Download Unconventional Monetary policy

Unconventional Monetary
policy
• In response to 2007/8 financial crisis, central banks around the world
began reducing short-term policy interest rates.
• For example, on 8 October 2008, as the financial crisis intensified,
central banks in Canada, China, the euro area, Sweden, Switzerland,
the UK, and the US all undertook a coordinated rate cut.
• But, faced with the prospect of a deep economic downturn, and with
short-term interest rates close to the zero lower bound, central
banks judged that further monetary stimulus would be required to
meet their objectives.
• They embarked on a range of measures that can broadly be described
as unconventional monetary policy.
CONVENTI0NAL UNCONVETIONAL
MONETARY POLICY: Quantitative Easing (QE)
• QE typically involves large-scale asset purchases financed by the
issuance of central bank money. These sorts of programmes of asset
purchases have been put into practice by the Federal Reserve, the
Bank of England, and the Bank of Japan, and are sometimes labelled
conventional unconventional monetary policy. The key distinguishing
feature of QE is that it involves the central bank seeking to directly
affect asset prices—for example, longer-term gilt yields—other than a
short-term interest rate and doing so by actively varying the size of its
balance sheet.
QE
• The Bank of England has overwhelmingly bought UK government bonds
from the non-bank private sector through its QE operations;
• the Fed has bought US Treasuries but also large quantities of agency debt
and agency-backed mortgage backed securities. The differences between
the assets bought by the Fed and the Bank of England are in fact not so
great, because the bulk of the mortgage-backed securities are guaranteed
by the US agencies, which are in effect government agencies.
• The expansion of the European Central Bank (ECB) balance sheet has come
about largely though repo operations – that is, the provision of loans
(many long term) in exchange for collateral (much of which are bank loans
and not government bonds).
QE: Differences among central banks goals
• The ECB long-term repo operations were designed to alleviate the
acute funding difficulties that many banks of Eurozone periphery had
( a sort of bank run problem.)
• The Bank of England and the Fed asset purchase operations were not
designed to handle a liquidity problem within the banking system.
Rather, they were designed to affect the yields (or prices) on a wide
range of assets – particularly on bonds issued to finance lending to
companies and households.
HOW QE WORKS?
• QE involves the monetary authority purchasing assets and injecting
broad money into the economy. In doing so, QE tries to directly affect
long-term interest rates. At the zero lower bound, the central bank
has no room to further reduce short-term interest rates. How the QE
works?
• The key difference between QE and a standard open market
operation is that QE involves a direct injection of a specified quantity
of broad money, rather than influencing its price through variations in
the price of base money.
• Another important difference is that central banks have gone beyond
purchasing short-dated government securities, the policy pursued by
the Bank of Japan between 2001 and 2006. Both the Bank of England
and the Federal Reserve have targeted longer-dated gilts, as well as
private-sector assets, including corporate bonds and mortgagebacked securities (MBS). That is because the effectiveness of QE may
depend on what is purchased, as well as how much.
Transmission Channel of QE
Transmission channel of QE : portfolio
rebalancing
• As the net supply of gilts of a certain maturity is restricted by the central
bank intervention, their price increases (and yield falls)—a so called local
supply effect.
• In order to rebalance their portfolios, investors will seek to re-invest the
money they hold, searching for alternatives to government bonds which
are now more expensive. A natural response is for investors to acquire
slightly more risky assets that are now relatively cheaper in comparison
to domestic government bonds, for instance high-quality corporate
bonds, foreign government bonds, or blue-chip equities. The sellers of
those assets will then in turn seek to rebalance their portfolios by holding
larger shares of riskier still assets. This process continues until all asset
prices have adjusted such that investors, in aggregate, are willing to hold
the overall supply of assets.
How QE works: portfolio rebalancing
• The nature of the mechanism was initially described inter alia by Tobin
(1961, 1963, 1969) and Brunner and Meltzer (1973). They stressed how
central banks, through varying the relative supplies of financial claims with
different durations (or maturities) and liquidity, could influence the pattern
of yields on different assets due to imperfect asset substitutability.
• An important ingredient of this portfolio balance channel is heterogeneity
across agents – some people have to come to hold different portfolios and
prices need to change to make this an equilibrium. Somebody ends up with
more of one sort of a claim as a liability (the central bank has issued more
money) and more of another as an asset, and someone else has taken the
other side of that.
From asset prices to spending
• Higher asset prices should stimulate increases in spending through both
reducing the cost of capital and increasing wealth.
• This argument relies on the portfolio rebalancing argument. This argument
has been criticised by the «irrelevance proposition» Woodford (2012)
• Krugman (1998). When interests are at the zero lower bound the only way
to reduce real interest rate is to create expectations of higher inflation in
the future. How to convince investors that monetary policy will in the
future be looser than would normally be ?
• This promise in dynamically inconsistent. However Both QE and forward
guidance can be ssen as an attempt to signal the market that short term
interest rates will be kept at a low level in the future.
«irrelevance proposition»
• Woodford (2012) offers a concrete example to illustrate how the
irrelevance proposition might work in practice.
• If the central bank buys MBS, as the Federal Reserve has done, it takes realestate risk on to its own balance sheet. While households will no longer
directly be exposed in the event of a house price crash, the central bank
will.
• Therefore, in the crash state, the central bank’s earnings will be lower. And
this will result in lower earnings distributed to the Treasury, which will in
turn result in higher taxes levied on the private sector.
• Thus, in aggregate, households’ post-tax income is equally affected in the
event of a house price crash, whether or not they or the central bank hold
MBS.
UNCONVENTIONAL UNCONVENTIONAL
MONETARY POLICY
• forward guidance concerning short-term interest rates: providing
information about the future path of policy
• credit easing schemes: extended provision of short term and longer
term liquidity to banks in order to ease credit conditions
• long-term repo operations
Empirical evidence and future concerns
• The consensus of the literature and the articles in this volume is that
unconventional monetary policy does work – asset market purchases
do lower yields and longer term interest rates and these lower
yields in turn have a positive effect on the economy. This is why
central banks are still contemplating further stages of QE. However,
there are also many things we do not know and several areas of
concern.
• The first is that even if QE has been effective in terms of boosting the
economy, recovery still remains fragile.
Future concerns.
• Another concern is that a high level of bank reserves might reduce
the level of interbank lending and lead that market to malfunction.
• Furthermore: When recovery occurs how will central banks reduce
the level of reserves and avoid high levels of inflation?
• Finally Fiscal implication: central bank purchases of government
bonds are helping to contribute to unsustainable levels of
government debt?