Monetary Policy: How and Why Central Banks Make People Save or Spend

Why interest rates can't be kept low and in what cases it's better not to give a loan.
Dialogue Chain. Episode 12. Alexey Zabotkin, Director of the Monetary Policy Department of the Bank of Russia, and Gabriel Di Bella, Ex-Resident Representative in Russia, IMF.

Di Bella: Hello, Alexey. I’m very happy to see you. And since this series of videos is used to explain what are the issues that central bank does and what are the main elements of the work of the central bank, I was wondering whether, given your position, you could explain to us in very simple terms what monetary policy is, what are the objectives of monetary policy, and also what are the instruments that the central bank has to, actually, achieve those objectives.

Zabotkin: The pleasure of seeing you is all mine, of course. And if we start with very simple terms, then the best way to explain, what monetary policy is, is to explain what its objectives are in the first place. The most universally accepted objective of the monetary policy is price stability and the general trust in the currency. And the monetary policy is the process, through which the monetary authority of the country – most commonly named central bank – is achieving that objective. Some of the central banks have additional objectives included in their mandate but the Central Bank of Russia pursues this single objective of price stability, which in our case, we determine as the inflation… consumer price inflation being on target over the medium term, and that target is defined as close to 4%.

Di Bella: So, provided that the Central Bank has inflation at around 4 % per year, the Central Bank monetary policy is working well.

Zabotkin: That’s how we judge it. And in order to achieve that objective, the Central Bank has one tool. And that is affecting the level of the interest rates in the economy. And, to be more precise, the level of the short-term interest rates. To do that we have certain operational procedures in place. And then what is of critical significance for the effectiveness of monetary policy is the transmission mechanism.

Di Bella: I see.

Zabotkin: How the changes in the short-term interest rates, which we regulate, transmit into the broader economy.

Di Bella: But, I mean, this interest rate, to put it more simply, is like the cost of money in a way, right?

Zabotkin: That is correct.

Di Bella: Very good.

Zabotkin: And the cost of money significantly affects the behavior of economic agents: households, firms, and other participants in our economic life. And namely: when the interest rates or cost of money is high, then the households prefer to save and consume less, whereas the firms… for them, it’s more expensive to carry out investments, and for that reason their demand for investment is low.

Di Bella: And in that case the inflation…

Zabotkin: …tends to go down.

Di Bella: Tends to go down, I see.

Zabotkin: And vice versa: when the interest rates are low, then the households have the incentive to consume more actively, to borrow, and the firms are able to expand their investment activity more significantly. And in that case, the utilization of the resources in the economy increases, and that puts upward pressure on the prices.

Di Bella: But then why not keeping interest rates always very low, so everyone consumes a lot?

Zabotkin: That is exactly because it will probably at some point violate the principle of price stability. Because if the interest rates are too low, and if that results in the too strong consumption, if the population is consuming more than what the economy is able to produce, then the inflation rate will go up.

Di Bella: And so tell me Alexey I know that before you were a very successful economist actually working on the other side, on the very large Russian bank. So tell me… I mean this is a little bit of a tricky question but I’m going to ask it anyway. When you were on the other side, how you perceived the job that the Central Bank was doing? Could you tell me a bit in what areas you thought that the Central Bank was always doing well – of course, talking about monetary policy – and what areas you thought that “Hmm, maybe here… maybe there’s more work to be done”?

Zabotkin: The first thing to say is that the Central Bank of Russia’s monetary policy over the past 10 years has undergone a very significant transition. It moved from the policy, which was centered on maintenance of the stability of the exchange rate to the inflation targeting regime, which we pursue right now. Even though the desire to have low inflation was regularly communicated by the Central Bank but under the fixed exchange rate regime or quasi-fixed exchange rate regime, that objective has not been reached. At that point, clearly, the monetary policy was not achieving the objective of the price stability. As the transition to the floating exchange rate regime happened, we moved to the new paradigm, and in this new paradigm, I think, there’re almost no reservations as far as the efficiency of the conduct of the monetary policy is concerned.

Di Bella: So, your evaluation is that the market thinks that with the inflation targeting it’s easier to achieve price stability, and also that the task of the Central Bank becomes more believable for agents in the market.

Zabotkin: Absolutely. And that the trust in the Central Bank and the Central Bank’s commitment to its objective and ability to deliver on that objective is the critical element for the efficiency of the monetary policy. The element of trust is very important and that is the reason why the communication is very important.

Di Bella: Excellent. But one thing that’s, I think, clear is that the Central Bank is not alone in the economy. There’re a lot of other different factors that may influence whether prices go up or go down. And one of these forces is also fiscal policy. I mean, and we know that in Russia because it’s a big oil exporter, revenues of the budget fluctuate together with oil prices. So, we know at the same time, that the Central Bank transitions towards inflation targeting, the government also transitions towards the implementation of the fiscal rule. So, tell me something. Does the job of the Central Bank become easier when there’s a predictable fiscal policy? And what would happen if fiscal policy were not predictable for the conduct of monetary policy?

Zabotkin: Well, you’re absolutely right. The fiscal policy is a very important factor, which affects the economy. And that applies not only to the oil-rich and export-oriented economies like ours, but actually to any economy whatsoever because the state and the public finances are a significant part in most of the modern economies. It hasn’t been the case 100 years ago, but now it is the case almost everywhere in the world. And for that reason, the predictability and the stability of the fiscal stance makes the conduct of the monetary policy easier. It is important for the greater macroeconomic stability and for the easier conduct of the monetary policy that the spending of the budget does not fluctuate together with the revenues. The essence of the fiscal rule is about anchoring the level of spending at a stable level which is isolated from the fluctuations in the oil prices.

Di Bella: I understand. So, just to go to the last point here. So, could you tell me a bit about how financial stability policies and monetary policies coordinate, and whether they should be only one thing, or actually they should be separated?

Zabotkin: That’s a very complex question. And I think there’s no universally accepted answer to that. That’s more or less the frontline of the current policy debate in the area of central banking. So, the way I tend to think about this is that the matters of financial stability are addressed by other instruments, which the central bank has in its possession. The monetary policy takes into account how the outlook for the financial stability and the workings of those instruments, which the central bank implements to reduce or to contain the risks to the financial stability, translate into the central bank’s macroeconomic forecast, namely in its inflation forecast. And then if with all these inputs there’s a case for the monetary policy adjustment, then the monetary policy could be adjusted. Otherwise, the financial stability risks are better addressed by other sets of instruments.

Di Bella: For instance, I mean, if we are seeing right now that there’s, I mean, some increase in consumer lending, and this consumer lending is creating some concerns in some analysts. So, this would be an issue of financial stability, correct? And so, what you are saying is that this kind of risk should be addressed not through changes in the key rate, but other types of instruments. For instance, what instruments?

Zabotkin: Absolutely. That’s the case. And in particular, consumer lending is a good example of that because the level of interest rates, which are in place for the consumer loans actually have a much greater component of the credit premium in them. The changes in the key rate will have not very large effects on the interest rates, which the banks are charging on consumer loans. The measures, which the Central Bank has been undertaking since last year, was the gradual increase in the risk weights, which are applied to the consumer loans. Without going into technicalities, it’s about how much capital the bank needs to originate consumer loans.

Di Bella: So, basically, making it more difficult for banks to actually lend more consumer loans.

Zabotkin: More expensive. More expensive for banks to lend to the consumers. The matter with the consumer lending at this point in time is that, you know, it’s not so much about the financial stability now. The household credit cycle is far from getting overextended. We are leaning against it in order to prevent its overextension.

Di Bella: I see.

Zabotkin: But what is important is that this distribution of consumer lending across the population is very uneven. So, the actual objective for us is to limit the increase in the debt load of those consumers, which already took a lot of… too much of the credit.

Di Bella: Own a lot. Very good. Alexey, it was a pleasure listening to you. Now you have to tell me, who you want to speak to next.

Zabotkin: Gabriel, thank you very much for the very interesting conversation. I think our next conversation will be with Ruben Enikolopov, the rector of New Economic School.

Di Bella: Excellent. Thank you so much.