions to long-term problems. Most of the instruments discussed above can be very efficient in solving present crisis and consequently setting the American economy on another upward trend. Federal Reserve officials should begin by looking into how central banking instruments were applied previously and thus understand the origin of problems that have brought the economy down. This should be followed by elaborate measures of improving on the instruments, while eliminating measures that had negative effects on the economy. In addition, the central bankers should consider that none of the rules and regulations regarding the instruments is cast in stone—they can be improved or eliminated altogether. This calls for aggressive regulatory reforms that would leave the instruments with more efficiency in achieving various ends. Failure to enact proper reforms would be tantamount to inviting a near total financial meltdown in the American economy.

References

Bruce D. & Stacey, L. (2004). Open Market Operations and Money Growth. Working

Paper 9410. Richmond: Federal Reserve Bank.

Benhabib, J. & Schmitt, S. (2003). Demerits of Taylor Rules. Working Papers 1237,

NYU.

Charles C. & Timothy, F. (2000). Money Growth & Determinacy. Working Paper,

Cleveland: Federal Reserve Bank.

Joydeep B. & Noritaka K., (2002). Tight Money Policies and Inflation. Canadian

Economics Journal. 38 (3): 185-217.

Woodford, M. (2001). Price Stability and Fiscal Requirements. Working Papers

8126. NEBR.