Monetary policy in a fixedexchange-rate regime Presentation by Anders Møller Christensen Assistant Governor, Danmarks Nationalbank May 2006
MONETARY-POLICY STRATEGIES 24-05-2006 DANMARKS NATIONALBANK 2
24-05-2006 DANMARKS NATIONALBANK 3 EXCHANGE RATE OF THE KRONE VIS-À-VIS THE EURO 1987-2006 Kroner per 100 euro 600 Market rate Central rate Limits of the fluctuation band 650 700 750 800 850 900 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Before 1999, a synthetic krone rate vis-à-vis the euro is applied, calculated on the basis of the krone rate vis-à-vis the D-mark and the D-mark-to-euro conversion rate fixed at 1 January 1999. Source: Danmarks Nationalbank.
24-05-2006 DANMARKS NATIONALBANK 4 EXCHANGE RATE OF THE KRONE VIS-À-VIS THE EURO 1999-2006 Kroner per 100 euro 720 725 Market rate Central rate Limits of the fluctuation band 730 735 740 745 750 755 760 2.25 per cent 2.25 per cent 765 770 1999 2000 2001 2002 2003 2004 2005 2006 Source: Danmarks Nationalbank.
24-05-2006 DANMARKS NATIONALBANK 5 VOLATILITY OF THE KRONE VIS-À-VIS THE EURO 1979-2006 3,5 3,0 2,5 2,0 1,5 1,0 0,5 0,0 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Note: The volatility is the 60-day moving standard deviation measured in per cent. Before 1 January 1999 the D-mark exchange rate is used. Source: Danmarks Nationalbank.
24-05-2006 DANMARKS NATIONALBANK 6 THE DANISH PARTICIPATION IN ERM II Within the ERM II the krone is allowed to fluctuate within a narrow band of +/- 2.25 pct. vis-à-vis the central rate against the euro (746.038 kroner per 100 euro). In practice however the krone has been kept very stable around the central rate. Denmark has concluded an agreement with the ECB on the narrow band. The standard fluctuation band in ERM II is +/- 15 per cent. The euro is at the core of ERM II, and the other participating currencies have central rates vis-à-vis the euro, but not vis-àvis each other. The obligation to intervene if a participating currency reaches one of its fluctuations margins rests on the central bank of the relevant member state and the ECB only. Other participating member states are under no obligation to intervene. Currently Denmark, Estonia, Cyprus, Latvia, Lithuania, Malta, Slovenia and Slovakia participate in ERM II.
24-05-2006 DANMARKS NATIONALBANK 7 MONETARY POLICY INSTRUMENTS Monetary-policy counterparties: Banks and mortgagecredit institutes. Weekly market operations ( open window ) Counterparties may raise 14-days loans against collateral and/or place funds by purchasing 14-day certificates of deposits (CD's). The rates of interest on the two types of 14-day transactions are normally identical. Standing facilities: Current-account deposits (Overnight deposits) within certain limits. Finetuning operations (purchase and sales of CD's), e.g. in case of major central-government payments.
24-05-2006 DANMARKS NATIONALBANK 8 DESIGN OF MONETARY POLICY INSTRUMENTS IN A FIXED EXCHANGE- RATE REGIME Danmarks Nationalbank's monetary-policy instruments resemble those of the Eurosystem. However, some differences related to the fixed-exchangerate regime: No marginal lending facility => No ceiling on overnight interest rate. This may help to dampen any unrest in the foreign-exchange market. A current-account-limit system => prevents a build-up of large current-account deposits which could be used to speculate in changes in interest and exchange rates. No reserve requirements Maturity of monetary policy instruments: 14 days (ECB 7 days).
24-05-2006 DANMARKS NATIONALBANK 9 MONETARY-POLICY INTEREST RATES IN DENMARK AND THE EURO AREA 1999-2006 Per cent 6,0 5,5 5,0 4,5 4,0 3,5 3,0 2,5 2,0 1,5 1999 2000 2001 2002 2003 2004 2005 2006 ECB's minimum bid rate/fixed tender rate Danmarks Nationalbank's lending rate Source: Danmarks Nationalbank and ECB.
24-05-2006 DANMARKS NATIONALBANK 10 INTERVENTION 1999-2006 Kroner per 100 euro 742 Kroner billion 40 743 30 744 20 745 10 746 0 747-10 748-20 749 Danmarks Nationalbank's net intervention foreign-exchange purchase Exchange rate, kroner per 100 euro, left axis -30 750 1999 2000 2001 2002 2003 2004 2005 2006 Source: Danmarks Nationalbank. -40
24-05-2006 DANMARKS NATIONALBANK 11 NUMBER OF DAYS WITH INTERVENTION 1998-2005 100 90 80 70 60 50 40 30 20 10 0 1998 1999 2000 2001 2002 2003 2004 2005 Source: Danmarks Nationalbank.
24-05-2006 DANMARKS NATIONALBANK 12 THE ORIGIN OF THE FIXED-EXCHANGE- RATE POLICY IN DENMARK Today commitment to a fixed-exchange-rate policy and stability oriented economic policies in Denmark. Historical background: After World War II fixed-exchange-rate policy within the Bretton Woods System. 1970s: Poorly managed macroeconomic policy and poor economic performance. Frequent devaluations. Fundamental change in 1982: Incoming government declared that devaluation would no longer be an instrument in economic policy. Since January 1987 there has been no change in the central rate of the krone vis-à-vis the D-mark and subsequently the euro.
24-05-2006 DANMARKS NATIONALBANK 13 GENERAL GOVERNMENT BUDGET BALANCE IN DENMARK 1970-2005 Per cent of GDP 6 4 2 0-2 -4-6 -8-10 -12 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 Source: Statistics Denmark.
24-05-2006 DANMARKS NATIONALBANK 14 GOVERNMENT BUDGET BALANCE IN DENMARK 1875-2005 Per cent of GDP 6 4 2 0-2 -4-6 -8-10 -12-14 -16-18 Banking crisis World War I Net lending 3 per cent World War II The "abyss" debate The " kickst art " 2005 1995 1985 1975 1965 1955 1945 1935 1925 1915 1905 1895 1885 1875 Source: Abildgren, K. (2005), Estimates of the government budget balance since 1875, Danmarks Nationalbank Working Paper, No. 30; and Statistics Denmark.
ANNUAL GROWTH IN CONSUMER PRICES IN DENMARK, GERMANY AND THE EURO AREA 1971-2006 Per cent 20 Denmark Germany Euro area (harmonised) 2 per cent 15 10 5 0-5 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Sources: Statistics Denmark, OECD and ECB. 24-05-2006 DANMARKS NATIONALBANK 15
24-05-2006 DANMARKS NATIONALBANK 16 BILATERAL EXCHANGE RATE AND RELATIVE PRICES BETWEEN DENMARK AND GERMANY 1970-2005 Index January 1982=100 150 125 100 75 50 Exchange rate (kroner per euro) Consumer prices in Denmark relative to consumer prices in Germany 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Source: Danmarks Nationalbank, OECD, ECB and Statistics Denmark.
10-YEAR BOND YIELD IN DENMARK AND GERMANY 1970-2006 Per cent 25 Denmark Germany 20 15 10 5 0 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Source: Danmarks Nationalbank. 24-05-2006 DANMARKS NATIONALBANK 17
24-05-2006 DANMARKS NATIONALBANK 18 YIELD ON GOVERNMENT BONDS AND MORTGAGE-CREDIT BONDS IN DENMARK 1900-2006 Per cent 22 20 18 16 14 12 10 8 6 4 2 Mortgage-credit bonds Government bonds 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 Source: Abildgren, K. (2005), A historical perspective on interest rates in Denmark 1875-2003, Danmarks Nationalbank Working Paper, No. 24; and Danmarks Nationalbank. 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
UNEMPLOYMENT IN DENMARK 1970-2005 Per cent of labour force 14 12 10 8 6 4 2 0 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 So u r ce: St at i st i cs Den m ar k. 24-05-2006 DANMARKS NATIONALBANK 19
BALANCE ON DENMARK S CURRENT ACCOUNT 1970-2005 Per cent of GDP 10 5 0-5 -10 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 So u r ce: St at i st i cs Den m ar k. 24-05-2006 DANMARKS NATIONALBANK 20
24-05-2006 DANMARKS NATIONALBANK 21 SPREAD BETWEEN MONETARY-POLICY INTEREST RATES IN DENMARK AND IN GERMANY/THE EURO AREA 1992-2006 Per cent 7,0 6,0 5,0 4,0 3,0 2,0 1,0 0,0 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 Source: Danmarks Nationalbank, ECB and Deutsche Bundesbank.
24-05-2006 DANMARKS NATIONALBANK 22 THE REQUIREMENTS FOR FISCAL POLICY IN A FIXED-EXCHANGE-RATE REGIME In a fixed-exchange-rate regime monetary policy is not available as a tool of stabilisation. The government must conduct its fiscal policy and economic policy in general so as to achieve stable economic development. Denmark are subject to the objectives and requirements of the Stability and Growth Pact on equal terms with euro area member states (although no sanctions if non-compliance).
24-05-2006 DANMARKS NATIONALBANK 23 TRANSPARENCY In a firm fixed-exchange-rate regime the central bank needs to be ready to take interest-rate decisions at more or less any time. The structure of the decisionmaking process is thus quite different from that of a central bank pursuing an inflation target. Moreover, the possibility of more or less real-time evaluation of the success of a fixed-exchange rate implies that there is no ambiguity with regard to fulfilment of the target. Accordingly the word transparency implies something different under a fixed-exchange-rate system and an inflation-targeting regime.
24-05-2006 DANMARKS NATIONALBANK 24 MACROECONOMIC PERFORMANCE AND VOLATILITY IN COUNTRIES WITH DIFFERENT REGIMES - THEORY Is the volatility in inflation and economic activity larger in a fixed exchange rate regime without monetary policy as a tool of stabilisation? Theory: A flexible exchange rate is often considered useful in order to insulate an economy from asymmetric shocks in a world with nominal wage rigidity and/or limited labour mobility. A fixed-exchange-rate policy can lead to excessive volatility and periods of protracted unemployment.
INFLATION (HICP) AND OUTPUT GAP 1996-2005 Per cent, year-on-year 4,5 4,0 3,5 3,0 2,5 2,0 1,5 1,0 0,5 0,0-0,5-1,0-1,5 Output gap (right axis) HICP Denmark Per cent of GDP 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 5 4 3 2 1 0-1 -2-3 -4-5 -6-7 Per cent, year-on-year 4,5 4,0 3,5 3,0 2,5 2,0 1,5 1,0 0,5 0,0-0,5-1,0-1,5 Finland Output gap (right axis) HICP Per cent of GDP 5 4 3 2 1 0-1 -2-3 -4-5 -6-7 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Per cent, year-on-year 4,5 4,0 3,5 3,0 2,5 2,0 1,5 1,0 0,5 0,0-0,5-1,0-1,5 Norw ay Output gap (right axis) HICP Per cent of GDP 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 5 4 3 2 1 0-1 -2-3 -4-5 -6-7 Per cent, year-on-year 4,5 4,0 3,5 3,0 2,5 2,0 1,5 1,0 0,5 0,0-0,5-1,0-1,5 Sw ed en Output gap (right axis) HICP Per cent of GDP 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 5 4 3 2 1 0-1 -2-3 -4-5 -6-7 Note: Output gap measures actual GDP less potential GDP in per cent of potential GDP. Sources: OECD and ECOWIN. 24-05-2006 DANMARKS NATIONALBANK 25
24-05-2006 DANMARKS NATIONALBANK 26 STANDARD DEVIATION 1996-2005 Standard deviation 1996-2005 Denmark Finland Norway Sweden Inflation (HICP), per cent yearon-year 0,63 0,89 1,09 0,86 Out put gap, per cent of GDP 1,19 2,13 1,46 1,67 Source: ECOWIN and OECD.
24-05-2006 DANMARKS NATIONALBANK 27 Regime shifts and macroeconomic volatility Christensen and Hansen (2005) OECD 1970-2003 - Regime shifts are rare events Ocurred once or not at all in any individual country Difference-in-difference estimation y it = α i + β t + γ FK regime_fk it + γ IT regime_it it + ε it Fixed time- and country effects Used by Giavazzi og Tabellini (2004) og Persson (2005) effects of political and economic liberalisations
24-05-2006 DANMARKS NATIONALBANK 28 Inflation level Per cent year-year 14 Inflation level Estimated common trend across countries Per cent year-year 14 12 12 10 10 8 8 6 6 4 4 2 2 0 75 80 85 90 95 00 0
24-05-2006 DANMARKS NATIONALBANK 29 Inflation volatility Volatility 3 Inflation volatility Estimated common trend across countries Volatility 3 2 2 1 1 0 75 80 85 90 95 00 0
24-05-2006 DANMARKS NATIONALBANK 30 Output gap volatility Volatility 4 Output gap volatility Estimated common trend across countries Volatility 4 3 3 2 2 1 1 0 75 80 85 90 95 00 0
24-05-2006 DANMARKS NATIONALBANK 31 Results: Regime shift and level of inflation FER -2,75-4,02 (-3,06) (-3,32) IT -1,78-2,31 (-1,84) (-2,78) FER 5Y before -3,41 (-3,32) IT 5Y before 0,47 (0,49) Shifts to inflation targeting (IT) as well as fixedexchange-rate (FER) policy are associated with lower inflation Inflation low (high) prior to shift to FER (IT)
24-05-2006 DANMARKS NATIONALBANK 32 Results: Regime shift and inflation volatility FER -0,44-0,60 (-2,18) (-1,98) IT 0,01 0,11 (0,03) (0,41) FER 5Y før -0,60 (-2,02) IT 5Y før 0,70 (1,69) Shift to FER associated with delining volatility Shift to IT not associated with changes in volatility Estimates robust to introduction of dummies for the years prior to regime shift no inverse causality Low (high) volatility prior to shift to FER (IT)
24-05-2006 DANMARKS NATIONALBANK 33 Results: regime shift and volatility in output gap FER -0,24-0,31 (-1,51) (-1,64) IT -0,12-0,12 (-0,51) (-0,47) FER 5Y før -0,18 (-0,77) IT 5Y før 0,08 (0,32) No significant changes associated with regime shifts Coefficients level of significance
24-05-2006 DANMARKS NATIONALBANK 34 Summary Shift to FER associated with a positive development Lower inflation, lower volatility in inflation Decline in volatility in output gap almost significant Shift to IT less favourable in our sample Lower inflation and that s it In accordance with some previous studies Results are not in accordance with last decades literature on IT to put it mildly Explanations?
24-05-2006 DANMARKS NATIONALBANK 35 Possible explanations IT-literature s modeling of exchange rate is (too) simple UIP, empirically unfounded? Exchange rate as shock creator, not shock absorber Monetary policy is considered the only instrument for stabilization in much of the literature Is fiscal policy more disciplined under FER? Is the need for active stabilization policy grossly overestimated in small open economies? Economic policy as a source for shocks? Are structural reforms regime dependent? Optimality vs. robustness
24-05-2006 DANMARKS NATIONALBANK 36 Concluding remarks Anchoring inflation expectations is central to inflation stabilisation A consistent fixed-exchange-rate policy can provide a transparent nominal anchor for a small open economy