Week 5 - Unconventional tools of monetary policy

Question 1

Conventional tool of monetary policy

Answer 1

The policy rate, which influences short-term interest rates
eg. Federal funds rate (=interest rate in MARKET RESERVE in the US), bank rate (UK)
- Policy rates were stuck at 0 after the financial crisis.

1. The Federal Reserve intervenes in the reserve by creating lots of reserves, so that banks w/ shortage of reserves like JPM can borrow & can avoid paying high interest rates charged by Bank of America, eg.
2. Now that excess supply > demand, the Fed can push down Fed funds rate. Cost of funds for banks is now lower, reserves for banks are now cheaper to borrow.
3. Can pass on lower cost to firms & households when they’re making loans, ie. charge them lower (short-term) int rates.

*Funding for these loans have only SHORT-TERM MATURITY (overnight maturity)! Fed might change int rates.
Therefore, banks only use these reserves for SHORT-TERM LENDING b/c long-term lending will expose bank to interest rates risk.

Question 2

Why were policymakers forced to implement unconventional tools of monetary policy to provide additional economic stimulus? And what is the difference between conventional vs unconventional tools?

Answer 2

1. Long-term interest rates were significantly above zero
2. Conventional monetary policy no longer effective b/c already reached ZERO LOWER BOUND.
3. Quantitative easing & Forward guidance were designed to decrease LONG-TERM INTEREST RATES, ie. flatten the yield curve

Question 3

Quantitative easing (QE) + 3 overall effects

Answer 3

1. QE is Asset purchases from the private sector (mostly commercial banks) financed by central bank money creation, ie. by CREATING ADDITIONAL RESERVES
   - Assets purchased were mostly govt bonds, but also corporate & MBS bonds
2. Reserves are a component of the MONETARY BASE, hence QE increases the money supply
3. Goal: this new money would eventually BOOST LENDING to firms & households, boost AD & consumption, lift economy out of recession,
   ie. boost PRIVATE SECTOR SPENDING
   - Banks are incentivised to lend out reserves now that they have access to the extra reserves, b/c they earn only little interest by keeping in CB

Overall, QE leads to a fall in govt bond yields, fall in corp. bond yields, fall in bank loan rates

*Monetary base = CB’s liabilities = Commercial banks’ reserves + Currency in circulation

Question 4

Yield on a long-term government bond must match __

Answer 4

Yield on a LT govt bond must match the average of policy interest rates expected over the lifetime of the bond
- to ensure that the bond is attractive to investors, or else more attractive to save money in the bank

Question 5

Axes of the bond yield curve + What does it mean if the yield curve is upward sloping?

Note: The slope of the yield curve is a powerful tool for predicting the future path of monetary policy.

Answer 5

Yield (%) against maturity

1. Markets expect BoE to increase policy rates in the coming years
2. Markets “price in” this information, investors trade on this info (ie. sell LT bonds), demand<supply, bond price falls, so bond yield increases until = interest rates investors can get in bank account
   > Hence yield curve slopes upwards

Question 6

Even when markets are predicting interest rates to stay flat, ie. even when the BoE is not planning on tightening monetary policy, yield curve will still be upward-sloping. Why?

Answer 6

Reflects INTEREST RATE RISK
- Interest rates are higher on long term bonds than short term bonds b/c LT bonds are RISKIER than ST bonds,
- due to greater UNCERTAINTY over the future path of the policy rate.
- Hence, investors require a LIQUIDITY PREMIUM (ie. a higher return) to induce them to hold the bonds

Interest rate risk = Risk of price fluctuations due to unexpected changes in int rates.

Question 7

2 aspects on how falling government bond yields feed through to the real economy

Answer 7

Through the PORTFOLIO RE-BALANCING CHANNEL
ie. changing the mix of assets held by the private sector

1. General equilibrium effect (draw Corporate bond market beside Govt bond market)
   - Due to QE, yield of LT govt bonds has fallen, investors are getting a low return. So they move their money OUT of govt bonds and into corporate bonds that are paying a higher return.
   - Supply for corporate bonds increases, supply>demand, bond price increases so CORPORATE YIELD FALLS.
   - Investors continue moving out of govt bonds to corp bonds UNTIL the yields of both assets are perfectly EQUALISED, so that investors no longer have any incentive to switch.
   - Achieved general eqm. NO-ARBITRAGE CONDITION
   ^Good b/c decreases borrowing cost for firms, boosting private sector spending
2. Market for bank lending
   - Banks use excess reserves to buy private sector assets, eg. corporate bonds, & lend to firms for investment & households as mortgages (again since keeping reserves in CB hardly pays interest)

Question 8

Government bond market
1. From where does the demand for funds arise?
2. Why is the demand curve vertical?
3. What happens when CB injects additional funds to the market?
4. What are the effects of QE?

Answer 8

1. Demand for funds comes from the govt seeking to finance its BUDGET DEFICIT
2. It is independent of interest rates, only depends on size of budget deficit & incentives, hence vertical
   - If govt wants to borrow more, demand curve shifts to the right.
3. Supply curve shifts to the right…
4. …causing supply of funds>demand. Interest rates need to fall, investing in govt bonds becomes less attractive. Investors exit market and SUPPLY FALLS until converge at new eqm, where eqm INTEREST RATE / long-term govt bond yield has FALLEN.

Question 9

A bank, eg. Barclays has 3 choices for using their excess reserves: buy govt bonds, buy corporate bonds, or increase bank lending to firms & consumers. What would it choose and why?

Answer 9

Choose to INCREASE BANK LENDING because return on bank lending (bank rate) is unchanged, still high
- QE decreased govt bond yields
- General equilibrium effect decreased corporate bond yields

Draw (Bank rate vs Q) beside (Corporate yield vs Q)

Therefore, rightward shift in supply of credit > demand, BANK LOAN INTEREST RATE DECREASES, cost of borrowing for firms decreases, inducing firms to borrow more. Consumers also borrow more.
- Again, boost investment & consumer spending, boost AD, stimulate economy.

Question 10

Forward guidance

Answer 10

An implicit commitment by the central bank to hold POLICY RATES at a lower level than required to meet the inflation target, in order to DEPRESS LONG-TERM YIELDS…
(targetting unemployment instead of inflation)

…by depressing market expectations of future interest rate rises
ie. same purpose as QE so FG was implemented to reinforce the effectiveness of QE & prevent further TAPER TANTRUMS (= when Fed Chairman informed that he may unwind QE / scale down Fed QE asset purchases)

^a way to calm the markets that the Fed won’t increase int rates anytime soon
- Unwinding QE means bond yields would rise, so markets reacted by selling govt bonds before they made a capital loss. Bond prices fell & bond yields increased - bad for the economy.

Question 11

What is the problem with Forward guidance?

Answer 11

Time inconsistency.
1. - FG implicitly pledges to keep short-term int rates at a lower level than required (to meet the inflation target) for a long time, in order to DEPRESS LONG-TERM YIELDS…
- As soon as economic recovery is underway, BoE is tempted to RAISE INTEREST RATES to CURB INFLATIONARY PRESSURES.
- Markets anticipate this and price in this info in int rates. So yield curve does not flatten as much as desired, long term borrowing costs don’t fall {much} → economy doesn’t recover as quickly as hoped.

Question 12

Suppose the UK yield curve is downward-sloping (known as an inverted yield curve). What does this tell us about the expected path of UK monetary policy?

Answer 12

1. Long term yields (on say, 10 year bonds) are LOWER than short term yields, which means the sequence of expected policy rates averaged over the next 10 years is lower than currently.
2. Hence, markets are expecting BoE to DECREASE POLICY RATES in the COMING YEARS.

Question 13

How might the use of QE boost the credibility of a forward guidance policy? (from PS5)

Answer 13

since the central bank is EXPOSING ITSELF to the RISK of a RISE in interest rates through its holdings of long term bonds

Question 14

How did Japan’s experience of QE in the 2000s shape Fed Chair Ben Bernanke’s thinking on how best to implement QE in the US? (from PS5)

Answer 14

1. QE was largely ineffective in Japan because banks simply HOARDED the excess reserves created by QE rather than lending them out to firms and households. 2. This influenced Bernanke to BUY PRIVATE SECTOR ASSETS instead of government bonds, hence directly decreasing corporate bond and mortgage rates. {b/c supply of funds in corp. bond market shifts right}
2. This injected money DIRECTLY into the pockets of firms and households, effectively cutting out the MIDDLEMAN.

Question 15

The authors mention that “the gains from asset purchases would seem to be clearest and largest in the euro area”.
2 reasons why the ECB was so slow to adopt QE (from PS5)

Answer 15

1. Concerns about INFLATIONARY consequences.
   - If QE is not eventually REVERSED by the central bank by selling off its asset purchases, then this is equiv. to
   debt monetisation: the central bank finances the government’s budget deficit through additional money creation.
   - This implies permanent expansion of the MONEY SUPPLY (AD keeps increasing) which pushes up inflation in the long run.

[2019 paper didn’t use this point]
2. Could raise concerns about the CENTRAL BANK’S INDEPENDENCE,
- i.e. is the government putting pressure on the central bank to monetise the debt in order to lower the cost of budgetary finance?
- This could UNDERMINE ANCHORING of INFLATION EXPECTATIONS

+ ECB also not allowed to go directly to corporate bond markets.
» Although the ECB is prohibited by law from direct monetary financing of member states government debt,&raquo_space; it may buy debt in the secondary markets

Question 16

In her 2016 Conservative Party Conference speech, Prime Minister Theresa May criticised QE for increasing wealth inequality in Britain. What did she mean by that? (from PS5)

Answer 16

1. QE aims to INCREASE ASSET PRICES through the portfolio re-balancing channel.
2. But this primarily benefits individuals who hold the assets, ie. they are already WEALTHY
3. Less accessible for those who are asset poor and still seeking to buy (in particular property).
   - poor ppl stay the same, wealth inequality gap increases

Question 17

What risks does the eventual reversal of QE assets purchases pose for the economy? (from PS5)

Answer 17

1. If reversal does eventually occur, it is expected to put upward pressure on yields and may have unpredictable consequences such as a “TAPER TANTRUM”.
2. However this would be LESS PROBLEMATIC if it is delayed until the economy is RECOVERING firmly, and also the increase would be much less than the amount by which the purchases pushed down on yields because markets would be functioning more normally at that stage.
   - This is also likely to be offset by banks buying government bonds to build up their liquidity buffers.

Question 18

The Bank of England has recently announced it will start tapering its quantitative easing (QE) programme of asset purchases. What do you think will be the effects on long term government bond yields, corporate bond yields and bank loan rates? (Illustrate your answer graphically).

[20m, Specimen paper]

Answer 18

1. The Bank of England decreasing its purchases of government bonds means that the supply of funds shifts left and government bond yields increases.
2. Investors switch out of corporate bonds into higher-yielding government bonds, which continues until the no arbitrage condition holds and the yields are equalised.
3. Commercial banks have depleted their reserves by buying up government bonds from the Bank of England, so they choose to cut lending to firms to boost their reserves (given that bank lending rates are now lower than both corporate and government bond yields).
4. Hence, the supply of credit shifts left increasing bank lending rates.
5. Additionally, firms switch out of expensive corporate bond issuance and into cheaper bank borrowing, hence the bank lending rate increases further and corporate bond yields decrease until the two are equalised and firms no longer have an incentive to switch.

Question 19

What does the Fed do if it goes ahead with the Reversal of QE asset purchases?

What do commercial banks do when they have depleted their reserves by buying up govt. bonds from the Fed?

[Qs inspired from 2020 paper]

Answer 19

1. The Fed would start SELLING govt. bonds
   - SUPPLY of funds shifts LEFT
   - govt. bond yields increase
2. When commercial banks have depleted their reserves by buying up govt. bonds from the Fed,
   - they choose to CUT LENDING to firms to BOOST their reserves
   - (given that bank lending rates are now lower than both corporate & govt. bonds yields)