Unconventional Monetary Policy: Direct Quantitative Easing (4)

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

How are unconventional measures implemented?

1 Direct Quantitative Easing

2 Direct Credit Easing

3 Indirect (or Endogenous) Quantitative/Credit Easing

1 Direct Quantitative Easing

When the central bank decides to expand the size of its balance sheet, it has to choose which assets to buy. In theory, it could purchase any asset from anybody. In practice, however, quantitative easing has traditionally focused on buying longer-term government bonds from banks. The idea is twofold: first, sovereign yields serve as a benchmark for pricing riskier privately issued securities. When long-term government bonds are purchased, the yields on privately issued securities are expected to decline in parallel with those on government bonds. Second, if long-term interest rates were to fall, this would stimulate longer-term investments and hence aggregate demand, thereby supporting price stability.

This is where banks play a critical role in the success of any quantitative easing policy. If the aim is to ensure that new loans are provided to the private sector, central banks should mainly purchase bonds from the banks. The additional liquidity would then be used by the banks to extend new credit. However, banks may choose to hold the liquidity received in exchange for the bonds in their reserves at the central bank as a buffer. In this case, the liquidity provided by the central bank remains within the financial sector; it does not flow out of it. This risk can be minimised if the central bank conducts this type of operation only at the lower bound – that is, when it has fully exploited the standard interest rate channel. At the lower bound the remuneration of deposits is null (or almost null) and there is hence little or no incentive for banks to park excess reserves with the central bank. Deploying a policy of quantitative easing at a policy rate different from the lower bound may necessitate a larger expansion of the central bank’s balance sheet and thus increase the risk exposure of the monetary authority.

In light of the above considerations, the soundness of the financial system is critical to the success of quantitative easing. When banks stop intermediating loans, this policy no longer works. Quantitative easing is successful if it narrows the market spreads between the rates paid on selected credit instruments and policy rates, thereby limiting the risks of a liquidity shortfall and encouraging banks to extend credit to higher interest-paying parties.

The Bank of Japan’s policy between 2001 and 2006 provides one example of quantitative easing. It had the following key features: first, it involved a shift in the operational target for money market operations from the uncollateralised overnight call rate to the outstanding balance of current account deposits at the Bank of Japan, or in short the bank reserves; second, it entailed outright purchases of Japanese government bonds to meet the target balance of current account deposits at the Bank; and third, it involved an explicit, public commitment to maintain these open market operations until the CPI did not fall on a sustainable basis.

During that period, the Bank of Japan had discussions with academics about strategies for avoiding prolonged deflation. These talks repeatedly gave rise to one particular question: why didn’t the Bank of Japan simply allow the yen to depreciate in order to stop the fall in consumer prices? This is the essence of Lars Svensson’s prominent suggestion of ‘The Foolproof Way’ out of deflation.  But if it were so simple, why did the Japanese authorities apparently fail to take the necessary measures to prevent deflation? The answer is: it wasn’t that simple. What ‘The Foolproof Way’ underestimates is the enormous difficulty of turning around expectations of prices and economic activity when the functioning of the financial system is seriously impaired. The failures to restructure Japan’s financial and corporate sector and to recapitalise banks have been widely documented as key reasons for the country’s anaemic growth rates and declining prices  – factors over which the Bank of Japan had little control.

Let me just add something on that matter: ‘The Foolproof Way’ wouldn’t work in today’s context either. Given the global dimension of the current financial crisis, it would not be possible for all countries to depreciate their currencies at the same time in order to push inflation up. Such a beggar-thy-neighbour policy would be ineffective in the present circumstances; worse, it would aggravate them by unleashing a protectionist backlash. In fact, the leaders of the G20 recently agreed to refrain from competitive devaluation of their currencies, and it is important to stick to this objective in both words and deeds. Although not all countries belong to the G20, I am confident that all advanced economies will comply with this principle.

There are some important lessons we can learn from the experience of quantitative easing in Japan:

• To begin with, it cannot be taken for granted that an increase in the monetary base results in easier monetary conditions. In fact, the money multiplier has significantly decreased during the last decade. This has, to a certain extent, reduced the effect of injecting money into the economy. 
• Second, as mentioned before, the banking system is crucial for the success of a quantitative easing policy.  However, given the high degree of de-leveraging which the Japanese economy, and the banking sector in particular, was undergoing, banks did not find themselves in a position to pass on the additional liquidity to the non-financial sector.
• Third, one of the expected effects of quantitative easing is a flattening of the yield curve at longer maturity which improves the medium to longer-term financing conditions for the private sector. But what ultimately matters for investment and spending decisions is the real interest rate and hence inflation expectations. Strictly speaking, an increase in the money supply should have implications for the expectations of the future price level. But quantitative easing will only affect expected inflation if the increase in the size of the central bank’s balance sheet is not only sizeable but also perceived as being permanent.  The experience of the Bank of Japan provides a clear-cut example of a temporary expansion of the monetary base that did not affect private sector inflation expectations.
• Fourth, it is not clear how it is possible to increase inflation expectations in a significant way while avoiding a rise in the nominal long-term interest rate after some time. Setting the real long-term interest rate as the operational target for monetary policy seems to be rather challenging in an environment with developed financial markets.
• Fifth, if quantitative easing is perceived as being long-lasting then it could also have an expansionary effect by relaxing fiscal constraints. Expansionary fiscal policies represent a sound instrument to stimulate aggregate demand during a deflationary period. In this respect, outright purchases of government bonds by the monetary authority could further strengthen fiscal effects i) by accommodating the supply of governments bonds, ii) by affecting the long-end of the yield curve - the risk premium - and iii) by re-anchoring inflation expectations to a positive target. In particular, the transition to a positive inflation regime reduces the burden on the future fiscal budget by guaranteeing its financial sustainability.  Of course, the relevance of this effect crucially depends on the duration of the quantitative easing policy and on a credible commitment to a well-defined exit strategy. In this respect, the broad effects stemming from the fiscal and monetary policy mix have been quite muted in stimulating the Japanese economy.
• Finally, it should be recognised that a government bond purchasing programme involves the risk of accumulating significant losses for the central bank. Government bonds would be purchased at rather high prices. If the easing measure turned out to be a success, the ensuing economic recovery would gradually entail an increase in long-term interest rates; this would bring down government bond prices, so that the central bank would eventually face losses. Concerns about central bank’s balance sheet and financial independence can seriously impede monetary policy.  Such constraints may be one reason why the Bank of Japan’s government bond purchasing programme has failed to restore positive inflation rates.

Let me also mention that in the context of the euro area the design of such unconventional policy measures poses some intricate challenges, due to its unique institutional framework. In the first place, we need to be mindful of the Treaty requirements relating to the prohibition of monetary financing and the granting of privileged access, as well as of the consistency with the Treaty principle of open market economy and the preservation of the disciplining function of markets for borrowers and lenders.  Although purchases of government bonds are possible in the secondary market, there is a risk to eventually become a market maker for public debt, which could be construed to be against the Treaty prohibition of monetary financing. Moreover, we have more than just one fiscal authority in the euro area. The Eurosystem would have to decide how to spread purchases of government bonds across euro area countries. If, for example, the Eurosystem only concentrated on public bonds with the best credit rating, it would risk providing privileged access to some countries, contravening Article 102 of the Treaty. If it spread purchases according to a specific key and ended up affecting cross-country differences in yields, it would be seen as granting privileged access, as financing conditions for some governments would be supported to a greater extent than for others. It may also be the case that the risk-free component of corporate bonds would not move exactly in tandem with the risk-free component of government bond yields. This would be tantamount to giving preferential treatment to government debt. These issues would need to be addressed before implementing a government bond purchasing programme in the euro area.

Main characteristics of unconventional measures (3)

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

 

Main characteristics of unconventional measures

When conventional tools can no longer achieve the central bank’s objective, policy-makers are confronted with a number of issues.

• First, the unconventional tools include a broad range of measures aimed at easing financing conditions. Having this menu of possible measures at their disposal – which are not mutually exclusive ones – monetary policy-makers have to clearly define the intermediate objectives of their unconventional policies. These may range from providing additional central bank liquidity to banks to directly targeting liquidity shortages and credit spreads in certain market segments. The policy-makers then have to select measures that best suit those objectives.
• Second, they should be wary of the possible side-effects of unconventional measures and, in particular, of any impact on the financial soundness of the central bank’s balance sheet and of preventing a return to a normal market functioning.

In general, unconventional measures can be defined as those policies that directly target the cost and availability of external finance to banks, households and non-financial companies. These sources of finance can be in the form of central bank liquidity, loans, fixed-income securities or equity. Since the cost of external finance is generally at a premium over the short-term interbank rate on which monetary policy normally leverages, unconventional measures may be seen as an attempt to reduce the spreads between various forms of external finance, thereby affecting asset prices and the flow of funds in the economy. Moreover, since these measures aim to affect financing conditions, their design has to take into account the financial structure of the economy, in particular the structure of the flow of funds. Let me elaborate on the possible measures.

One way to affect the cost of credit would be to influence real long-term interest rates by impacting on market expectations. Expectations may work through several channels. For instance, the central bank can lower the real interest rate if it can induce the public to expect a higher price level in the future.  If expected inflation increases, the real interest rate falls, even if the nominal interest rate remains unchanged at the lower bound. Alternatively, policy-makers can directly influence expectations about future interest rates by resorting to a conditional commitment to maintain policy rates at the lower bound for a significant period of time.  Since long-term rates are prima facie averages of expected short-term rates, the expectation channel would tend to flatten the entire yield curve when policy-makers commit to stay at the lower bound. Moreover, a conditional commitment to keep the very short-term rate at the lower bound for long enough should also prevent inflation expectations from falling, which would otherwise raise real interest rates and curtail spending. In either case, if the management of expectations is successful, it would – ceteris paribus – reduce the real long term rate and hence foster borrowing and aggregate demand.

Another way in which the central bank can influence the cost of credit is by affecting market conditions of assets at various maturities – for instance, government bonds, corporate debt, commercial paper or foreign assets. Two different types of policies can be considered. The first aims at affecting the level of the longer term interest rate of financial assets across the board, independently of their risk. Such type of policy would operate mainly by affecting the market for risk free assets, typically government bonds. This policy is typically known as ‘quantitative easing’. The second policy is to affect the risk spread across assets, between those whose markets are particularly impaired and those that are more functioning. Such a policy would be usually referred as ‘credit easing’. The two types of policies affect differently the composition of the central bank’s balance sheet.  Another difference is that ‘credit easing’ can generally be conducted also at above-zero levels of the short-term nominal interest rate, while quantitative easing should make sense only when the interest rate is at zero or very close to zero. However, both operations aim at increasing the size of the central bank balance sheet and therefore expanding its monetary liabilities.

Let me now consider quantitative easing and credit easing in turn.

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.

Conventional and Unconventional Monetary Policy (1)

Keynote lecture at the International Center for Monetary and Banking Studies (ICMB),
Geneva, 28 April 2009

The escalating financial crisis since last autumn of 2008 has pushed the theme of conventional and unconventional monetary policy to centre stage. 

Central banks throughout the world have been responding to the crisis by taking both 

• conventional and 
• unconventional policy measures. 

It is important to have a 

• good understanding of the unconventional policies and 
• how they differ from the conventional ones.

To understand, focus on four groups of questions:

1.  First, why and when should central banks resort to such measures? 

There is no tried-and-tested timetable or sign-posted pathway for moving from conventional to unconventional measures. For instance, an issue to consider is whether unconventional measures should or can be implemented 

• only after the nominal short-term interest rate has reached its lower bound and while downside risks to price stability prevail, or 
• be adopted while interest rates are still positive.

2.  Second, what are the main characteristics of unconventional measures?

3.  Third, how are unconventional measures implemented if and when they are needed? 

To answer this question, we have to distinguish between different types of unconventional measures, 

• from quantitative easing 
• to credit easing. 

Each measure has different effects and counter-effects, depending on the structure of the financial system or other factors.

3.  Fourth, how and when do central banks need to unwind the extra monetary stimulus? 

By definition, unconventional measures are not what is generally done, so they are not supposed to become the standard mode of monetary policy. When deciding on them, monetary policy-makers have to think ahead and ask themselves: 

• “We can get in, but how do we get out?” 
• They need to consider carefully the timing of their withdrawal of such monetary measures – for there are risks in doing it too early, and there are risks in leaving too late.