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Monetary policy in exceptional times

The last 5 years have been a major challenge for the theory and practice of monetary policy. The key channel of conventional monetary policy has been severely impaired and the target policy rates in some countries have approached zero.
Par Urszula Szczerbowicz
 Billet du 31 janvier 2013

The last five years have been a major challenge for the theory and practice of monetary policy. The Lehman Brothers collapse, on September 15, 2008, was followed by a dramatic increase in risk premia and a generalized panic on financial markets that spread from the United States to other parts of the world. As a result the assets fell substantially and the global economy was threatened by a credit crunch. The central banks reacted to the increase in risk premia by lowering their main interest rates. However, since the beginning of the subprime crisis the transmission of central bank rates to other interest rates, which is a key channel of conventional monetary policy, has been severely impaired. Moreover, the target policy rates in some countries have approached a level close to zero:  0-0.25% in the United States, 0-0.1% in Japan, 0.5% in the United Kingdom and 0.75% in the euro-zone.

Faced with these constraints, important central banks all systematically implemented unconventional monetary policies that can be categorized into three groups: 
  • Expectation management strategy. Central bank commitment to keep policy rates at low levels can affect the expectations of the future interest rates and therefore reduce the long-term interest rates.
  • Changes in the composition of the central bank balance sheet by purchasing unconventional (risky) assets (credit easing).
  • Expansion of monetary base by providing banks with excess reserves at the central bank (quantitative easing).
While management is expected to communicate on monetary policy intentions, credit easing and quantitative easing require important changes in central bank balance-sheet management. In normal times, central bank assets in developed countries are typically composed of short-term safe assets and short-term loans to financial institutions. Since 2007 this traditional asset structure was modified by the following operations: i) exceptional longer-term liquidity provisions, ii) collateral rules easing and iii) risky asset purchases. Furthermore, the increase in central bank unconventional assets holdings resulted in overall balance sheet increase (quantitative easing).

Transformation of the role of the central bank 
By implementing unconventional monetary policies the central banks endorsed new roles that were vividly criticized by some researchers and policy-makers and strongly encouraged by others. Central banks exceeded the conventional role of the lender of last resort function as they provided almost unlimited inexpensive funds to financial institutions and practically substituted themselves for the interbank market. They also enlarged eligible collateral and directly purchased unconventional risky assets. The Fed for instance exposed its balance sheet to important amounts of mortgage-backed securities and asset-backed securities, the ECB distributed unlimited three-year loans to banks and the Bank of Japan and the Bank of England purchased commercial papers and corporate bonds. 

Furthermore, the purchases of longer-term government debt, conducted by four central banks mentioned above to different extent, diminished sovereign risk held by private agents. Additional consequence of longer-term government bonds purchases is that they helped governments to increase the borrowing without having to face higher interest rates. This is especially true in the United States, the United Kingdom and Japan where the long-term interest rates remain at a very low level (respectively around 1.7%, 1,7% and 0,8%) even though the governments increased substantially their debt. The central bank role in financing governments is a controversial one, and the monetary authorities never stated it as their objective.

Unconventional balance-sheet management and new central bank roles during the crisis may have important consequences on the behavior of market participants that are yet difficult to evaluate. The unlimited liquidity provision for instance can have perverse effects on the money market. Indeed, the important functions of interbank transactions such as information aggregation, price discovery and peer monitoring are reduced if unlimited liquidity is available from the central bank. In this case central bank interventions can create greater uncertainty in the interbank market rather than enhance liquidity exchange as intended. Moreover, such unlimited funding can contribute to maintain “alive” insolvent banks which would not start lending to the companies and households even with additional liquidity. This argument was often made with respect to the Bank of Japan (2001-2006), accused of artificially maintaining “zombie” banks and in this way postponing the recovery (Szczerbowicz, 2012b). 

Another important issue is linked to the credit risk that the central banks accepted on their balance sheet. As the central banks' profits are transferred in fine to the Treasury, the taxpayers are directly impacted by the monetary policy decisions. The central banks protected themselves by imposing important cuts on accepted collateral and purchased assets. As long as the economy recovers as planned, they will make profit on these assets. If however another shock hits the economy and the existing problems are not solved, the central bank could bear losses and face the dilemma whether to ask the government for rescue (recapitalization, lending of sovereign bonds) or just monetize the loss. 

Finally, the critics mention the inflation threat as a consequence of unconventional measures. However, the impact of unconventional monetary policies on inflation is more complex. First, from an empirical and a theoretical point of view it is not certain  that such an effect would appear. Second, if inflation is a potential danger, it can also have a beneficiary effect in a deflationary environment. 

Effectiveness of unconventional measures
There is a rapidly growing literature that empirically evaluates the effectiveness of unconventional monetary policies. Unconventional asset purchases, and long-term government bonds in particular, were found to be effective in lowering long-term interest rates in the United States (Hamilton and Wu, 2011; Szczerbowicz, 2011) and in the United Kingdom (Joyce, 2010). Szczerbowicz (2012a) evaluated the impact of all ECB unconventional monetary policies on the euro-area sovereign spreads and found that the sovereign bond purchasing programs proved to be the most effective in reducing these spreads. The strong impact in the euro-area periphery suggests that the central bank intervention in sovereign market is particularly effective when the sovereign risk is important. 

The effects of exceptional liquidity provisions are more controversial. On the one hand, they relieved liquidity-constrained banks and prevented the credit crunch. This was particularly the case of the ECB three-year loans granted to banks (3y LTRO). The banks borrowed more than €1 trillion which covered their immediate funding needs and prevented them from selling assets and cutting some types of lending (Aglietta et al. 2012). On the other hand, their impact on the interbank lending is uncertain and contested by several studies (Taylors and Williams, 2009, Angelini et al., 2011).

The empirical results provide some positive evidence on the effectiveness of unconventional monetary policies on market interest rates and in particular on longer-term interest rates. However, the ultimate objective of unconventional policies was an increase in lending to companies and households and these unconventional measures were not accompanied by a rise in higher monetary aggregates. The pass-through of lower interest rates induced by unconventional policies to lending rates to companies and households would be a key element to evaluate overall effectiveness of these measures.

Aglietta, M., Carton, B. & Szczerbowicz, U. , La BCE au chevet de la liquidité bancaire, La Lettre du CEPII N°321, May 2012.

Angelini, P., Nobili, A. &  Picillo, C., The interbank market after august 2007: What has changed, and why? , Journal of Money, Credit and Banking 43(5), 923–958, 2011.

Hamilton, J. D. & Wu, J. C., The effectiveness of alternative monetary policy tools in a zero lower bound environment,Journal of Money, Credit and Banking 44, 3–46, 2011.

Joyce M. A. S., Lasaosa, A., Stevens, I. & and Tong, M. The Financial Market Impact of Quantitative Easing in the United Kingdom, International Journal of Central Banking, vol. 7(3), pages 113-161, September 2011.

Szczerbowicz, U., Are Unconventional Monetary Policies Effective?, Working Papers CELEG 1107, Dipartimento di Economia e Finanza, LUISS Guido Carli, 2011.

Szczerbowicz, U., The ECB Unconventional Monetary Policies: Have They Lowered Market Borrowing Costs for Banks and Governments? CEPII Working Paper, N°2012-36, Décembre 2012.

Szczerbowicz, U., Have the ECB unconventional monetary policies lowered market borrowing costs for banks and governments?, CEPII Working Paper, Forthcoming 2012b.

Taylor, J. B. and Williams J. C. , A black swan in the money market American Economic Journal: Macroeconomics 1(1), 58, 2009a.

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