bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

12
12.1 Introduction
THE MONETARY AUTHORITIES AND FINANCIAL MARKETS 353
The Monetary Authorities
and Financial Markets
‘It's official. There is a Greenspan put option'. Financial Times,
January 4, 2001.
What you will learn in this chapter:
• Why central bank action on official short-term rates has so much leverage
over market rates
• How the behaviour of financial markets may place constraints upon central
bank policy-making
• How information can be derived from financial markets that can help in making
economic forecasts.
In two other sections (4.2 and 9.4) where we refer to central bank instruments
of monetary policy we drew attention to the recently emerged consensus
that the only satisfactory instrument is the short-term rate of interest.
We have also shown (in Section 4.2 especially) how central banks can use
repo and similar money market deals to set the price at which reserves are
made available to the banking system and we looked at how changes in official
rates are reflected in other, market, short-term rates. In this chapter we
are concerned with a broader question but one to which the interest rate setting
process nonetheless has some connection. The big question is the relationship
between central bank decision-making and financial markets and
one way of caricaturing the relationship is one of a struggle for power. The
central bank wishes to set domestic interest rates at some target level for the
achievement of its policy objectives but is reluctant to do so for fear that
markets (typically the forex or bond markets) will react badly, pushing the
exchange rate or long-term interest rates to undesirable levels. A variation
on this theme, often expressed by critics of ‘globalisation’, is that the size
and instability of international capital flows makes it virtually impossible
for any but the very largest monetary authorities to operate an independent
monetary policy (Cornford and Kregel, 1996; Mosley , 1997). If there is any
truth in such a picture, however, one must wonder how it is that individual