Why implement unconventional policy measures? (2)

KEYNOTE LECTURE AT THE INTERNATIONAL CENTER FOR MONETARY AND BANKING STUDIES (ICMB),
GENEVA, 28 APRIL 2009

Why implement unconventional policy measures?

Let me start with the first question: why and when do central banks need to resort to unconventional policy measures?

Let me first clarify what we mean by ‘conventional’ measures. Nowadays, monetary policy mainly acts by setting a target for the overnight interest rate in the interbank money market and adjusting the supply of central bank money to that target through open market operations. To minimise the risk exposure of the central bank’s balance sheet, all liquidity-providing operations normally take place in the form of reverse transactions against a menu of eligible collateral. In other words, in normal times the central bank is neither involved in direct lending to the private sector or the government, nor in outright purchases of government bonds, corporate debt or other types of debt instrument. By steering the level of the key interest rates, the central bank effectively manages the liquidity conditions in money markets and pursues its primary objective of maintaining price stability over the medium term. This has proved to be a reliable way of providing sufficient monetary stimulus to the economy during downturns, of containing inflationary pressures during upturns and of ensuring the sound functioning of money markets.

But in, so to speak, abnormal times conventional monetary policy tools may prove insufficient to achieve the central bank’s objective. Generally, there may be two reasons for this.

• First, the economic shock is so powerful that the nominal interest rate needs to be brought down to zero. At that level, cutting policy rates further is not possible, so any additional monetary stimulus can be undertaken only by resorting to unconventional monetary policy tools. Broadly speaking, the additional monetary stimulus when the policy interest rate is at zero can be achieved in three complementary ways: (i) by guiding medium to long-term interest rate expectations, (ii) by changing the composition of the central bank’s balance sheet, and (iii) by expanding the size of the central bank’s balance sheet.   All of these measures have one element in common: they are designed to improve financing conditions beyond the very short-term interbank interest rates.
• Second, non-conventional measures may be warranted even when the policy interest rate is above zero if the monetary policy transmission process is significantly impaired. Under these circumstances, central banks have two (not necessarily mutually exclusive) alternatives, namely (i) to reduce the short term nominal interest rate even further than in normal conditions, and (ii) to act directly on the transmission process by using non-conventional measures.

The experience of the past year and a half – a very stressful time for the global financial system – have shown that non-standard tools might be needed even before policy rates have been cut to their lower bound. When the turmoil started in summer 2007 and central banks worldwide stepped in to provide additional liquidity to financial markets, it appeared that conventional measures could still do the job. Although markets were not operating normally, far from it, tensions in the euro area interbank market were considerably eased by supplementary longer-term refinancing operations. But things changed as the crisis intensified in September and October last year. Shortly after the collapse of Lehman Brothers, the spread between the three-month Euribor and the overnight interest rate EONIA – which in normal times would on average be around 10 basis points – rose to an all-time high of 156 basis points on 13 October. Market liquidity virtually dried up, and the sudden loss of confidence among market participants threatened to have a lasting effect on the orderly functioning of the euro area money market.

Under these circumstances, easing monetary policy by simply lowering official interest rates would not have been enough. Whenever the transmission channel of monetary policy is severely impaired conventional monetary policy actions are largely ineffective. Any policy decision therefore needed to take account of the extraordinary situation in money markets. Central banks have different tools to cope with the extraordinary situation in interbank markets, and their choice largely depends on institutional characteristics, but not only. The situation of the banking sector and the types of shock hitting it are also important. So while it is tempting to draw cross-country comparisons among such non-conventional measures, it is also rather misleading.

An issue to consider when implementing non conventional policies is the risk of hindering the functioning of markets by substituting or interfering with them. Agents’ refinancing needs may become excessively dependent on operations settled with the central bank. In other words, financing conditions may become overly attractive as a result of central bank operations and may crowd out other channels, reducing the incentives for restarting normal market conditions.