Unconventional Monetary Policy

Question 1

conventional monetary policy

Answer 1

targeting short-term interest rates (OMOs) such that it kick starts the economy

Question 2

why is conventional monetary policy limited?

Answer 2

negative nominal interest rates are a tax on depositors / investors and can be avoided through hoarding cash (therefore irrational)

even if there is not a zero lower bound for interest rates, there is some lower bound that limits the use of monetary policy to stimulate demand in deep recessions

negative interest rates might cause collapse of banking system by extracting money

Question 3

why is fiscal policy a limited alternative to support demand in deep recessions?

Answer 3

fiscal policy is an alternative way to support demand in deep recession but the scope is limited due to rising debt ratios - government contributions to demand now being reduced

Question 4

what was the initial CB response to the 2008 financial crisis?

Answer 4

started with conventional policy response

started with CBs broadening their traditional lender-of-last-resort (LOLR) functions

starting in 2008, CBs around the world began reducing short-term interest rates in response to the recession

e.g. 8th October 2008, CBs of Canada, China, Euro area, Sweden, Switzerland, UK and US all undertook a coordinated rate cut

but this conventional response was insufficient due to the ZLB being reached on 16th December 2008

Question 5

when was the ZLB hit in the 2008 financial crisis?

Answer 5

16th December 2008

Question 6

when did the CBs of Canada, China, the Euro area, Sweden, Switzerland, the UK and the US undertake a coordinated interest rate cut?

Answer 6

8th October 2008

Question 7

what was unconventional monetary policy originally a response to?

Answer 7

unconventional monetary policy was a response to the Great Recession of 2008/9 when conventional policy responses were insufficient

Question 8

who splits unconventional monetary policy into two categories?

Answer 8

Bowdler & Radia, 2012

Question 9

what are the two categories Bowdler & Radia, 2012 split unconventional monetary policy into?

Answer 9

‘conventional unconventional monetary policy’
AND
‘unconventional unconventional monetary policy’

Question 10

what policy is classed as conventional unconventional monetary policy?

Answer 10

quantitative easing (QE)

Question 11

what policies are classed as unconventional unconventional monetary policy?

Answer 11

forward guidance

qualitative easing (balance sheet composition)

credit easing (easing banks’ credit constraints)

Question 12

what is forward guidance?

Answer 12

FG is a signal about future policy paths, providing information to the market

extended period language, linking rates to numerical targets for unemployment, inflation etc.

FG should lower market expectations for short-term rates into medium term which should flatten long end of yield curve and, given a stable external finance premium (EFP), deliver stimulus in private credit markets

Question 13

is forward guidance time-dependent or state-dependent?

Answer 13

both

time-dependent (extended period language)

state-dependent (linking rates to numerical targets)

Question 14

give an example of the extended period language of forward guidance.

Answer 14

as soon as the effective lower bound was reached in December 2008, the Federal Open Market Committee (FOMC) announced that the Federal Funds Rate (FFR) target was likely to remain unchanged “for some time” and then later in March 2009 for “an extended period” (Bowdler & Radia, 2012)

Question 15

how does forward guidance work to act as a stimulus to the economy?

Answer 15

FG should lower market expectations for short-term rates into medium term which should flatten long end of yield curve and, given a stable external finance premium (EFP), deliver stimulus in private credit markets

Question 16

how does credibility and belief in the CB affect the effectiveness of forward guidance

Answer 16

Yates (2003) outlines the clear benefits of the central bank’s policy intentions being believed

The more faith the private sector has in the CB’s ability and inclination to pursue its announced targets, the less interest rates have to be cut to counter the effect of a fall in demand

If the private sector expects rates to be cut, expected inflation will be higher than otherwise, and real rates therefore lower, and that will boost spending and inflation

Thus, more credible central banks are better able to weather large shocks without hitting the ZLB

Question 17

who outlines the clear benefits of the CB’s policy intentions being believed?

Answer 17

Yates, 2003

Question 18

is there evidence to support the effectiveness of forward guidance?

Answer 18

Woodford, 2012 offers a range of evidence to show that financial market measures of interest rate expectations generally respond to CB communications; however, financial markets have not fully priced in the cuts implied by the announcements

“central bank statements about future policy can, at least under certain circumstances, affect financial market” (Woodford, 2012)

Question 19

who provides evidence to support forward guidance?

Answer 19

Woodford, 2012

Question 20

what is the limitation to forward guidance?

Answer 20

credibility concerns via time-inconsistency critique, ‘commitment to irresponsibility’

once the economy begins to recover owing to the reduction in real rates that the CB’s promise had delivered, then there is no incentive for the CB to follow through on its promise

CB will have already reaped the rewards of its promise and will now find it optimal to return inflation to target rather than letting it remain above

if they do commit to irresponsibility then they are neglecting their often primary mandate of achieving the inflation target

any pledges on future actions inherently lack credibility as the CB cannot control future economic circumstances and cannot control future monetary policy committees and their personnel

Question 21

what is ‘commitment to irresponsibility’?

Answer 21

a limitation to forward guidance

once the economy begins to recover owing to the reduction in real rates that the CB’s promise had delivered, then there is no incentive for the CB to follow through on its promise

CB will have already reaped the rewards of its promise and will now find it optimal to return inflation to target rather than letting it remain above

if they do commit to irresponsibility then they are neglecting their often primary mandate of achieving the inflation target

any pledges on future actions inherently lack credibility as the CB cannot control future economic circumstances and cannot control future monetary policy committees and their personnel

Question 22

what is qualitative easing (balance sheet composition)?

Answer 22

CB can vary balance sheet composition to detoxify the market and twist the yield curve

Question 23

give an example of qualitative easing.

Answer 23

first Fed move in 2007/08 was to sell Treasury bonds & purchase privately issued bonds (e.g. asset backed securities) with aim of detoxifying the market (get rid of toxic debt/risky assets)

presence of toxic assets was inhibiting normal functioning of financial system so aimed to increase lending by cleansing market

related move was to offer CB loans against lower quality collateral and to financial institutions other than deposit-taking institutions

Operation Twist in 2012 involved Fed selling short-dated govt bills and investing proceeds in long bonds (to twist the yield curve)

Question 24

what was Operation Twist?

Answer 24

Operation Twist in 2012 involved the Fed selling short-dated government bills and investing the proceeds in long bonds to twist the yield curve

Question 25

what are the limitations of qualitative easing?

Answer 25

credible but constrained by the size of CB balance sheet (finite)

people had no idea what they were buying, so couldn’t work out the probability of default etc.

banks weren’t lending as they had to meet capital-equity ratios

Question 26

what is credit easing?

Answer 26

reducing bank funding costs in order to stimulate bank lending (Bowdler & Radia, 2012)

policies that were implemented to encourage banks to lend by making credit and liquidity more readily available

giving banks loans to ensure they don’t go under

Question 27

give evidence of credit easing.

Answer 27

National Loan Guarantee Scheme in 2011: aimed to reduce the risk to investors who commit capital to the banking sector through government guarantees for up to £20 billion of bank debt

Funding for Lending Scheme (FLS) in July 2012 by BoE and HM Treasury : BoE provide funding to commercial banks for up to 4 years

Question 28

what is the limitation to credit easing?

Answer 28

moral dilemma of rewarding those who caused the crisis

relies on banks to pass on the benefits to the rest of the economy

Question 29

what is quantitative easing?

Answer 29

QE involves the CB, in its role of monopoly issuer of currency, purchasing assets and injecting broad money into the economy on a large scale (Bowdler & Radia, 2012)

tries to directly affect the long-term interest rates which is important when at or near the ZLB as conventional monetary policy has no room to manipulate

CBs create new liabilities (cash reserves) and assets, so there is balance sheet expansion across all agents involved

can also be used as a signalling device in that it reveals information about the likely path of future monetary policy

Question 30

how much QE have the UK and the UK introduced?

Answer 30

addition to the monetary base - £435bn in UK
- $3trillion+ in the US

Question 31

can QE be used as a signalling device?

Answer 31

QE can be used as a signalling device in that it reveals information about the likely path of future monetary policy

by undertaking asset purchases, CB may demonstrate its commitment to its objectives and its confidence in achieving them at the ZLB

this may also help maintain credibility and keep inflation expectations anchored

Question 32

when was QE first adopted?

Answer 32

Adopted by Bank of Japan in early 2000s, BoE and Federal Reserve in 2009

Question 33

what distinguishes QE from standard open market operations?

Answer 33

QE has a radically different scale than what we’d expect of regular OMOs
- in regular OMOs, the extent of any creation of new money and purchase of assets would be limited (finite intervention)
- in QE, scale of intervention is bigger & potentially unlimited
- e.g. FED committed to $120 billion of asset purchases every month until US unemployment rate came below critical level

QE is distinguished from conventional monetary policy because it involves the CB seeking to directly affect asset prices, e.g. longer-term gilt yields rather than short-term interest rate (Bowdler & Radia, 2012)
- contrasts conventional policy, which focuses on setting the short-term interest rate, which in turn affects long-term interest rates through expectations of future short-term interest rates

QE takes place when the policy interest rate is at / near the ZLB

QE brings new and unknown risks
- commitment to buy the bond in bigger volumes and to hold them for longer periods. If you do those two things then there’s a bigger chance that eventually when you do dispose of these assets as a central bank, you’re going to sustain a financial loss

Question 34

what are the five stages of the portfolio rebalancing channel of QE?

Answer 34

1. QE leaves private investors long in cash that yields a low return and short in positive yield assets
2. thus, rebalance portfolios towards corporate bonds & equities
3. IR on corporate bond is coupon/price and equities is dividend/price. These IR are positive even when CB at ZLB
4. portfolio rebalancing from QE drives up corporate bonds & equities, depressing IR in shadow banking sector
5. facing lower financing costs in shadow banking sectors, corporations are better able to engage in hiring, investing, etc

Question 35

what does the portfolio rebalancing channel depend on?

Answer 35

critically depends on the incentive of major investors to rebalance their portfolio in the aftermath of the QE intervention

Question 36

what are the caveats to the portfolio rebalancing channel?

Answer 36

in times of recession, there might be heightened liquidity preference, in which case all that the QE is going to do is meet the liquidity demand of major investors, and things will stop there (won’t be any knock on effects in terms of the costs of private finance and the potential benefits of that in the real economy)

portfolio rebalancing may be limited by regulatory constraints on assets investors hold (e.g. pension funds required to hold gilts) or by high levels of investor risk aversion
- regulations facing pension funds and insurance companies (e.g. capital requirements and requirements to hold a certain share of sovereign debt) may limit abilities to re-orientate their portfolios away from government bonds (Bowdler & Radia, 2012)

small firms and households will not benefit directly, only indirectly if large corporations choose to spend the gains from cheaper finance

strength of any portfolio rebalancing channel depends on degree of substitutability between assets (Bowdler & Radia, 2012)

if portfolio rebalancing fails then QE used to purchase government bonds will result in a fall in the velocity of circulation of money rather than a surge in inflation

Question 37

explain QE as a commitment / signalling technology.

Answer 37

QE can be interpreted as a way of committing to very lax monetary conditions for an extended period (information revealed about the likely path of future monetary policy)

QE raises the narrow, and ultimately the broad money supply, so that there is an excess supply of liquidity in the money markets

precondition for normalising monetary policy in the future is that you first dispose of this excess pool of liquidity that you’ve created at the zero lower bound through these various waves of QE

draining this liquidity will take time as bond sales must be gradual to avoid sharp movements in their prices and yields that could destabilise governments and private investors who hold bonds

if CB tries to raise interest rates quickly during the phasing out of QE deposits will flood to the CB and this will prove expensive for the CB

to limit such costs the CB will raise the interest rate more gradually and this helps to allay private sector fears that spending in response to current low interest rates will cause those interest rates to rise

by undertaking asset purchases, a CB may demonstrate its commitment to its objectives and its confidence in achieving them at the ZLB (may help maintain credibility & keep inflation expectations anchored)

Question 37

how is QE linked to transparency of CB operations?

Answer 37

positive effects on transparency:

• CBs that implement QE programmes often provide detailed information about the size, scope and objectives which enhances financial markets’ and the public’s understanding of the central bank’s actions and intention
• often involves regular reporting which enables a closer tracking of the CB’s balance sheet and the impact of QE on the money supply

negative effect on transparency:

• QE programmes are complex, making it difficult to predict the potential impacts on asset prices and market behaviour

Question 38

how does QE affect liquidity levels?

Answer 38

QE may operate at times of financial market stress

by increasing the volume of trading, and therefore the liquidity of financial markets, CB asset purchases may be able to bring down liquidity premia (Bowdler & Radia, 2012)

Question 39

how does the exchange rate channel of QE work?

Answer 39

as part of portfolio rebalancing investors will diversify into foreign assets

this boosts the supply of domestic currency on foreign exchange markets

depreciation of exchange rate gives temporary stimulus to economy as foreign demand for home-produced exports increases as their price is relatively more competitive

expect major wave of QE to be followed by exchange rate depreciation = should stimulate tradable sector (net exports more competitive, net export volumes should increase) (Yates, 2003)

Question 40

what are the limitations to the exchange rate channel?

Answer 40

the effectiveness of the exchange rate channel as unconventional monetary policy depends on whether the central bank is mandated to follow an inflation target
- when a central bank is mandated to follow an inflation target, it rules out conducting unlimited quantities of market operations by running the printing press

one concern is that during the circumstances in which QE was implemented, it’s probably the case that the price elasticity of export demand is very, very weak
- just because product becomes significantly cheaper, doesn’t necessarily trigger a big increase in demand

any exchange rate channel would only apply to unilateral QE
- if all of the major economies are engaging in quantitative easing simultaneously, then the effects of the different national quantitative easing policies are going to cancel out and currency values will be roughly where they were to start with

to ‘defend’ lower exchange rates the central bank would have to make a credible promise to print unlimited quantities of its own currency to buy foreign assets (Yates, 2003)
- this is problematic as it runs counter to the original aim of monetary policy of monetary stability and therefore, may not be believed

Question 41

how does the fiscal channel of QE work?

Answer 41

QE bids up the prices of government bonds and reduces the interest rates payable on the debt they represent
- this reduces debt service costs for governments and allows them to implement fiscal consolidation more gradually (reduces fiscal pressure on gov)
- so demand at higher levels than it would be absent QE

flow of QE is what matters for interest rates on government debt
- one-off intervention only delivers short-term decline in government bond yields, temporary benefits to overall finances

Question 42

what are the limitations to the fiscal channel of QE?

Answer 42

forcing down long-term interest rates on bonds reduces annuity rates and hence incomes for pensioners and creates deficits in company pension funds that must be made good by companies and their employees

if these negative income effects are powerful enough then QE could have perverse effects on total demand

retired people have high propensity to consume so if income removed from pensioner groups through decline in government bond rates delivers a significant hit to overall consumption

Muellbauer argues that this was an unintended consequence of Japanese QE over the last decade
Older population in Japan, relatively more retired people (significant adverse impact on overall expenditure)

Question 43

what is Muellbauer’s critique of the fiscal channel of QE?

Answer 43

forcing down long-term interest rates on bonds reduces annuity rates and hence incomes for pensioners

given Japan’s older population with relatively more retired people, this had a significant adverse impact on overall expenditure