Monetary Policy from the Point of View of an NBU Economist
Monetary policy decisions are based on model forecasts.
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On Wednesday, September 2, 2020, at 13:00, about 60 participants left a meeting in Zoom – the open session of the Monetary Policy Committee meeting was over. In the afternoon, monetary policy decisions were discussed at the closed session. And only after that were decisions taken by the Board. Personally, I have never been lucky enough to attend the closed session of a Monetary Policy Committee meeting, but I know what is discussed there. It is the model forecasts prepared by the staff of the Monetary Policy and Economic Analysis Department, with the participation of experts. Read this article for more on how it is done.
In July – September 2019, the National Bank of Ukraine twice reduced the key interest rate by a half a percentage point, to 17% and 16.5% per annum. “Won’t we squeeze the economy?” “Will we have a quiet double-election year?” In July – September 2020, the interest rate stood unchanged twice, at 6%. “Are we sufficiently stimulating the economy?” “Aren’t we overlooking a rise in inflationary pressures?” To answer these questions, the Monetary Policy Committee and the Board need to use detailed calculations made by NBU economists.
Eight times a year, the National Bank takes decisions on monetary policy. Eight times a year, the central bank economists prepare an overview of the economic situation, on which those decisions are based. The macroeconomic forecasts underlying our recommendations for monetary policy are updated four times a year. In this piece, I will talk about the forecasting process and the National Bank’s modeling tools.
Mechanism of monetary policy’s impact on the economy
Monetary policy affects the economy with a lag. First, market rates (on bank loans and deposits, yields on domestic government bonds) are determined by the market participants, they do not respond to the key policy rate immediately. Second, businesses and households need time to change their investment and consumption decisions, affecting domestic demand. The same applies to financial investors, their currency positions and the impact on the exchange rate. Finally, changes in demand and exchange rates are only reflected in prices over time.
For example, a low rate today will stimulate economic growth and inflation next year. This inertia means that trends need to be seen in advance, and it takes time to rectify mistakes.
The entire state’s economy is a complex phenomenon, and therefore, the monetary policy’s impact mechanism – the so-called transmission mechanism – is complex.
Figure 1. Monetary transmission mechanism scheme
Source: author’s illustration. Note: Ukraine’s economy is also constantly affected by external shocks, such as commodity prices, monetary policy of partner countries, weather conditions, etc. Demand, supply and the exchange rate also affect inflation expectations. However, we have not shown this here, so as not to overload the figure.
In order to have a structural understanding of the economy and the role of monetary policy, the National Bank economists build macroeconomic models. At their core are assumptions about economic relations, as confirmed by many studies. For example, other things being equal, we cannot expect lower inflation with a weaker exchange rate. And low interest rates stimulate demand only together with rising inflation.
NBU macroeconomic models
Macroeconomic models are sets of mathematical equations to explain certain economic phenomena. Addressing a wide range of the central bank’s needs requires a comprehensive system of models. Typically, such models allow for the analysis of leading indicators and short-term forecasting (1-2 quarters), the modeling of economic cycles and the impact of monetary policy in the medium term (1-2 years).
Using a whole set of models is a normal thing for a central bank. Our set includes econometric models (taking into account only statistical relationships in the data, e.g. devaluation leads to higher prices) and the semi-structural Quarterly Projection Model (based on economic laws, e.g. lower interest rates reduce the attractiveness of savings and so they should stimulate consumption). We use the former for short-term forecasting, and the latter for medium-term forecasting and monetary policy analysis. We also use other models as auxiliary tools.
To build econometric models, we take into account economic relationships, such as lower food price inflation after a good harvest or rising prices for imported goods after a weakening exchange rate. Different components of inflation have different sets of explanatory variables. We evaluate the strength of relationships by looking into the history using statistical methods. This approach allows us to come up with good short-term forecasts.
Sometimes, we project the same variable using several models. We then put the forecasts together, taking into account the historical quality of forecasts produced with the help of each method. Model simulations are supplemented by expert judgments, as the whole array of data being analyzed cannot always be formally shown in econometric models.
The system of automatically collecting data from the websites of large supermarkets allows us to quickly assess the inflation dynamics. Such assessments become the starting point for further calculations.
We organize all forecasting tools around the Quarterly Projection Model (QPM). It can systematize the available arrays of information, integrate the other models’ results and the judgments of the experts and Board members. The QPM reflects our overall vision of Ukraine’s economy and monetary policy’s role in it. The model is flexible and relatively easy to use.
We model Ukraine’s economy as small (Ukraine’s GDP in 2019 was 0.18% of the global GDP) and open (the trade-to-GDP ratio is close to 100%). The QPM falls under the class of models that are used successfully in many central banks and international institutions around the globe. Our model has a standard structure but specific characteristics. These include heterogeneous changes in prices for different groups of goods, insufficient confidence in monetary policy, high openness of the economy and dollarization.
The model combines well-known economic laws. Its key components include:
- aggregate demand equation – investment-saving curve: the equation takes into account the interest rates (stimulating or depressing demand for loans), the exchange rate (defining the balance between imports and exports), global commodity prices (expensive grain and base metals will increase the income and purchasing power of exporters), the investment attractiveness (affecting investment inflows and outflows). Fluctuations in aggregate demand form the economic cycle;
- equation of the four main components of inflation (core, regulated, fuel price and raw food price inflation) – Phillips curves: the components have different imported parts (oil imports affect the price of gasoline rather than the price of tomatoes), responding differently to supply and demand factors (the price of tobacco reacts little to demand, but quickly to excise tax changes);
- nominal exchange rate equation – uncovered interest rate parity: the value of hryvnia depends on the difference between the rate of return on hryvnia and foreign currency financial instruments; sovereign risk premiums, foreign exchange interventions by the NBU and the commodity prices for exported Ukrainian goods also play an important role;
- key interest rate response rule – Taylor’s rule: monetary policy responds to inflation’s projected deviation from the target, and to the stage of the economic cycle (an overheated or overcooled economy); in case of conflicting goals, priority is given to stabilizing inflation.
The coefficients in the QPM equations reflect our vision of the strength of individual economic relationships and transmission mechanism channels in Ukraine. Some of them, such as the length of the economic cycle, are estimated based on historical data. Others are linked to the structure of Ukraine’s economy, such as the imports to GDP ratio. Some are selected according to analogous models used in other central banks, and also in such a way that the model should provide the desired properties. The latter include the so-called response functions, i.e. conditional simulation of the economy’s response to certain shocks. Figure 2 shows the response functions with regard to an unexpected rise in the key interest rate. This simulation illustrates the monetary transmission mechanism.
We are constantly adapting our modeling tools to changes in the economy by developing new models, modifying and re-evaluating old ones.
Should there be a quick response or “wait and see”? For how long will the National Bank be ready to postpone meeting the inflation target in order to smooth the economic cycle? Considering different scenarios allows for the modeling of different inertial / aggressive interest rate responses, as well as a trade-off between stabilizing inflation and smoothing the economic cycle.
Figure 2. Key interest rate shock response functions
Source: Grui and Vdovychenko (2019). Note: the horizontal scale indicates quarters; the values on the graphs are the average for the quarter; at the beginning of the simulation, all variables are at their equilibrium levels, deviating from them due to the key policy rate shock; lowering the exchange rate means strengthening it.
Response functions demonstrate how we model the economy’s response to interest rate shocks over a certain period of time. Shock is the deviation of the actual key interest rate from the rate determined by the model equation (Taylor’s rule). This shock is also called a monetary policy shock.
According to the simulation, the central bank raises the interest rate by 1 p.p. but is immediately aware of the deviation from the policy rule, beginning to gradually reduce the rate at the next meeting in the same quarter. The average quarterly rate increase is close to 0.9 p.p. – the peak on the upper left graph (with all the graphs showing the variables’ average quarterly values).
A higher key interest rate strengthens the exchange rate, restraining aggregate demand. Stronger exchange rates and lower demand lead to a slowdown in inflation. The maximum impact on inflation is achieved in 3-5 quarters. The key interest rate goes down in response to weaker demand and lower-than-target inflation. Over time, economic fluctuations subside and monetary policy returns to normal.
Monetary policy decisions are based on macroeconomic forecasts. We prepare them four times a year, publishing them in inflation reports. An assessment of the accuracy of our forecasts can be found in the April 2020 report. It is as good or even better than the forecasts by other organizations. We are good at projecting the current account balance, inflation and our key interest rate dynamics.
Forecasts regarding the development of different parts of the economy should be comprehensive and consistent with each other. To achieve this, we use models that help combine economic theory and information from different sources. The process of preparing a forecast can be divided into four stages:
- developing outside assumptions,
- assessing the economy’s current state,
- building a forecast and agreeing on it,
- discussing the forecast with an expert panel.
In the first stage, we make assumptions about the macroeconomic variables that are beyond the impact of monetary policy. These include global indicators such as commodity market prices, inflation and economic growth of partner countries, as well as administered prices. To make our own assumptions about the global indicators, we process the forecasts by foreign organizations. The forecasts regarding the administratively controlled component of inflation take into account the plans with regard to excise taxes published by the Government, and assumptions about the prices of imported energy resources.
In the second stage, we assess the stage of Ukraine’s current cycle. All other things being equal, a cyclical economic upturn and high consumer demand will stimulate inflation, while on the other hand, a cyclical downturn will slow it down. However, the economic downturns of 2008-2009 and 2014-2015 were atypical. They were caused by crises and accompanied by high inflation due to devaluation. Economic growth reflects the recovery from the crises (Figure 3).
Figure 3. Economic cycle in Ukraine
Sources: SSSU, author’s calculations. Note: the trend is estimated by using the Hodrick-Prescott filter at two historical intervals; the broken trend in 2014 marks a structural change in Ukraine’s economy; the deviation from the trend of seasonally adjusted quarterly GDP indicates the economic cycle.
We also estimate the equilibrium exchange rate and its cyclical deviations. The latter affect the foreign trade competitiveness and the prices of imported factors of production. The equilibrium level of the exchange rate changes, as it depends on the situation in the global commodity markets and labor productivity in the economy. Fixing the exchange rate can therefore only increase deviations, as it does not allow the foreign exchange market to correct them itself.
Long-term deviations from equilibrium exchange rate levels may cause its rapid adjustment, as was often the case in Ukraine’s history. Furthermore, significant changes in the exchange rate have a large impact on inflation.
Other analyzed cyclical variables include fluctuations in unemployment and the average wages. At this stage, we also assess the rigidity / softness of monetary policy. To do so, we compare interest rates with the calculated neutral level.
Analyzing the economy’s current state creates the initial conditions for further forecasting. In our forecasts, monetary policy responses are usually aimed at smoothing the cyclical economic fluctuations.
In the third stage, we combine forecasts based on different models and expert assessments. For example, econometric models are best to make projections for the next 1-2 quarters, during which period, the impact of changes in monetary policy does not have enough time to show up. We believe that in the time horizon of up to six months, monetary policy has no chance to affect the inflation of raw food products (raw vegetables, eggs, etc.). The current state of affairs for the indicators whose data are published with a significant delay should also be assessed, e.g. GDP and unemployment. The semi-structural Quarterly Projection Model takes into account monetary policy, looking 1-2 years ahead.
Forecasts may contain expert adjustments of individual variables by a certain amount, at a certain point in time. Such adjustments reflect additional information that is not covered in our models. For example, we took into account the impact of a significant increase in the minimum wage on the average wages in 2017. The decision to raise the minimum wage in 2020-2021 call for similar calculations.
Finally, the model generated forecasts are not used mechanically but are discussed by a group of experts. In the fourth stage, we identify potential inconsistencies, so additional adjustments to the forecasts may need to be made, following the discussion. The process continues iteratively until a consensus is reached among the experts involved.
Figure 4. Forecasting stages
Source: author’s illustration. Note: revising assumptions is possible subject to significant changes in the prospects of the outside environment during the forecasting process.
The next decision on the key interest rate will be made by the Board and announced on Thursday, October 22. Our updated macroeconomic forecasts (during the open session of the meeting) and recommendations (behind closed doors) will be presented at the Monetary Policy Committee meetings on Tuesday and Wednesday. Both will take into consideration the mechanism of monetary policy impact on the economy and be based on macroeconomic models.
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