Thursday, January 28, 2010

Unconventional monetary policy responses

In an earlier post, I had blogged about the challenges facing monetary policy in the aftermath of the sub-prime mortgage crisis and the Great Recession. In this context, the debate about unconventional monetary policy also assumes significance in view of widespread concerns that central banks cannot exit from their prevailing loose interest rate policies (as and when inflationary pressures mount) without first contracting their massively expanded balance sheets.

Monetary policy hitherto was confined towards achieving primarily price stability (while balancing economic growth considerations), and interest rates were considered its primary tool. However, in the aftermath of the sub-prime bubble bursting, and the global credit markets virtually freezing and plunging into terminal declines, Central Banks across the world were forced to step in with extraordinary measures like quantitative easing.

Claudio Borio and Piti Disyatat draw the distinction between such "balance sheet policies" and "interest rate policy" and define unconventional monetary policy as falling under the broader category of balance sheet policy (similar to open market operations in the forex market to achieve a desired exchange rate), whereby the central bank uses its balance sheet to affect directly asset prices and financial conditions beyond the short-term, typically overnight, interest rate (or interest rate policy). In other words, balance sheet policies involve efforts to expedite the effectiveness of interest rate policy signals by changing the profile of central bank's balance sheet in terms of size, composition and risk profile.

The instruments of balance sheet policies include inter-bank market conditions through modification of discount window facility, exceptional long-term operations, broadening of eligible collateral and of counter-parties, inter-central bank FX swap lines, introduction or easing of conditions for securities lending; and influencing non-bank credit market through CP funding/purchase/ collateral eligibility, ABS funding/purchase/collateral eligibility, corporate bond funding/ purchase/collateral eligibility, and purchases of other securities. They also include purchases of government bonds and foreign currency securities, and changing targets for bank reserves.

Bank reserves are the sum of a banks' holdings of deposits in accounts with their central bank and the currency that is physically held in its vaults (while central banks do not pay any interest on reserves, as a result of a legislative change in the US in October 2008, the Fed can pay interest at the Federal funds rate for excess reserves). All banks are required to hold a share of their deposits as mandatory reserves, and this helps central banks establish a target (short-term) interest rate. If the reserve ratio drops below the legally required minimum, a bank must add to its reserves by borrowing the requisite funds from another bank that has a surplus of reserves in its account with the central bank. If the Central bank wants a higher federal funds rate, it drains reserves and if it wants a lower rate, it adds reserves till the desired interest rate is achieved in either case.

By virtue of its monopoly over reserves, the central bank can set the quantity and the terms on which it is supplied at the margin, and if need be buy and sell unlimited amounts to achieve the chosen price (which would be the opportunity cost on excess reserves). This also means that "the same amount of bank reserves can coexist with very different levels of interest rates and conversely, the same interest rate can coexist with different amounts of reserves" - ie. interest rates and reserves are decoupled.

Of relevance is only how the reserves are remunerated relative to the policy rate. Central banks typically remunerate excess reserve holdings (over and above any minimum requirements) at a rate that is below the policy rate, leaving banks with little incentive to keep excess reserves (and get rid of unwanted balances by lending in the overnight inter-bank market). This also means that once the demand for mandatory bank reserve requirements have been met, the central bank can set the overnight rate at whatever level it wishes by signaling the level of the interest rate it would like to see, and without indulging in any open market operations (or liquidity management operations) on reserves.

The central bank can also decide to remunerate the excess reserves at the policy rate, especially when it wants to expand liquidity to affect broader financial market conditions. In such conditions, the the opportunity cost of holding reserves for banks becomes zero so that the demand curve becomes effectively horizontal at the policy rate, and the central bank can then supply as much as it likes at that rate. Therefore by paying interest on reserves at the policy rate banks would be indifferent about the amounts held, and interest rates and reserves stand decoupled. Either way, interest rates and reserves are decoupled giving banks the freedom to manage the size and structure of their balance sheets separate from the policy rate targeted.

As Borio and Disyatat write,

"Monetary policy can, and often is, implemented without calling for significant changes in the size of the central bank’s balance sheet. Given a policy that is exclusively focused on setting a short-term interest rate, the overall size of central banks’ balance sheets will be primarily driven by exogenous (autonomous) factors, such as the demand for cash by the public, government deposits, and reserve requirements...

The decoupling of interest rate from balance sheet policy means that unwinding balance sheet policy and shrinking the central bank’s balance sheet are not preconditions for raising interest rates. For example, central banks that pay interest on excess reserves simply have to raise this rate along with the policy rate to implement an interest rate tightening without changing the outstanding amount of bank reserves... Since excess reserves are very close substitutes with short-term claims on the central bank or the government, what the central bank buys and the credit it extends are more important than how these operations are financed...

Discussions of exit strategies can also be delineated along two separate dimensions - the appropriate level of interest rates, on the one hand, and the desired central bank balance sheet structure, on the other. The former is likely to be dictated exclusively by considerations about the traditional inflation output trade-off; the latter is likely to be influenced also by considerations about market impact, including the potential disruptions that an unwinding might cause."

Apart from signaling intent like interest rate policy, balance sheet policies help bring about desired changes in balance sheets of private financial institutions which face liquidity constraints and are saddled with illiquid assets. Central bank actions to acquire illiquid (risky and toxic) assets, or readiness to buy or accept them as collateral, increases the liquidity of the portfolios of the holders of these assets. As the authors write,

"The removal of risky assets off banks’ balance sheets obviates the need for distress sales to comply with risk-based capital constraints and frees up capital (that is, raises the ratio of capital over risk-weighed assets), which can help support credit growth. The combination of stronger balance sheets, higher collateral values and higher net worth, may help loosen credit constraints, lower external finance premia and revive private sector intermediation."

However, it needs to be emphasized that unconventional monetary policy responses should be resorted to under extraordinary circumstances and should not become a part of the Central Bank's armory of regular monetary policy activities. Borio and Disyatat write,

"As central banks move away from the simplicity and well-rehearsed routine of interest rate policy, they face much trickier calibration and communication issues. As they substitute for private sector intermediation, they may favour some borrowers over others, tilting the level playing field, and could risk making the private sector unduly dependent on public support. As they purchase government debt, they come under pressure to coordinate with the public sector debt management operations. And as their balance sheets expand and they take on more financial risks, central banks risk seeing their operational independence and anti-inflation credentials come under threat in the longer term.

As a result, questions about coordination, operational independence and division of responsibilities with the government loom large. These costs suggest that unconventional monetary policies should best be seen as special tools for special circumstances. The costs also point to the need for appropriate governance arrangements, designed to limit the risk that the central bank anti-inflation priorities are undermined in the medium term. And they put a premium on early exits, as soon as economic conditions permit."

Update 1
Ricardo Reis has an NBER working paper that reviews the unconventional US monetary policy responses to the financial and real crises of 2007-09, by dividing them into three groups - interest rate policy, quantitative policy, and credit policy.

Update 2 (24/7/2011)

Excellent FT interactive graphic on the debate surrounding QE.

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