Seppo Honkapohja: International spillovers from unconventional
monetary policy easing and exit - what do we know?
Remarks by Mr Seppo Honkapohja, Member of the Board of the Bank of Finland, in the
panel session "Unconventional Monetary Policy and Its Reversal: Policy Options for Growth
and Stability", Asian Economic Panel, Helsinki, 9 June 2014.
* * *
Introduction: the global financial crisis and the crisis in Europe
The start of the global financial crisis can be dated in different ways. One plausible date is
almost seven years ago in August 9 in 2007 when significant turmoil in financial markets
appeared. This unrest continued and in September 2008 a financial panic brought financial
markets to a halt and the resulting economic downturn in 2008-2009 which for a while
resembled the pace of developments in the Great Depression.1 In Europe, a further stage of
the crisis appeared in 2010 when a sovereign debt crisis hit some euro area countries. Some
of the roots in the Euro crisis were due to specific features of construction of the European
Monetary Union, but the crisis was also triggered by the second-wave shocks from the global
financial crisis.
The first-round effect of the 2007-2008 panic was a vast deterioration of balance sheets of
banks and other financial institutions. Growing uncertainty about asset and collateral quality
squeezed credit and dried up liquidity. The downward spiral of the financial system, unseen
in developed countries for eight decades, called for prompt and extraordinary policy actions.
Monetary policy responses
Management of short-term interest rates became the key policy tool and the stabilization of
inflation the central policy objective during the Great Moderation period. This standard policy
framework turned out insufficient to contain the panic. The Federal Funds Rate in the United
States hit the zero lower bound in December 2008 and has remained at this level ever since.
The European Central Bank also started a series of reductions of its Main Refinancing
Operations (MRO) rate.
With little or no room for further interest rate reductions, the central banks in developed
countries turned their attention to highly unconventional measures, previously regarded as
inconsistent with the inflation targeting paradigm. The objective of these measures was to
maintain financial liquidity and stability. However, the move towards longer-term maturities
was also designed to flatten the yield curve and stimulate real investment. In November 2008
the Federal Reserve started the first round of quantitative easing and began to buy a wide
class of assets, including mortgage-backed securities, long-term government debt and bank
debt. By mid-2010 the stock of these assets at the FED reached 2.1 trillion dollars. In the
second round, it bought another 600 bln USD. Similar non-standard measures have been
taken by the Bank of England and Bank of Japan.
The unconventional measures of the ECB in response to the crisis have been somewhat
different. ECB's tools focused on supporting liquidity and funding for the banking system. The
ECB introduced the fixed rate and full allotment principle to all refinancing operations in
October 2008. It extended collateral eligibility to less liquid assets. Between 2009 and 2011,
the Longer-Term Refinancing Operations (LTROs) were extended to maturities of up to
3 years. The ECB also started a purchase program of covered bonds which are a key source
of funding credit for private banks in many Euro area countries.2
Most importantly, the ECB did not initiate purchases of government bonds. However, in
2010-2012 the ECB operated the Securities Market Programme (SMP), which amounted to
sterilized interventions on public and private bond markets (in practice only public). This was
done to to facilitate monetary policy transmission in countries that faced severe sovereign
debt problems.
The culmination of the Eurozone crisis in mid-2012 was tamed by the creation of the ECB's
OMT (Outright Monetary Transactions) program. I quote President Draghi's promise that
"Within [its] mandate, the ECB is ready to do whatever it takes to preserve the euro".3 OMT is
a conditional promise to buy in the secondary market without limit government bonds of
selected Euro area countries. OMT has worked and remarkably, there has so far not been
any need to activate the program.
International spillovers
Liquidity support operations by central banks at different stages, explicit state guarantees to
banks and expansionary policies succeeded in stopping the recession, which changed the
course of developments in comparison to the 1930's. These unconventional policy measures
were not implemented in a group of economically disconnected islands, but in a globalized
world with synchronized financial cycles and few borders for capital.4 It is therefore important
to ask what the consequences of these new forms of monetary policy for other countries are
and how strong are the potential spillovers.
One new line of theoretical research points to positive effects of international spillovers.5 If
country-specific shocks have global repercussions and intermediaries in both countries face
similar balance sheet constraints (think USA and the Euro area), a policy implemented in one
county will help the other one as well. However, if these policies are costly, they may lead to
a free-rider problem in which both countries wait for the policy being implemented in the
other.
These predictions seem to be confirmed empirically, at least in the US case. The first round
of QE seems to have substantially reduced bond yields not only in the US, but also in
Germany, Japan and the UK.6 It also contributed to the weakening of the US dollar, although
the impact on net exports is a bit harder to assess.7
The evidence for ECB policy spillovers is, on the other hand, much weaker. This may in part
be due to the fact that the European Central Bank focused on reducing intra-Euro yields.
These operations actually lifted German bond yields as the safe heaven effect subsided and
in fact strengthened the Euro. The net sale of Eurozone bonds (i.e. net inflows) was strongly
2
See e.g. Cour-Thimann and Winkler (2013), "The ECB's non-standard monetary policy measures", ECB
Working Paper No. 1528, April 2013.
3
Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in
London 26 July 2012 (www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html).
4
Rey Hélène (2013), "Dilemma not Trilemma. The global financial cycle and monetary policy independence",
paper presented at the Jackson Hole Symposium, August 2013.
5
Dedola L., Karadi P., Lombardo G. (2013), "Global implications of national unconventional policies", Journal of
Monetary Economics, No.60, 2013.
6
Neely Ch. (2013), "Unconventional Monetary Policy Had Large International Effects", Federal Reserve Bank of
St. Louis Working Paper 2010-018D, August 2013.
7
Glick R., Leduc S. (2013), "The Effects of Unconventional and Conventional U.S. Monetary Policy on the
Dollar", Federal Reserve Bank of San Francisco Working Paper, 2013-11, May 2013.
reflected in the financial account dynamics and closely co-moved with the exchange rate
since the beginning of the crisis.
More generally, however, spillovers seem to be asymmetric, with significant impact of the
FED abroad, but not the other way round. For Japan and the UK, the smaller size of these
operations may be one explanatory factor.8
At the very least, therefore, unconventional policies had marked effects on exchange rates.
In the Eurozone, the impact was in the opposite direction than in economies which
implemented QE. Currency depreciations of large economies, in turn, clearly recall thoughts
about beggar-thy-neighbor policies9 and procyclical waves of capital flows going abroad.10
This leads me to discuss the impact of unconventional policies on emerging economies. It
has been widely acknowledged that the low returns on assets in the developed world have
substantially increased capital inflows to emerging economies, which offer higher yields. For
example, a substantial increase of non-financial corporate debt was observed.11 Equity prices
went up and sovereign yields subsided.12 The side effect of this demand was real
appreciation of these currencies. In fact, the international spillovers of FED's QE seem to
affect emerging economies more strongly than advanced ones, or even for the US itself.13
The implications of currency depreciation in one country may theoretically have some
positive effects as well. In an integrated world negative demand shocks spill over and can
create a liquidity trap in both countries.14 The solution to escape it is to inflate the economy.
Done in isolation, this leads to currency depreciation and beggar-thy-neighbor effects. But if
both countries inflate, then depreciations cancel out and both economies can get out from
the trap.
Appreciation may be a problem for a small open economy facing its own zero lower bound,
because the bound makes its own monetary policy less effective.15 But if the goods that the
economy produces are complements of those produced in the U.S. (think of commodities
used as input in production), the net effects might be positive.
Tapering
Since September 2012, the FED has been purchasing MBS and treasuries at 85 bln per
month. In May 2013 it announced a gradual unwinding of QE3, which was then put
off/postponed in September. Eventually, the tapering started in January 2014, and it is
currently 45 bln USD per month.
8
Rogers J., Scotti Ch., Wright J. (2014), "Evaluating Asset-Market Effects of Unconventional Monetary Policy: A
Cross-Country Comparison", International Finance Discussion Papers, Board of Governors of the Federal
Reserve System, No. 1101, March 2014.
9
Eichengreen B. (2013), "Currency War or International Policy Coordination?", mimeo, January 2013.
10
Reinhart C. and Reinhart V. (2008), "Capital Flow Bonanzas", NBER Working Paper No. 14321, September
2008.
11
Lo Duca M., Nicoletti G., Vidal Martinez A. (2014), "Global Corporate Bond Issuance. What Role for US
Quantitative Easing", ECB Working Paper No. 1649, March 2014.
12
Fratzscher M., Lo Duca M., Straub R. (2013), "On the International Spillovers of US Quantitative Easing", ECB
Working Paper No. 1557, June 2013.
13
Chen Q., Filardo A., He D., Zhu F. (2012), "International spillovers of central bank balance sheet policies", BIS
Papers No.66, October 2012.
14
Jeanne O. (2009), "The Global Liquidity Trap", mimeo, October 2009.
15
Haberis A., Lipinska A. (2012), "International Policy Spillovers at the Zero Lower Bound", Federal Reserve
Board Finance and Economics Discussion Series, 2012-23, April 2012.
The announcement and postponement episode stirred some unease internationally, not least
in emerging economies. The economic debate has then focused on whether the tapering will
trigger a pull-out of capital from the emerging world and potentially trigger a new wave of
turbulence, akin to those from 1990s and 1980s.16
Preliminary research suggests that news about tapering did have indeed an impact abroad.
Announcements by chairman Bernanke were are associated with larger nominal exchange
rate depreciations, stock market contractions as well as increases of credit default swaps.17
Although the initial impact of these announcements has not been necessarily correlated with
the strength of the country's fundamentals, over time the attention of financial markets has
turned towards more fragile countries. This includes mainly economies which initially
witnessed sharp inflows and real appreciations reflected in large current account deficits.18
India, South Africa, Turkey, Argentina had to increase interest rates early this year to contain
exchange rate slump.
Nevertheless, the currency depreciations have not been a unifying story in the developing
world. In fact, according to the January 2014 World Bank report, over 60% of developing
countries witnessed appreciation throughout the taper-talk period (April-August 2013).19 In
many emerging countries, e.g. Chile, Malaysia, and Mexico, the depreciations were much
more pronounced.
The diversity of responses to tapering across different countries, even those within the same
geographic region, suggests that domestic factors are the key in amplifying or absorbing
these foreign shocks. One clear aspect is the degree of leverage in the banking sector, which
has been on the rise in many Asian countries since early 2000s.20
It remains a valid question whether and to what extent can the potential negative effects of
tapering be spared. The way of implementing the tapering may play a role per se. There are
two aspects of this problem. The first is the degree of commitment to policy
announcements.21 The second is the potential for policy synchronization and cooperation.
The mandate of all major central banks is focused solely on domestic policy objectives.
Nevertheless, the interconnectedness of global financial markets means that domestic policy
decisions which are harmful abroad may ultimately backfire at home. The financial crisis has
proved that the interpretation of the legal mandate can be subject to some interpretation,
depending on the severity of circumstances. It can also be noted that international
coordination of monetary policies is not without precedent. One example is the Plaza Accord
in 1985, a joint intervention to weaken the US dollar. Also, in October 2008 four major central
banks cut their key policy rates in a coordinated fashion.
At this junction it is not clear if tapering is going to have clear negative effects in emerging
economies. The World Bank documents made negative forecast revisions of GDP growth
internationally after May 2013. On the other hand, for financially stable economies, moderate
16
Calvo G., Leiderman L., Reinhart C. (1993), "Capital Inflows and Real Exchange Rate Appreciation in Latin
America", International Monetary Fund Staff Papers, 40:1, March 1993.
17
Aizenman J., Binici M., Hutchison M. (2014), "The Transmission of Federal Reserve Tapering News to
Emerging Financial Markets", NBER Working Paper No. 19980, March 2014.
18
Eichengreen B., Gupta P. (2013), "Tapering Talk. The Impact of Expectations of Reduced Federal Reserve
Security Purchases on Emerging Markets", mimeo, December 2013.
19
World Bank Global Economic Prospects, January 2014.
20
Forbes K. (2014), "Capital Flow Volatility and Contagion: A Focus on Asia", Reserve Bank of India - Asian
Development Bank volume on Managing Capital Flows, forthcoming.
21
Woodford M., "Methods of Policy Accommodation at the Interest-Rate Lower Bound", paper presented at the
Jackson Hole Symposium, August 2012.
depreciations may turn expansionary.22 Finally, unwinding unconventional monetary policy is
ultimately a signal of US recovery and should therefore be interpreted as good news.
Another piece of good news might be that, at the end, the spillover effects of policies like QE
seem to work through standard, well understood channels, i.e. through exchange rate
movements and interest rate differentials. From this perspective it is hard to say what makes
these unconventional policies distinct.23