Relevance of a Taylor-type rule in the active monetary policy of Bank Al-Maghrib

Nicolas Moumni[*], Salma Dasser[**]

Abstract

As the central banks of developed countries, the central bank of Morocco (Bank Al-Maghrib, BAM) has, since the 1990s, upgraded instruments and practices concerningitsmonetary policy. The purpose of this study is to examine the implementation by the institution of a Taylor-type rule in its active monetary policy via interest rates.

For this, we conducted the estimation, by the generalized moments method (GMM) justified for its technical qualities, of backward-looking and forward-lookingTaylor rule versions, simple and augmented by the monetary aggregate M1(with and without smoothing), over the period 1995-2009. Our results do not support the use by the central bank of Morocco such a rule.

The operational objective of Bank Al-Maghrib is to regulate liquidity in the money market, by influencing the overnight interbank interest rate. This rate is the main transmission channel of monetary policy. In this context, we favor the hypothesis of a discretionary monetary policy.

JEL classification: E 52, E 58

Keywords: Taylor rule, monetary policy, Morocco.

Introduction

Like the central banks of developed countries, the central bank of Morocco (Bank Al-Maghrib), has since the decades 1980-1990, modernized instruments of monetary policy, played an important role in market reform and monetary and financial restructuring and concentration of the banking sector in Morocco, to greater competition.

Since the new framework, the central bank interventions have evolved from a control based on direct methods such as credit controls and automatic refinancing of banks by the rediscount to the indirect control interest rates in particular. Since its independence, gained in 2006, Bank Al-Maghrib (BAM), follows the standard international practices, of seeking to direct bank liquidity, mainly to ensure price stability.

In this “small open economy” where about half the population is still rural and whose financing the economy is heavily dominated by the banking sector, the modernization of business practices was she accompanied by an introduction, by BAM, of Taylor-type rule in the active monetary policy via interest rates?

In theoretical terms, the challenge to the discretionary monetary policy by the Nobel Prize for Economics Kydland and Prescott, through their publication in 1977, because of time inconsistency that it entails, the literature highlights the effectiveness and credibility of monetary policy as justification for implementing monetary rule. But the emphasis has been put, for about three decades, on the interaction between monetary and financial sphere, because of the considerable development of financial markets this may lead to a conflict between price stability and financial stability.

After the failure of the Keynesian corpus in explaining global inflation of the 1970s, the new classical economics based on rational expectations (Muth), which focuses on imperfect information in order to explain the economic situation, has questioned the Phillips curve and concluded to the ineffectiveness of political, fiscal and monetary policy, discretionary cyclical macroeconomic stabilization.

Since the 1980s, new developments in macroeconomic policy maker recommends, in developed countries, submitting the policy mix in a “straitjacket” of rules for controlling inflation and public deficit. These fixed rules would guarantee the credibility of monetary authorities and of the state. Since 1998, Morocco is no exception to this almost universal practice, as the EU and the ECB, the objectives of public deficit to 3% of GDP and inflation around 2%.

The aim of this work is precisely to question the relevance of the construction of the reaction function of BAM through a Taylor-type rule in a country where the informal economy represents nearly 20% of GDP and the banking rate does not exceed 47% in big cities.

To this end we devote our first section to the monetary policy ruleand the interaction between monetary sphere and financial sphere. We proceed in our second section to the analysis of monetary policy since its BAM modernization during the 1990s. In a third section, we question the determination of an active monetary policy in Taylor rule, using quarterly data over the period 1995-2009.Estimates of different versions of the Taylor rule will be implemented by the generalized momentsmethod (GMM), which proves to be the most appropriate, given the statistical characteristics of the series used.

I- Rationale of the monetary policy rule

I-1 Rationale of the monetary policy rule: the importance of expectations

The debate on the active role of money in economy holds, since the 16th century, a crucial place in academic circles. In the sixties, the question of the impact of currency on the economy will rest with the work of Friedman and Schwartz (1963) on Real Business Cycle (RBC) that does not have a crucial role in monetary policy.

Moreover, following the failure of Keynesian in explaining global inflation of the 1970s, research in macroeconomics has led to two new trends: New Classical Economics (NEC), under the influence of Lucas, Sargent, Wallace andBarro and especially real business cycle theory (RBC), with the work of Kydland, Prescott, Long and Plosser. Both approaches retain the assumption of optimal operation of markets that are balanced by price. Then, the theory of disequilibrium, with Clower, Leijonhufvud and Grossman introduced the phenomena of sticky prices and wages to explain the imbalances in the markets (especially labor-market).

There is also the new classical economics based on rational expectations (Muth) whichfocuses on imperfect information to explain the economic situation, it has questioned the Phillips curve and concluded to the ineffective policies, fiscal and monetary discretionary cyclical macroeconomic stabilization.

As regards the theoretical foundations of monetary policy, the work initiated by Kydland and Prescott (1977), Barro and Gordon (1983) on the problem of time inconsistency, provide a rationale for rules, compared with discretionary policy, given the expected benefit of greater credibility for monetary policy.

Given the emphasis on price stability in the long run, the nominal anchor is now regarded as the obligatory passage of any effective monetary policy. This takes asreference a nominal anchor as the rate of inflation (or money) in order to secure the general level price. The mainstream literatureputs forward the fact that this the anchor, first keeps expectations at a moderate level and secondly, an answers the problem of time inconsistency.

In the short term, monetary authorities may choose the ease of a more expansionary discretionary policy previously announced to a private sector (businesses and households) to boost the activity (and lower unemployment). Only the private sector will build on the continuity of policy and discretion will adjust its expectations by integrating higher prices in its calculations. So by this behavior, self-perpetuating, inflation expectations come true. Hence, the recommendation for the central bank to implement monetary policy rule and stick to it.

I-2Enhancement of the interaction between monetary policy and financial sector

In the early 1980s, in a context of liberalization of capital movements and development of international financial markets, central banks of developed countries have gradually beenadopting a monetary policy based on controlling the instrument of short termnominal interest rates.

For the past three decades, the financial liberalization in the world leads to greater market depth and a dramatic increase their liquidity. But the valuation of financial assets is done by transforming them into currency. After the phases of stock market euphoria, the cycle turns led to the financial crisis that creates a shortage of liquidity and often credit rationing.

Under these conditions, the central bank has no choice but to lower its interest rates to provide the liquidity needed to maintain the functioning of financial markets and monetary and credit support to the real economy, thus playing its role of LLR (Aglietta, 2010).

Indeed, the Fed’ keeping of interest rates very low, 1% from 2001 to 2004, combined with abundant savings in emerging countries, placed on the U.S. financial markets have been the source of excess global liquidity, uncontrolled by the U.S.A. These cash that was loaned by the U.S. investment banks to households in the form of variable rate mortgages, most of which a large part in the subprime segment, securitized subsequently caused a bubble in the sector.

But the long rise in interest rates by the Fed between spring 2004 and spring 2007 from 1% to 5.25% reported unbearable financial burden of this category of borrowers forcing most of them for sale or seized by the lenders of their property. This increase rate has led to the bursting of the housing bubble and financial crisis starting in the summer of 2007.

We see how the "easy" credit may initiate a new market cycle by encouraging the purchase of financial assets that may be the origin of a new financial bubble. Hence the interaction loop monetary sphere/financial sphere, these cycles do not necessarily have the same regularity.

It should also be noted that central banks have as one of their objective, price stability, but also the functioning of the money market.Monetary policy should guide interest rates in order to ensure the preservation of purchasing power of money. Regarding the money market, the central bank's mission is to respond to pressures of capital markets to meet potential liquidity needs. Thus, a conflict may arise between, on the one side, a monetary policy, and on the other side, credit policies and interest rates.

I-3 Specification of the Taylor rule

In 1993, Taylor suggested in his empirical study on the American period 1987-1992 a relatively simple monetary rule that links the Federal Reserve nominal interest rate the two inflation targets and activity. The application of this rule by the central bank leads tolowering interest rates in a context of low economic activity and inflation, and the increase in cases of inflationary pressures and rising economic activity, facilitating return the economy to equilibrium.

This rule is written as follows : , were is the nominal interest rate in the short term, theequilibriumreal interest rate, and , respectively inflation and inflation target and the output gap, defined as is the difference between the current level production and itspotential medium-term.

The weights (0.5) granted to the inflation gap and output gap are equal, reflecting a concern for both goals by the mandate of the FED.These are precisely the coefficients (alpha and beta) that we consider in our empirical study.

But, the Taylor rule is purely empirical.It has no theoretical basis. Therefore, Svensson (2002) and other economists after him, seek to provide a theoretical framework. For these authors, the Taylor rule may establish, within defined macroeconomic models, a solution of optimal control of constrained minimization of a loss function of the central bank.

In its fight against inflation, the quest for credibility by the central bank on the announced level, justifies the adoption of an active monetary rule instead of discretionary monetary policy. It should be noted that active monetary rule depends on the specific country reaction function.

II-The monetary policy of Bank Al-Maghreb in an economy depends in its bank credit financing

II-1 Modernization of the monetary policy of BAM, the Treasury and the Casablanca stock exchange

Morocco's central bank was created in 1907, following the international conference at Algeciras in 1906, by representatives of 12 European countries, USA and Morocco. Its statutes were type-company, its headquarters were based in Tangier. His capital was shared between the signatory countries, excluding USA, was then majority owned by France.

At the international level, during almost three decades, the objective of price stability assigned to monetary policy, has become a virtual standard and implies a greater autonomy of central banks. Thus, like the major central banks around the world, Moroccan law n° 76-03 empowers the Bank Al-Maghrib on the conduct of monetary policy and endowed legal means to conduct surveillance and security systems and payment instruments (BAM site, Home, portal).

One major consequence of the revision of the statutes of the BAM is the abolition of financial assistance granted by that institution to the Treasury to finance the budget deficit.

Indeed, Article 6 of the new status of Bank Al-Maghrib, in operation since 2006, stipulates that: "the objective of monetary policy is to ensure price stability." This is a primary objective of monetary policy assigned to the modernized institution. What about international practices? The Fed mandate is "dual" because it gives equal priority to the fight against inflation as well as support to economic growth and employment. But the mandate of the BAM, as the ECB, is more "hierarchical", because its primary mission is price stability.

However, despite the modernization of monetary policy, the economy remains heavily dependent, for its financing, on the banking system. It has experienced significant movements of concentration and restructuring in the late 1990s. Since the Banking Act of 1993, BAM has played an active role in providing the necessary reforms to Morocco for a banking sector strengthened further. Such restructuring should allow for moreefficiency in the financing of the national economy and also to cope with competition, particularly European, in view of its complete liberalization by 2012.

In 2006, the three largest banks held about 57% of the credit market; this share was only about 26% in 2004. Given the concentration movement known as the credit market in Morocco, it begs the question on its real scope for some borrowers ([1]).This restructuring has apparently not led to greater competition for customers, such as households and SMEs.

Also, to facilitate the financing of the Moroccan economy through alternative channels of bank loans, BAM has profoundly modernized Moroccan money market by opening private issuers and creating Securities Division (TCN). Now, private operators are on the money market, in addition to treasury bills, virtually all international standards instruments: certificates of deposit issued by banks, bills finance companies and commercial paper issued by not financial companies.

But money market modernization could not have been donewithout the Moroccan Treasury. Indeed, by 1989, the Treasury, like the current practices in OECD countries, introduced the technique of the award for his bills, ensuring competition between underwriters to finance government deficits by borrowing. The subscription of treasury bills has been extended gradually over time, to all investors. At the beginning, only banks were allowed to award. Gradually, the market was open to financial institutions, insurance companies, then to the public and private companies, since 1995, finally, individuals and non-residents.

It should be noted, moreover, that the Casablanca stock exchange which is the main channel of direct funding has lived during the 1990s, modernization. Since 1993, the Moroccan Stock Market has adopted various measures and reforms aimed at creating conditions for efficiency and transparency needed to promote direct financing of the national economy by raising capital.

However, despite the modernization of the Casablanca Stock Exchange since 1993, it is clear that the financing of the Moroccan economy remains heavily dependent on bank loans (bank-based). Loans of banking institutions are the main source of funding for our economy; they represent more than 80% of GDP.

As an illustration of this, in July 2008, loans of bank has been an annual increase of just over 25%. In this financing of the Moroccan economy, production and investment companies receive the highest proportion of bank loans.The dynamismof construction sector and public works and services is that they absorb the good part.

II-2 From monitoring of monetary aggregates to multi-criteriaapproach

In the modernizing of Moroccan banking and financial system, Bank Al-Maghrib has been known to evolve since the 1980s, the instruments of monetary policy. It was based, since independence, the direct control methods such as credit restrictions, which limited the rate of money creation, and the rediscount ceilings for banks to automatically refinance at fixed rates with Central Bank. Thus, by this mechanism, commercial banks provided the credit necessary to the functioning of the Moroccan economy.

Let’s note that, before its independence, the operational framework for monetary policy in BAM was to have as a reference monitor the progress of a monetary aggregate for which it set a standard for growth in a range determined atthe beginning of each year.

This strategy is based theoretically on the assumption of stable money demand function. However, since the seminal work of Friedman (1959),Meltezr (1963) and Chow (1966), abundant empirical studies in developed countries and least in developing countries have most often led to rather contradictory results on stability of money demand function.

In the few studies conducted on the aggregates in Morocco ([2]), conclusions about the stability of the narrow aggregate M1 and the broad aggregate M3 is also a controversial author to another. In their majority, they explain this instability by the monetary and financial reforms undertaken by Morocco since the 1990s and by financial innovations that they have induced. The empirical study by H. Baddi (2010) on the function of money demand in Morocco between 1983 and 2007, on quarterly data, concluded that instability of the broad aggregate M3 and the stability of the narrow aggregate M1.

Because of this instability which seems to have concerned either as M3, or M1, the monetary authorities in Morocco have taken as an indicator M3 through until 1998 and then selected M1 from 1999 under its stability, and finally return to the M3 in 2006.

Since then, BAM has adopted a comprehensive strategy based on a multi-criteria approach. Now, the inflation risk is diagnosed through the following five elements: the evolution of aggregate demand pressures on production capacity, monetary conditions and asset prices, the import price and predicting the inflation (BAM site, home, portal).

While in the 1970s, the policy of quantitative monetary targets was used in a number of countries like Germany, France, Switzerland, United Kingdom, Canada, Japan and USA, since 2003, this strategy is hardly news. It is true that the ECB had his debut set at 4.5% growth rate of M3 as a reference value for monetary growth. But it was found during the 2000s, the actual growth rate of M3 was more than twice its reference value at times. It was 11-12% in autumn 2006, for example.However, the rate of inflation in the euro area has remained close to the target set by the Maastricht Treaty of 2%. This led, in May 2003 the ECB to establish a new monetary policy strategy that relies more on the two pillars, but on an "economic analysis" and "monetary analysis" or the reference value reference to the growth of M3 is no longer valid.