A brief reminder of (what used to be) non-conventional monetary policy
Prior to the great financial crisis 2008-09, monetary policy in most developed economies operated mainly through short-term interest rates on special lending and borrowing facilities. The rough conceptual reference was the “Taylor rule”. 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 great financial crisis and the European sovereign crisis necessitated a transformation of the operational frameworks, mainly for two reasons:
- Policy rates approached their lower bounds but natural real rates of interest had also dropped to around zero, for both cyclical and structural reasons (view post here) and failed to recover after the crisis (view post here). Trapped at their lower bound policy rates lost the power to stabilize financial conditions in the face of further actual or potential adverse shocks. The consequence was a growing risk of inflation expectations becoming de-anchored (view post here) making economies particularly vulnerable to declines in goods and asset prices. Threats to price stability are asymmetric and skewed towards deflation (view post here) because unduly tight monetary policy is harder to correct and unduly easy policy. Moreover, there is a distinct risk of self-fulfilling dynamics: inflation expectations shift lower, real rates rise, debt burdens increase and consumption and pricing power soften (view post here). Economies are vulnerable even to shocks that were previously thought of as favorable, such as declines in import prices or labor costs (view post here).
- The systemic financial crises 2008-2012 obstructed monetary policy transmission and challenged central banks’ ability to stabilize financial conditions for non-banks. The popular 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 as whole.
The “new normal” non-conventional monetary policies that evolved after the great financial crisis can be condensed into four principal categories:
- Forward guidance for policy rates means conditional or unconditional pre-commitment to future monetary policy rate levels. This policy uses institutional credibility to influence interest rates at longer maturities (view post here). 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. 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. It is distinct from the idea of helicopter money that is explained below. Moreover, not all central bank balance sheet expansions have been 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 the reduction of interest rate term premia and credit spreads. Qualitative and quantitative easing are often conjoined. One of the most powerful channels of non-conventional monetary policy is duration extraction, i.e. the combination of central banks’ balance sheet expansion and duration extension (view post here). Combined quantitative-qualitative easing also aims at compressing credit spreads. Thus, the ECB’s “Public Sector Purchase Programme” buys 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) due to the expansion of collateralization in market transactions (view post here). Collateral policies influence financial conditions through the secured lending channel, for example by reducing risks of collateral shortages and secured funding constraints (view post here). For example, the broadening of eligible securities in ECB refinancing operations increased the pledgeability of collateral of euro area banks (view post here). Also, 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.
Some economists also classify negative nominal interest rates as a non-conventional policy. Modestly negative rates have been introduced in several 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 has technically become possible to reduce policy rates even deeply negative (view post here). 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 or to avoid deflation, some form of debt monetization or “helicopter money”, i.e. direct monetary transfers to non-banks, may be considered as policy option (view post here). The barriers for this in the U.S., the euro area and Japan are high but not insurmountable. This policy could work through fiscal expansion backed by outright central bank funding or restructuring of sovereign debt currently held by central banks. “Helicopter money” should have a more direct impact on actual inflation and long-term inflation expectations than central banks’ operations with the financial system (view post here).