Rodrigo Vergara: Monetary policy through asset markets - lessons from
unconventional measures and implications for an integrated world
Opening remarks by Mr Rodrigo Vergara, Governor of the Central Bank of Chile, at the Central
Bank of Chile's Nineteenth Annual Conference, Santiago, 19 November 2015.
* * *
Monetary policy has mostly been about setting the appropriate interest rates to stir the
economy towards a path coherent with its fundamentals. In this sense, the developments in
most central banks in the last 6 years have not been out of the box, so to speak. But we can
probably say, with little risk of overstating reality, that the ways of achieving changes in the
cost of credit through monetary policy has changed significantly since the global financial crisis.
To fully appreciate the extent of these changes, it's useful to do a quick recap of what traditional
monetary policy was prior to 2008. In the vast majority of countries, the name of the game was
setting the stance of the short term rates -indeed, the overnight rate at which banks lend to
each other. The hope was that, by influencing this very short-term rate, monetary policy actions
would feed into the broader economy by affecting longer term rates, as well as spreads of
riskier forms of credit which in the end are the channels by which the policy stance affects the
cost of borrowing of households and firms. In this context, perhaps the biggest advances of
monetary policy of the last 20 years leading to the GFC had to do with the transparency and
the overall macroeconomic coherency of interest rate decisions, which led, among other
transformations, to the adoption of explicit inflationary objectives in a number of advanced and
emerging market economies.
In the aftermath of the global crisis, it soon became clear that traditional MP was simply not
going to cut it, especially given the limitations of other policy options, such as fiscal expansion,
to reactivate the global economy after the major blow it suffered. Central bankers were forced
to be creative and think outside the box of traditional monetary tools in order to make a
difference.
A useful framework to understand how policy tools have evolved is to think about interest rates
in the following way. The price of a given form of debt, issued at a particular maturity and by a
specific counterparty, is the sum of three main components. The first is the expectations of
short-term, risk-free debt over the maturity of the instrument. Let's call this component the path
of risk-neutral rates. The second is the compensation for risk that must be offered to an investor
to account for the fact that longer maturity instruments are more volatile (have higher duration)
than short-term rates, let's call it the term premium channel. The third is simply default risk. In
essence, all policy actions by the Fed, the ECB, the banks of Japan, England, Canada, and of
many small open economies in the last 6 years have been about affecting long-term rates by
influencing one, and often times more, of these interest rate components.
Take the case of forward guidance. When nominal rates reached the ZLB, and particularly due
to the low inflation environments, traditional monetary policy became very constrained -fully
constrained by definition, one might say, given the impossibility of lowering short term rates
any further. However, to the extent that one can credibly influence the expected path of future
monetary policy actions, risk-neutral rates at different horizons can be lowered, perhaps even
significantly so. However, as pointed out by Mike Woodford in an influential paper presented
at Jackson Hole a few years ago, to truly make a dent on rates with this strategy, central
bankers were likely to run into a temporal-inconsistency problem. This problem is basically that
in the event that long-term rates can be reduced enough to jump-start the economy, the
expost optimal policy stance would be inconsistent with the one promised in the midst of
stagnation. Quoting from his paper: "the future policy that one wishes for people to anticipate
is one that the central bank will not have a motive to implement later, if it makes its decisions
then in a purely forward-looking way, on the basis of its usual stabilization objectives." (end
quote) This does seem like a hard conundrum to get away from, and probably limits the traction
of this type of tool as a strong driver of longer-term rates.
Partly due to these limitations, Central banks have also directly tackled the term premium by
purchasing large quantities of long-term assets. The idea is that by removing some duration
from the fixed income markets, private investors' aggregate exposure to interest rate risk is
diminished, leading to a lower required compensation for bearing such risk. Of course, this
logic relies on some form of imperfections and/or market segmentation, but there is by now
significant evidence, including some excellent papers to be presented in this conference, that
QE has had a measurable impact on long-term rates through this channel. A similar logic
applies to the default risk-premium: to the extent that returns on safer debt are compressed by
central bank purchases, investors are tempted to reach for yield into other fixed-income
markets, such as mortgages, corporate bonds, and emerging market instruments.
Against this backdrop, it seems appropriate to dedicate this year's conference to taking stock
of the transformations that have occurred in monetary policy, if not in the objectives, at least in
the tools by which these objectives are achieved. Moreover, such introspection seems crucial
to our understanding of how to go forward. Indeed, it is very likely that such measures will
become standard practices, with the subtitle "unconventional" eventually scratched off
altogether.
In fact, there are several reasons to suspect these exceptional measures are here to stay. On
the one hand, it might very well be the case that we are witnessing profound structural changes
that imply a new normal of much lower interest rates that we have been accustomed to -I
suspect the keynote address by Larry Summers tomorrow may touch upon such issues. If this
is so, then it is more likely that we will run into the ZLB in future business cycles, forcing central
banks to tap upon these so-called unconventional measures time and again. On the other
hand, these measures have apparently worked. Why then should we not embrace them as
part of our standard set of instruments?
The structure of this conference follows the logic of addressing three main aspects of the
transformation in the practice of Monetary Policy in the last decade. Our first session includes
three papers that tackle, from both a theoretical and empirical perspective, the impact of such
unconventional measures on interest rates at different horizons and over a wide variety of
securities. Here we are fortunate to have among the presenters Dimitri Vayanos, Gautti
Eggerston, and Eric Swanson, all accomplished scholars who have dedicated an important
part of their research in recent years to delve deeper into the quantitative effects of such
policies.
The second session deals with the financial stability considerations of these measures. After
all, to date several unconventional policy efforts have begun in Japan, the US, Europe and
elsewhere, but none has so far ended -in short, we are not out of the woods yet, and claiming
success might still be a bit preliminary. The concern is that while an ambitious program of asset
purchases might be welcome by different investor classes as asset prices are pushed upwards,
it might prove much more difficult to orchestrate an orderly retreat which inevitably relies on
increasing discount rates at which future income streams are priced. This is particular true if
some projects were only funded to begin with due to the exceptionally low interest rate
environment, and/or if such investments were intermediated by fund managers who care not
only about income streams, but also (and mostly) about short-term price fluctuations. Here we
will have an interesting discussion including papers by Stephen Morris, Michael Woodford, and
Gustavo Suarez, which will enlighten us about the theoretical aspects to keep in mind when
evaluating the broader consequences of asset purchase programs, as well as the empirical
evidence regarding the effects of the risk-taking channel on the quality of loans originated.
But this is not only a conference about monetary policy in developed economies. Indeed,
securities from emerging markets fit naturally into the category of riskier assets that are
expected to be affected by investors' search for yield in an environment of low interest rates,
as has been documented by a growing and exciting empirical literature. This will be the topic
of the third and final session of the conference, and will include presentations by Helene Rey,
Simon Gilchrist, and Elias Albagli. This topic is of particular concern for central bankers and
policymakers in LATAM and other emerging regions, which have good reasons to be worried
with the consequences of US monetary normalization in an environment where further
exchange rate pass-through will put increasing pressure on our inflation targets, while at the
same time interest rate pass-through puts increased pressure on subpar levels of growth.
Before giving an official start to our nineteenth annual conference, let me end by stressing a
related but perhaps less appreciated aspect by which the events of the last few years have
changed, I believe in both a fundamental and desirable manner, the way monetary policy is
handled and communicated. And if you permit me, I will illustrate the point using the recent
Chilean experience.
In Chile, although economic conditions have been far less complex than in developed
countries, we have also experimented with unconventional policies ... and frankly, I think the
experience has been successful.
First, in response to the Global Financial Crisis of 2008 the Bank increased the supply of
liquidity in pesos and dollars - through repos and swaps -, augmented the extensions of the
swap program, and broadened the range of eligible collaterals. They were all measures
designed to align market rates with the Monetary Policy Rate and to mitigate foreign currency
liquidity tensions. Forward guidance was also an important tool. With the Monetary Policy Rate
close to zero - we cut the interest rate from 8.25% to 0.5% in less than a year - ,
communicating that we planned to keep a very low short-term interest rate for an extended
period of time. This was essential in keeping medium and long term interest rates low.
These measures - as well as some other more exogenous developments such as the rapid
recovery of commodity prices - allowed the economy to rebound quite fast from a mild
recession in 2009. Actually, in the post-crisis years GDP growth was above 5% in a context of
low inflation.
Over time, these measures were eliminated, but certainly the lessons we learned from the
crisis have been incorporated into our policy analysis and toolkit. Among the most significant I
would mention two: First, the fact that the central bank must be rapid to respond and use all
the available tools if necessary. Second, that a clearer signal about what we believe will be the
path of interest rates in the future helps to have a more efficient transmission of the Monetary
Policy, particularly in turbulent times. In fact, in the more recent period, marked by a higher
than normal level of uncertainty associated with both a grimmer outlook for the Chinese
economy and the normalization of monetary policy in the United States, we have made a
special effort to signal the financial market what is the likely direction of our monetary policy in
our baseline scenario as well as the risks involved. We have done this by increasing the
transparency of our analysis and, especially, by being more precise in our communication. Of
course it is too soon to make a comprehensive and definite analysis about the costs and
benefits of this policy, but in my view this extra amount of forward guidance has been positive
in order to achieve a smoother economic adjustment in difficult times.
I thank you for being here, and without further delay, welcome to our nineteenth annual
conference: "Monetary policy through asset markets: lessons from unconventional measures
and implications for an integrated world."