Non Conventional Monetary Policies

The operational frameworks of central banks have changed fundamentally in the wake of the great financial crisis. Non-conventional monetary policies have become the new normal in all large developed economies. Their main forms have been forward guidance and the usage of central banks’ balance sheets for market interventions that target term, credit and other risk premia. Non-conventional policies have created new systemic risks, such as [i] prolonged sedation of markets through containment of asset price volatility, [ii] exhaustion of scope for further monetary stimulus in future crises and [iii] addiction of economies to cheap funding.

Background

Non-conventional policies: the “new normal”

Prior to the great financial crisis 2008-09, monetary policy in most developed economies focused on operating through a short-term interest rate. The most popular reference was the “Taylor rule”, according to which a central bank would adjust its policy rate in accordance with changes in expected underlying inflation and economic growth. Exchange rates, money, and credit aggregates were widely monitored but not usually targeted directly.

The financial crises of the 2000s and 2010s transformed the operational frameworks of developed countries’ central banks, mainly for two reasons:

  1. Policy rates reached their zero lower bound and even turned negative in some developed countries. Simultaneously the estimated natural rate real of interest dropped to zero and has failed to recover since (view post here). Hence, the traditional Taylor rule of policy rate setting was compromised.
    At the lower bound conventional policy loses its power to balance financial conditions. As a result, inflation expectations can become de-anchored (view post here) and economies are particularly vulnerable to additional negative shocks to goods and asset prices. Threats to price stability are asymmetric and skewed towards deflation (view post here). There is a distinct risk of self-fulfilling dynamics as inflation expectations would shift lower, real rates would rise, debt burdens would become heavier and consumption and pricing power would decline (view post here). Economies become vulnerable even to shocks that reduce production costs, such as commodity price and wage declines (view post here).
  2. Repeated systemic malfunctioning of financial intermediation compromised the monetary policy transmission process and eroded confidence in central banks’ stabilizing influence.  A sequence of crisis episodes gave rise to fears that the impact of monetary policy rates on yield curves, equity premia, and credit spreads would be muted. A major concern was that monetary easing would be like “pushing on a string”: accommodative conventional monetary conditions no longer translated reliably into accommodative financial conditions for the economy.

These changes have given rise to new non-conventional monetary policies. Their main purpose has been to allow further monetary policy accommodation at the zero lower bound and to secure or restore the influence of central banks on broader financial conditions. Since interest rates have remained close to their zero lower bound to this day (view post here), non-conventional monetary policy has become the “new normal”.

“Unconventional monetary policies such as forward guidance and large-scale asset purchases give central banks effective instruments when the traditional policy interest rate is near zero…These policies have had meaningful effects on longer-term interest rates and other financial conditions. The precise impact on unemployment, GDP, and inflation is harder to determine.”

John C. Williams, President of the Federal Reserve of San Francisco

Types of non-conventional policies

The non-conventional monetary policies that have evolved since the great financial crisis can largely be condensed in to four principal categories:

  • Forward guidance for policy rates means conditional or unconditional pre-commitment to future monetary policy rate levels.  It uses communication and credibility to influence interest rates at longer maturities (view post here). A forward guidance regime can be crucial because normally at the zero bound both downside and upside shocks to inflation can push real rates higher. This “double risk” can translate into excessive real rate expectations unless the central bank credibly commits to keep rates “low for long”. All major developed market central banks have used explicit forward guidance since the great financial crisis.
  • Quantitative easing denotes the expansion of the monetary base (central bank deposits and cash), typically through the purchase of government securities. The Bank of Japan was the first large modern central banks to deploy “QE” when it started buying JGBs (Japanese government bonds) in size in 2001, but the Federal Reserve, the Bank of England and, finally in 2015, the ECB all followed. Quantitative easing on its own is not “printing money” because it constitutes an exchange of financial claims rather than purchase of goods and services against un-backed currency. Also, not all central bank balance sheet expansion is quantitative easing: a large part of ECB operations during the great financial and euro crises simply reflected the intermediation of a dysfunctional money market (view post here).
  • Qualitative easing refers to the purchase of various types of assets for the purpose of risk premium compression, particularly credit spreads and interest rate term premia. Typically qualitative and quantitative easing are conjoined. The U.S. large-scale asset purchase programs were directed at both government and mortgage-backed securities. The ECB’s “Public Sector Purchase Programme” can buy sovereign risk of very different quality (view post here).  An example of pure qualitative easing would be the Federal Reserve’s “Maturity Extension Program”, which aimed at reducing term premia, and the  ECB’s “Security Market Program”, which initially sterilized liquidity effects and hence only aimed at reducing longer-dated bond credit spreads and term premia.
  • Collateral policies manage supply and pledgeability of collateral assets, which has greatly gained in importance since the great financial crisis (view post here). They influence financial conditions through the secured lending channel, for example by reducing risks of collateral shortages and secured funding constraints (view post here). Thus, the U.S. “Term Securities Lending Facility” increased the supply of Treasury general collateral to primary dealers at the height of the great financial crisis. Also, the broadening of eligible securities in ECB refinancing operations increased the pledgeability of collateral of euro area banks (view post here).

Some economists also classify negative policy rates as a new policy. Modestly negative rates have become common in developed countries and seem to transmit to the rest of money market and capital market rates for the most part much like positive rates do. However, negative policy rates bear risks for the profitability and functioning of the financial system (view post here) and  seem to have downside limits at present. It may technically be possible to reduce policy rates significantly below zero. One approach would be to levy a variable deposit fee at the central bank cash window to enforce value decay of paper currency relative to electronic money (view post here).  However, a new policy of this type would require considerable economic pressure and preparation.

If current non-conventional monetary policies fail to secure inflation targets and avoid deflation, some form of debt monetization or “helicopter money” will be considered as a policy option (view post here). The barriers for this in the U.S., the euro area and Japan are high but not insurmountable. Policies would aim at a fiscal expansion and could include outright central bank funding or a restructuring of sovereign debt currently held by central banks. These policies might have a more direct impact on actual inflation and long-term inflation expectations than central banks’ operations with the financial system (view post here).

“The problem with QE is that it works in practice, but it doesn’t work in theory.”

Ben Bernanke, Federal Reserve Chairman, 2014

The impact on systemic risk

Risks of non-conventional policies

Non-conventional monetary policies affect systemic risk. Long-term consequences, side-effects, and exit strategies are all highly uncertain. Markets have only limited historical experience to rely upon. Some pitfalls have already become apparent:

  • Sedation: Non-conventional policies suppress market volatility by design.  There is evidence that central banks have long used policy rates to stabilize financial markets in times of distress (view post here).  However, since the great financial crisis 2008-09 policy interventions have taken place across securities markets. Hence central banks nowadays wield greater direct influence over asset prices than in a conventional policy rate-setting environment (view post here). Protracted suppression of volatility, however, typically fosters undue leverage (view post here). Suppression of volatility also creates a false sense of robustness of conventional risk metrics (view post here) and may even impair the ability of investment professionals to cope with high and prolonged market distress on a personal basis (view post here).
  • Exhaustion: Non-conventional policies become less effective overtime. Yields and credit spreads have a lower bound at zero or slightly below and the more compressed they are, the less incremental economic support can be provided through them (view post here). Unfortunately, yield compression cannot easily be reversed in times of economic improvement, because low-yield periods naturally produce enhanced leverage and vulnerability to monetary tightening (view post here and here) sometimes aggravated by flawed regulation (view post here and here). This is why declines in real interest rates tend to be self-perpetuating over longer time horizons (view post here). At some stage all scope for yield, term and credit premia compression will be exhausted.
    Moreover, there are constraints on the volume of central bank interventions. Liquidity constraints have become an increasing concern as central banks have taken a sizeable share of some types of bonds from the market. Legal limitations can arise from restrictions on eligibility of securities for central bank interventions and prohibitions of outright government financing (view post here).
    Finally, ultra-low and or even negative real interest rates pose a danger to profitability and financial health of the financial system (view post here). Asset purchases flatten the yield curve and reduce the returns on maturity transformation and credit risk. If these purchases are combined with a negative policy rates banks’ interest rate margins are compressed even further, because the zero low bound still applies to most of their deposits. At this point a large share of bank liabilities no longer reprice when market rates fall.  Also, interest rate margins affect reported bank earnings with lags and in a staggered fashion and hence have a lasting impact. Meanwhile, insurance companies and pension funds, whose liabilities often have a longer maturity than their assets, face outright losses.
  • Addiction: Financial institutions have become more dependent on non-conventional ‘life support’, particularly on cheap funding and explicit credit market stabilization programs.
    • Some research suggests that the term premia in global government bond markets have broadly turned negative in the 2010s, a historic shift that was fostered by policy support for a global duration carry trade (view post here). There is also evidence that inflation risk premia have turned negative (view post here and here) in large developed countries, with significant spillover to other countries. Conversely, quantitative estimates suggest that a rebound of term premia in a large dominant market, like the U.S., would put upward pressure on borrowing costs in virtually every economy around the globe, whether its local conditions can take it or not (view post here).
    • There is evidence that non-conventional policies have discouraged or slowed balance sheet repair after the great financial crisis (view post here), particularly in the euro area.
    • Global financial leverage has further increased since 2007, notwithstanding declining debt service capacity of public and private borrowers due to diminishing expected nominal GDP growth (view post here). As a consequence of high leverage, institutional credit and money markets have remained vulnerable, even with ultra-easy monetary conditions (view post here).  On the whole, markets have become more vulnerable to failure or reversal of non-conventional policy support (view post here). These concerns have been validated by recurrent episodes of government bond yield surges, such has Japanese bond yield rise in 2013, the U.S. treasury sell-off (“taper tantrum”) in summer 2013 (view post here) and the German government bonds sell-off (“bunds tantrum”) in spring 2015. Generally, history has provided many examples of easy monetary policy leading to financial booms and subsequent crises (view post here).

There are hopes that macroprudential measures might offset the addictive quality of ultra-easy monetary policy in the developed world, as they rein in financial risk taking (view post here). However, macroprudential policies are largely new and untested, have worked best as a complement (not offset) to monetary policy. Also, they often focus on specific sectors only, such as banking and housing (view post here).

“We do see that real estate dynamics or high household debt levels in some countries signal the risk of increasing imbalances…they relate to the continued very high level of household indebtedness and the low level of mortgage collateralisation…That being said, monetary policy is not the appropriate tool for addressing local and sectoral financial risks. Rather, targeted macroprudential policies, which can be tailored to local and sectoral conditions, are the right answer.”

Mario Draghi, March 2017