Unconventional monetary policy

• Why do we need unconventional monetary policy?

• The tools of monetary policy
1. Liquidity provision
2. Asset purchases
3. Quantitative Easing
4. Credit Easing
5. Policy Duration Commitment
6. Others
• Exit from QE
Monetary Policy Tools in Response to
Global Financial Crisis
Unconventional tools were used by CBs in response to the
global financial crisis of 2007/08. Why?
A) Impairment of financial system
• Heightened vulnerabilities which has led to some markets
freezing – collapse of confidence because of the
fragility of financial system.
• Collapse of financial market and intermediation –
weakened/hinder monetary transmission mechanism.
• As a result, conventional tools were unable to bring about
effective productive use whereby investment spending
shrunk and economy collapse (real GDP fell at an annual
rate of 8.9% in the 4th quarter of 2008, unemployment rate
soared)
Monetary Policy Tools in Response to
Global Financial Crisis
B) Zero lower bound problem
• Severity of recession pushed optimal policy rate to zero
lower bound on interest rate.
• There is no further room for interest rate to be pushed
further – not sufficient to stimulate economy.
• People will not have incentive to keep cash in financial
institutions (like paying bank to keep money instead of
getting returns). Cash held on hand.
• Inflation is low and situation of a deflation seem like a
real threat – should lower interest rate further but don’t forget
we are having zero lower bound issue.
 Monetary Policy Tools in Response to
Global Financial Crisis
C) Vicious cycle of asset prices falling
• Falling/lower asset prices weakened balance sheets of
firms and individuals – increased borrowing constraints.
• Higher funding costs led to further assets sales.
• Increased assets sales – depressed asset price further and
this amplified credit contraction Asset is collateral

Thus, non interest rate tools (non-conventional monetary

policy tools) have to be used.
Watch a video lecture :
http://www.stlouisfed.org/education_resources/feducation-traditional-
and-non-traditional-monetary-policy-tools/
 Non-conventional monetary policy
tools
Characteristics of non-conventional monetary policy tools?
• It includes a broad range of measures aimed at easing
financing conditions such as additional CB liquidity to the
banks (steps that directly target the cost and availability of
external finance to banks, households and non-financial
companies).
• Should be cautious on the possible side effects of
unconventional measures such as any impact on the financial
soundness of the CB’s balance sheet.
What are the non-conventional monetary policy tools?
• Liquidity Provision
• Large Scale Asset purchases
• Quantitative Easing
• Credit Easing
• Policy Duration Commitment - Forward policy guidance
Non-conventional monetary policy tools
Liquidity Provision
• Fed expands its lending facilities to provide liquidity to the
financial markets.
• The provision of liquidity by a CB can help mitigate a financial
crisis but CB faces a tradeoff –inducing moral hazard.
• Question that arises: How could a CB distinguishes between
liquidity pressures stem primarily from a breakdown in the
financial market functioning (market issue) and liquidity
problems fundamentally derive from underlying concerns about
their solvency (issues in banks themselves).
• Conducted in three forms:
- Discount window expansion
- Term auction facility(TAF)
- New lending programs
 Liquidity Provision
 Discount Window Expansion:
• Fed lowered the discount rate to 50 basis points above “st
the FFR target from 100 basis points and subsequent to fro
only 25 basis points above the FFR target. win
tha
• Its use is limited. Why? ban
 Term Auction Facility (TAF): (in
• TAF was set up in Dec 2007. Final TAF auction was on
March 8, 2010.
• The amount increased tremendously. Started from $20
billion and up to $400 billion in the US.
• encourages additional borrowing amid concerns that many
investors are reluctant to lend especially at maturities
beyond the very shortest terms given the condition of many
FI’s. (Unwilling to take medium and long-term risks)
 Term Auction Facility
The mechanism
• All loans extended under TAF were fully collaterized and
funds were allocated via auction in which FIs bids the amount
they want up to a pre-specified limit and an interest rate that
they would be willing to pay for such funds. Interest rate
lower than discount rates. More popular compared to DWE
• All loans made under TAF were repaid in full with interest, in
accordance with the terms of the facility.

Read: Term Auction Facility.

http://www.federalreserve.gov/newsevents/reform_taf.htm
 New Lending Programs
 New lending programs:
• Fed broadened its provision of liquidity to new financial
institutions and purpose.
• Under this program investment banks is eligible for loans.
Lending is given to promote purchases of commercial
papers, mortgage backed-securities and other asset backed
securities as well.
• Engage in lending to JP Morgan to assist in purchase of
Bear Stearns and to AIG to prevent failure.
 Large-Scale Asset Purchases
• During the crisis, there is little scope for lower short term
interest rates to stimulate the economy, Fed resorted to large
scale asset purchases (LSAPs).
• Nov 2008: Government Sponsored Entities Purchase
Program – purchased $1.25trillion of mortgage backed
securities (MBS) guaranteed by Fannie Mae and Freddie
Mae. Objective: to stimulate the MBS mkt and hopes that
with more liquidity in MBS, the risks level will be lower,
leading to lower interest rates on residential mortgages
to stimulate housing market.
• Nov 2010 – June 2011: Completed purchase of $600 billion
long term Treasury securities at a rate of about $75 billion
per month. known as the QE2 (quantitative easing 2). The
purchase is to lower long term interest rate which then could
stimulate investment spending and the economy.
 Quantitative Easing
• The most high profile form of unconventional monetary
policy was first applied to Japan when it dealt with the
bursting of real estate bubble and deflationary pressures in
the 1990s
• Following the financial global crisis of 2007/08, US, the
Euro area and UK all followed Japan in adopting QE.
• QE involved the purchase of government securities from
the banking sector to boost the level of cash reserves
and eventually to lead to a spill over to the real
economy.
• The impact of quantitative easing on the central banks
balance sheet:
1. Assets side: Treasury bonds will increase
2. Liabilities side: Reserve of banks in central bank will
increase the money in the hands of banks become
higher due to the purchase of G securities.
 Quantitative Easing

Reduce
the default

Long term gov

bond

Source: Joyce, M., Miles, D., Scott, A., and Vatanos, D. (2012), Quantitative easing and
unconventional monetary policy- An introduction. The Economic Journal, 122: 271-288.
 Quantitative Easing
• The implementation of QE are different among the Fed,
BOE and ECB’s:
• Fed bought US treasuries and large quantities of
agencies’ debt and agencies’ backed mortgage
securities while BOE bought UK govt bonds from the
non- bank private sector through QE operations
• In addition to asset purchases, ECB’s transactions were
also over repo operations – provision of loans in
exchange for collateral (involved mostly bank loans and
not government bonds).
• Several rounds of QE was conducted by Fed increasing
Fed’s balance sheet (assets) from less than $1 trillion in
2007 to $4 trillion
• In June 19, 2013, Ben Bernanke announced the tapering of
some of the Fed’s QE policies contingent upon positive
economic data.
 Quantitative Easing
• The differences can also be found in terms of QE
objective.
• the BOE and Fed operations were not designed to handle
a liquidity problem within the banking system but rather to
affect the prices on a wide range of assets particularly on
bonds issued to finance lending to companies and
households.
• On the other hand, In addition to the objective above,
ECB was also trying to address the substantial outflow of
euro deposits from banks in some of the peripheral
countries in the other banks in the euro area; The QE is to
provide liquidity to these fund-constrained banks.
 Credit Easing
• Instead of expanding the size of CB’s balance sheet, credit
easing shifts the composition of the balance sheet away
from risk free assets and towards risky assets.
• A simple example: CB sell short term US treasury bills (risk
free asset) and buy mortgage backed securities (risky
assets) of similar maturity.
• The impact on the central bank balance sheet:
1. Asset side: the amount of risk free assets will drop and the
amount of BS will has propotional increase
2. Liabilities side: ntg happen
 Credit Easing
• How does CE boost the economy?
1. CB’s purchase of asset in the credit market– Increase the
liquidity- enable the allocation of resources.
2. Purchase of an asset in reduces the interest rate in that
market, helps to reduce the burden of borrowers in the
credit market. (example, purchase of mortgage-based
securities reduces the mortgage lending rate in the US.)
• CE can be applied on long-term bonds (its interest rate more
relevant to investment). Long term
bond
• It is expected that it is harder for central bank to exit CE than
QE. Why is that so?
1. Risky assets are harder to sell compared to treasury bills.
Harder to dispose it off as and when CB wishes to do so.
 Policy Duration Commitment
• Simplest unconventional approach is for a CB to make a
commitment today for future policy target rates. The aim is to
calm uncertainties in markets and corporations.
• Promise to keep their policy target rate low for an
extended period. CBs hope it will convert low ST interest
rates into lower long term int. rates
• How is it done? Making commitment to keep interest rate
low, either conditional or unconditional
• In Dec 2012, Fed declared that it would not raise interest
rate until USA’s unemployment rate dropped to at least
6.5% so long as inflation remained at 2.5%.
• In August 2013, BoE followed suit – leaves rate low until
unemployment is down to at least 7%, so long as
inflation and financial markets remained well behave
 Others
• Negative interest rate:
1. Interest rate is set to negative to discourage saving.

• Operation Twist:
1. Sell short-term bond and use the proceeds to buy long-
term bond. The objective is to lower the long-term interest
rate.
 Exit from QE
• Why do we need to exist?

- Afraid of inflation in the long run.

• How can we exit from QE?

1. To sell assets in CB in huge volume. Remember that the
QE involves purchase of assets (government bonds/private
bonds etc.) from financial institutions.
2. Increase the deposit rate of reserve (ior). Consequently, the
banks will choose to hold more money and will not involve
in interbank market. The credit creation process stops.
 Exit from QE
• The benefits of second option is that there is no need for fire
sales of illiquid assets when interest rate raises because the
banks can keep their reserve and earn returns.
• However, CB will bear net losses for higher deposit rate on
reserves.
• International coordination should be put in place as well,
especially between the US and EU. Exit at different timing
among different countries can create high volatility in the
stock market and exchange rate.
• However, it is difficult considering different situations and
considerations in different countries in terms of:
1. Economic achievement (US has shown some sign of
bubbles due to unconventional monetary policies)
2. Inflation target( EU has a more strict requirement on
inflation compared to US)
The central bank balance sheet before
and after Lehman Brother crisis
Read: Joyce, Miles, Scott and Vayanos
(2012). Quantitative Easing and
unconventional monetary policy- An
introduction. Economic Journal, 122, 271-
288.