Lorenzo Bini Smaghi: Conventional and unconventional monetary policy
Keynote lecture by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European
Central Bank, at the International Center for Monetary and Banking Studies (ICMB), Geneva,
28 April 2009.
* * *
1. Introduction1
Centre International d'Etudes Monétaires et Bancaires
It is a pleasure to be at the to deliver
this keynote lecture on unconventional monetary policy measures.
This topic has not featured prominently in the speeches given by central bankers in recent
decades. But the escalating financial crisis since last autumn has pushed the theme to centre
stage. Central banks throughout the world have been responding to the crisis by taking both
conventional and unconventional policy measures. It is important to have a good
understanding of the unconventional policies and how they differ from the conventional ones.
I would like to focus on four groups of questions:
1. First, why and when should central banks resort to such measures? There is no
triedand-tested timetable or sign-posted pathway for moving from conventional to
unconventional measures. For instance, an issue to consider is whether
unconventional measures should or can be implemented only after the nominal
shortterm interest rate has reached its lower bound and while downside risks to price
stability prevail, or be adopted while interest rates are still positive.
2. Second, what are the main characteristics of unconventional measures?
3. Third, how are unconventional measures implemented if and when they are needed?
To answer this question, we have to distinguish between different types of
unconventional measures, from quantitative easing to credit easing. Each measure
has different effects and counter-effects, depending on the structure of the financial
system or other factors.
4. Fourth, how and when do central banks need to unwind the extra monetary stimulus?
By definition, unconventional measures are not what is generally done, so they are
not supposed to become the standard mode of monetary policy. When deciding on
them, monetary policy-makers have to think ahead and ask themselves: "We can get
in, but how do we get out?" They need to consider carefully the timing of their
withdrawal of such monetary measures - for there are risks in doing it too early, and
there are risks in leaving too late.
As you might know, the ECB Governing Council will be discussing and taking decisions on
the use of unconventional measures on 7 May. My remarks here today, made on a strictly
personal basis, in no way prejudge those decisions. Both my visit here and the subject of my
lecture were arranged some time ago. My intention today is to offer a rationale for such
measures, not to pre-announce them.
2. Why implement unconventional policy measures?
Let me start with the first question: why and when do central banks need to resort to
unconventional policy measures?
Let me first clarify what we mean by "conventional" measures. Nowadays, monetary policy
mainly acts by setting a target for the overnight interest rate in the interbank money market
and adjusting the supply of central bank money to that target through open market
operations. To minimise the risk exposure of the central bank's balance sheet, all
liquidityproviding operations normally take place in the form of reverse transactions against a menu
normal times
of eligible collateral. In other words, in the central bank is neither involved in
direct lending to the private sector or the government, nor in outright purchases of
government bonds, corporate debt or other types of debt instrument. By steering the level of
the key interest rates, the central bank effectively manages the liquidity conditions in money
markets and pursues its primary objective of maintaining price stability over the medium
term. This has proved to be a reliable way of providing sufficient monetary stimulus to the
economy during downturns, of containing inflationary pressures during upturns and of
ensuring the sound functioning of money markets.
But in, so to speak, abnormal times conventional monetary policy tools may prove insufficient
to achieve the central bank's objective. Generally, there may be two reasons for this.
•
First, the economic shock is so powerful that the nominal interest rate needs to be
brought down to zero. At that level, cutting policy rates further is not possible, so any
additional monetary stimulus can be undertaken only by resorting to unconventional
monetary policy tools. Broadly speaking, the additional monetary stimulus when the
policy interest rate is at zero can be achieved in three complementary ways: (i) by
guiding medium to long-term interest rate expectations, (ii) by changing the
composition of the central bank's balance sheet, and (iii) by expanding the size of the
central bank's balance sheet.2 All of these measures have one element in common:
they are designed to improve financing conditions beyond the very short-term
interbank interest rates.
•
Second, non-conventional measures may be warranted even when the policy interest
rate is above zero if the monetary policy transmission process is significantly
impaired. Under these circumstances, central banks have two (not necessarily
mutually exclusive) alternatives, namely (i) to reduce the short term nominal interest
rate even further than in normal conditions, and (ii) to act directly on the transmission
process by using non-conventional measures.
The experience of the past year and a half - a very stressful time for the global financial
system - have shown that non-standard tools might be needed even before policy rates have
been cut to their lower bound. When the turmoil started in summer 2007 and central banks
worldwide stepped in to provide additional liquidity to financial markets, it appeared that
conventional measures could still do the job. Although markets were not operating normally,
far from it, tensions in the euro area interbank market were considerably eased by
supplementary longer-term refinancing operations. But things changed as the crisis
intensified in September and October last year. Shortly after the collapse of Lehman
Brothers, the spread between the three-month Euribor and the overnight interest rate EONIA
- which in normal times would on average be around 10 basis points - rose to an all-time
high of 156 basis points on 13 October. Market liquidity virtually dried up, and the sudden
loss of confidence among market participants threatened to have a lasting effect on the
orderly functioning of the euro area money market.
Under these circumstances, easing monetary policy by simply lowering official interest rates
would not have been enough. Whenever the transmission channel of monetary policy is
severely impaired conventional monetary policy actions are largely ineffective. Any policy
decision therefore needed to take account of the extraordinary situation in money markets.
Central banks have different tools to cope with the extraordinary situation in interbank
markets, and their choice largely depends on institutional characteristics, but not only. The
situation of the banking sector and the types of shock hitting it are also important. So while it
is tempting to draw cross-country comparisons among such non-conventional measures, it is
also rather misleading.
An issue to consider when implementing non conventional policies is the risk of hindering the
functioning of markets by substituting or interfering with them. Agents' refinancing needs may
become excessively dependent on operations settled with the central bank. In other words,
financing conditions may become overly attractive as a result of central bank operations and
may crowd out other channels, reducing the incentives for restarting normal market
conditions.
3. Main characteristics of unconventional measures
When conventional tools can no longer achieve the central bank's objective, policy-makers
are confronted with a number of issues.
•
First, the unconventional tools include a broad range of measures aimed at easing
financing conditions. Having this menu of possible measures at their disposal - which
are not mutually exclusive ones - monetary policy-makers have to clearly define the
intermediate objectives of their unconventional policies. These may range from
providing additional central bank liquidity to banks to directly targeting liquidity
shortages and credit spreads in certain market segments. The policy-makers then
have to select measures that best suit those objectives.
•
Second, they should be wary of the possible side-effects of unconventional measures
and, in particular, of any impact on the financial soundness of the central bank's
balance sheet and of preventing a return to a normal market functioning.
In general, unconventional measures can be defined as those policies that directly target the
cost and availability of external finance to banks, households and non-financial companies.
These sources of finance can be in the form of central bank liquidity, loans, fixed-income
securities or equity. Since the cost of external finance is generally at a premium over the
short-term interbank rate on which monetary policy normally leverages, unconventional
measures may be seen as an attempt to reduce the spreads between various forms of
external finance, thereby affecting asset prices and the flow of funds in the economy.
Moreover, since these measures aim to affect financing conditions, their design has to take
into account the financial structure of the economy, in particular the structure of the flow of
funds. Let me elaborate on the possible measures.
One way to affect the cost of credit would be to influence real long-term interest rates by
impacting on market expectations. Expectations may work through several channels. For
instance, the central bank can lower the real interest rate if it can induce the public to expect
a higher price level in the future.3 If expected inflation increases, the real interest rate falls,
even if the nominal interest rate remains unchanged at the lower bound. Alternatively,
policymakers can directly influence expectations about future interest rates by resorting to a
conditional commitment to maintain policy rates at the lower bound for a significant period of
time.4 Since long-term rates are prima facie averages of expected short-term rates, the
expectation channel would tend to flatten the entire yield curve when policy-makers commit
to stay at the lower bound. Moreover, a conditional commitment to keep the very short-term
rate at the lower bound for long enough should also prevent inflation expectations from
falling, which would otherwise raise real interest rates and curtail spending. In either case, if
the management of expectations is successful, it would - ceteris paribus - reduce the real
long term rate and hence foster borrowing and aggregate demand.
Another way in which the central bank can influence the cost of credit is by affecting market
conditions of assets at various maturities - for instance, government bonds, corporate debt,
commercial paper or foreign assets. Two different types of policies can be considered. The
first aims at affecting the level of the longer term interest rate of financial assets across the
board, independently of their risk. Such type of policy would operate mainly by affecting the
market for risk free assets, typically government bonds. This policy is typically known as
"quantitative easing". The second policy is to affect the risk spread across assets, between
those whose markets are particularly impaired and those that are more functioning. Such a
policy would be usually referred as "credit easing". The two types of policies affect differently
the composition of the central bank's balance sheet.5 Another difference is that "credit
easing" can generally be conducted also at above-zero levels of the short-term nominal
interest rate, while quantitative easing should make sense only when the interest rate is at
zero or very close to zero. However, both operations aim at increasing the size of the central
bank balance sheet and therefore expanding its monetary liabilities.
Let me now consider quantitative easing and credit easing in turn.
4. How are unconventional measures implemented?
How can the size and composition of the central bank balance sheets be modified? The
straightforward way is for the central bank to directly purchase assets in the relevant
markets.
4.1 Direct quantitative easing
When the central bank decides to expand the size of its balance sheet, it has to choose
which assets to buy. In theory, it could purchase any asset from anybody. In practice,
however, quantitative easing has traditionally focused on buying longer-term government
bonds from banks. The idea is twofold: first, sovereign yields serve as a benchmark for
pricing riskier privately issued securities. When long-term government bonds are purchased,
the yields on privately issued securities are expected to decline in parallel with those on
government bonds. Second, if long-term interest rates were to fall, this would stimulate
longer-term investments and hence aggregate demand, thereby supporting price stability.
This is where banks play a critical role in the success of any quantitative easing policy. If the
aim is to ensure that new loans are provided to the private sector, central banks should
mainly purchase bonds from the banks. The additional liquidity would then be used by the
banks to extend new credit. However, banks may choose to hold the liquidity received in
exchange for the bonds in their reserves at the central bank as a buffer. In this case, the
liquidity provided by the central bank remains within the financial sector; it does not flow out
of it. This risk can be minimised if the central bank conducts this type of operation only at the
lower bound - that is, when it has fully exploited the standard interest rate channel. At the
lower bound the remuneration of deposits is null (or almost null) and there is hence little or
no incentive for banks to park excess reserves with the central bank. Deploying a policy of
quantitative easing at a policy rate different from the lower bound may necessitate a larger
expansion of the central bank's balance sheet and thus increase the risk exposure of the
monetary authority.
In light of the above considerations, the soundness of the financial system is critical to the
success of quantitative easing. When banks stop intermediating loans, this policy no longer
works. Quantitative easing is successful if it narrows the market spreads between the rates
paid on selected credit instruments and policy rates, thereby limiting the risks of a liquidity
shortfall and encouraging banks to extend credit to higher interest-paying parties.
The Bank of Japan's policy between 2001 and 2006 provides one example of quantitative
easing. It had the following key features: first, it involved a shift in the operational target for
money market operations from the uncollateralised overnight call rate to the outstanding
balance of current account deposits at the Bank of Japan, or in short the bank reserves;
second, it entailed outright purchases of Japanese government bonds to meet the target
balance of current account deposits at the Bank; and third, it involved an explicit, public
commitment to maintain these open market operations until the CPI did not fall on a
sustainable basis.
During that period, the Bank of Japan had discussions with academics about strategies for
avoiding prolonged deflation. These talks repeatedly gave rise to one particular question:
why didn't the Bank of Japan simply allow the yen to depreciate in order to stop the fall in
consumer prices? This is the essence of Lars Svensson's prominent suggestion of "The
Foolproof Way" out of deflation.6 But if it were so simple, why did the Japanese authorities
apparently fail to take the necessary measures to prevent deflation? The answer is: it wasn't
that simple. What "The Foolproof Way" underestimates is the enormous difficulty of turning
around expectations of prices and economic activity when the functioning of the financial
system is seriously impaired. The failures to restructure Japan's financial and corporate
sector and to recapitalise banks have been widely documented as key reasons for the
country's anaemic growth rates and declining prices7 - factors over which the Bank of Japan
had little control.
Let me just add something on that matter: "The Foolproof Way" wouldn't work in today's
context either. Given the global dimension of the current financial crisis, it would not be
possible for all countries to depreciate their currencies at the same time in order to push
inflation up. Such a beggar-thy-neighbour policy would be ineffective in the present
circumstances; worse, it would aggravate them by unleashing a protectionist backlash. In
fact, the leaders of the G20 recently agreed to refrain from competitive devaluation of their
currencies, and it is important to stick to this objective in both words and deeds. Although not
all countries belong to the G20, I am confident that all advanced economies will comply with
this principle.
There are some important lessons we can learn from the experience of quantitative easing in
Japan:
•
To begin with, it cannot be taken for granted that an increase in the monetary base
results in easier monetary conditions. In fact, the money multiplier has significantly
decreased during the last decade. This has, to a certain extent, reduced the effect of
injecting money into the economy.8
•
Second, as mentioned before, the banking system is crucial for the success of a
quantitative easing policy.9 However, given the high degree of de-leveraging which
the Japanese economy, and the banking sector in particular, was undergoing, banks
did not find themselves in a position to pass on the additional liquidity to the
nonfinancial sector.
•
Third, one of the expected effects of quantitative easing is a flattening of the yield
curve at longer maturity which improves the medium to longer-term financing
conditions for the private sector. But what ultimately matters for investment and
spending decisions is the real interest rate and hence inflation expectations. Strictly
speaking, an increase in the money supply should have implications for the
expectations of the future price level. But quantitative easing will only affect expected
inflation if the increase in the size of the central bank's balance sheet is not only
sizeable but also perceived as being permanent.10 The experience of the Bank of
Japan provides a clear-cut example of a temporary expansion of the monetary base
that did not affect private sector inflation expectations.
• Fourth, it is not clear how it is possible to increase inflation expectations in a
significant way while avoiding a rise in the nominal long-term interest rate after some
time. Setting the real long-term interest rate as the operational target for monetary
policy seems to be rather challenging in an environment with developed financial
markets.
• Fifth, if quantitative easing is perceived as being long-lasting then it could also have
an expansionary effect by relaxing fiscal constraints. Expansionary fiscal policies
represent a sound instrument to stimulate aggregate demand during a deflationary
period. In this respect, outright purchases of government bonds by the monetary
authority could further strengthen fiscal effects i) by accommodating the supply of
governments bonds, ii) by affecting the long-end of the yield curve - the risk premium
- and iii) by re-anchoring inflation expectations to a positive target. In particular, the
transition to a positive inflation regime reduces the burden on the future fiscal budget
by guaranteeing its financial sustainability.11
Of course, the relevance of this effect
crucially depends on the duration of the quantitative easing policy and on a credible
commitment to a well-defined exit strategy. In this respect, the broad effects
stemming from the fiscal and monetary policy mix have been quite muted in
stimulating the Japanese economy.
•
Finally, it should be recognised that a government bond purchasing programme
involves the risk of accumulating significant losses for the central bank. Government
bonds would be purchased at rather high prices. If the easing measure turned out to
be a success, the ensuing economic recovery would gradually entail an increase in
long-term interest rates; this would bring down government bond prices, so that the
central bank would eventually face losses. Concerns about central bank's balance
sheet and financial independence can seriously impede monetary policy.12 Such
constraints may be one reason why the Bank of Japan's government bond
purchasing programme has failed to restore positive inflation rates.
Let me also mention that in the context of the euro area the design of such unconventional
policy measures poses some intricate challenges, due to its unique institutional framework.
In the first place, we need to be mindful of the Treaty requirements relating to the prohibition
of monetary financing and the granting of privileged access, as well as of the consistency
with the Treaty principle of open market economy and the preservation of the disciplining
function of markets for borrowers and lenders.13 Although purchases of government bonds
are possible in the secondary market, there is a risk to eventually become a market maker
for public debt, which could be construed to be against the Treaty prohibition of monetary
financing. Moreover, we have more than just one fiscal authority in the euro area. The
Eurosystem would have to decide how to spread purchases of government bonds across
euro area countries. If, for example, the Eurosystem only concentrated on public bonds with
the best credit rating, it would risk providing privileged access to some countries,
contravening Article 102 of the Treaty. If it spread purchases according to a specific key and
ended up affecting cross-country differences in yields, it would be seen as granting privileged
access, as financing conditions for some governments would be supported to a greater
extent than for others. It may also be the case that the risk-free component of corporate
bonds would not move exactly in tandem with the risk-free component of government bond
yields. This would be tantamount to giving preferential treatment to government debt. These
issues would need to be addressed before implementing a government bond purchasing
programme in the euro area.
4.2 Direct credit easing
Credit easing is a policy that directly addresses liquidity shortages and spreads in certain
(wholesale) market segments through the purchase of commercial paper, corporate bonds
and asset-backed securities. The effectiveness of measures which are aimed at wholesale
financial markets depends on their importance in the financing of households and firms,
which varies considerably from country to country. (It is notably lower in the euro area than in
the US, for example). It is also a more attractive strategy in times of acute bank distress, for
obvious reasons.
Two things need to be noted here. First, buying privately issued securities is not
fundamentally different from buying government bonds in terms of the impact on the money
supply or the monetary base. Second, buying privately issued securities implies that the
central bank interacts directly with the private sector and is thus stepping into the realm of
credit risk - just as any normal commercial bank would do. Outright purchases of privately
issued securities affect the risk profile of the central bank's balance sheet. In order not to
compromise the financial independence of the central bank, policy-makers need to carefully
assess the eligibility of all assets on account of the implications they could have for the risk
exposure of the central bank's balance sheet.
Caution is also called for in another respect. Outright purchases of privately issued securities
need to be carefully planned to avoid allocative distortions in terms of industries, firms or
regions. Also the size of the issuer matters. While it is easy to see how large firms can
benefit from the central bank's purchases of privately issued securities, it is more difficult to
ensure that small and medium-sized companies get equal treatment. Given the limited depth
of corporate bond markets in many economies, purchases of privately issued securities
might therefore be a difficult endeavour for policy-makers.
The Federal Reserve's approach since December 2007 has been a high-profile example of
credit easing. The Fed has established several lending programmes to provide liquidity and
improve the functioning of key credit markets. The Term Auction Facility, for instance, helps
to ensure that financial institutions have adequate access to short-term credit, while the
Commercial Paper Funding Facility provides a backstop for the market for high-quality
commercial paper.14 More recently, the Fed, in cooperation with the US Treasury
Department, has begun to purchase asset-backed securities such as mortgage securities
backed by government-sponsored enterprises (GSEs).
How effective have these measures been? It's too early to say. Moreover, with a wide range
of unconventional monetary policy measures - since March the Fed has also been
purchasing government bonds in parallel - it is extremely difficult to single out the impact of
any specific measure. That being said, the spreads on eligible commercial paper in the
United States have come down following the introduction of the Fed's Commercial Paper
Funding Facility (see Chart 1). Also, the Fed's purchases of GSE debt and GSE-guaranteed
mortgage-backed securities have resulted in a decline of the 30-year conforming mortgage
rates by more than one percentage point following the announcement of this programme in
late November 2008, and have continued to decline since its expansion on 18 March 2009
(see Chart 2). The narrowing of the spread between mortgage rates and Treasuries also
suggests that the Fed's programme of purchasing agency-related mortgage securities may
have been effective in easing mortgage market conditions.
4.3 Indirect (or endogenous) quantitative/credit easing
The measures described above foresee the direct acquisition by the central bank of the
assets, in exchange for central bank money. This implies that the central bank directly holds
the assets, until maturity or resale, and thus the risk on its balance sheet. An alternative way
is to increase the size of the balance sheet by lending to banks at longer maturities, against
collateral which includes assets whose markets are temporarily impaired. This policy affects
directly the yield curve over the horizon at which policy operations are conducted or
committed to be conducted. For instance, monetary policy operations with maturity of 6
months directly affect the 6 months interbank money market. This is particularly the case if
the operations are conducted at a fixed rate, full allotment. The horizon of the yield curve
which is affected may be lengthened to the extent that the central bank commits to conduct
such type of tenders for a given period of time. For instance, if the central bank commits to
conduct 6 months refinancing operations with fixed rate tenders for 2 years, the yield curve
over the two and a half year horizon is likely to be influenced.
The increase in the monetary base is determined endogenously by the banking system,
based on banks' preference for liquidity and thus on the state of stress of the banking
system. In normal conditions, when financial markets function properly, the size of the central
bank balance sheet would be such that the overnight rate would coincide with the short term
refinancing rate of the central bank and excess reserves are negligible. Under stress, the
size of the central bank balance sheet would increase, on the basis of banks' increased
demand for excess reserves, to the point that the overnight rate would be lower than the
short term main refinancing rate.
Another aspect of such a policy relates to the quality of the collateral. By enlarging the pool
of the collateral accepted for the refinancing operations with the central bank, the financing
conditions by banks to these sectors are facilitated, which should be reflected in the credit
spreads that banks charge in particular to the corporate sector. This technique also enables
the counterparties of the central bank to choose the collateral to use in their refinancing
operations. In times of market stress there will be a natural tendency for banks to use a
greater amount of assets of a lower quality. The overall collateral deposited with the central
bank will vary endogenously, depending on the state of stress of the financial markets. The
eligibility of certain categories of assets for monetary policy operations will facilitate their
creation and trade among market participants.
In the euro area, the ECB decided to adopt a "fixed-rate full-allotment" procedure: since
October 2008 eligible counterparties in the euro area have had access to unlimited liquidity
for periods ranging from one week up to six months at a fixed rate. At the same time, we
implicitly eased monetary conditions further by expanding the list of assets eligible as
collateral in Eurosystem refinancing operations. The Eurosystem accepts a broad range of
assets as collateral in all its credit operations. This feature of the Eurosystem's collateral
framework, together with the fact that access to Eurosystem open market operations is
granted to a large pool of counterparties, has been key to supporting the implementation of
monetary policy in times of stress. The in-built flexibility of its operational framework allowed
the Eurosystem to provide the necessary liquidity to address the impaired functioning of the
money market without encountering widespread collateral constraints throughout much of
2008. It was only towards the end of the year that, in the light of the extension of refinancing
for terms longer than overnight in euro and in US dollars as well as the recourse to fixed rate
full allotment tender procedures, the Governing Council decided to expand the list of eligible
collateral on a temporary basis until the end of 2009.
In 2008 the average amount of eligible collateral increased by 17.2%, compared with 2007,
to a total of €11.1 trillion. As regards the composition of collateral put forward, the average
share of asset-backed securities increased from 16% in 2007 to 28% in 2008, overtaking
uncovered bank bonds as the largest class of assets put forward as collateral with the
Eurosystem. Uncovered bank bonds accounted on average for slightly less than 28% of the
collateral put forward in 2008. The average share of non-marketable assets increased from
10% in 2007 to 12% in 2008. By contrast, the average share of central government bonds
dropped from 15% in 2007 to 10% in 2008.
In my opinion, these changes to our monetary policy implementation can be better
characterised as "endogenous credit easing" rather than "quantitative easing", since the main
aim is to relax banks' collateral and funding liquidity constraints, so that they will expand
credit supply. Moreover, it is a policy that has been implemented at above-zero level of the
short term nominal interest rates.
It should also be emphasised that, given the importance of the banking channel in providing
credit to the economy, the unconventional policy measures that would best suit the euro area
are likely to differ in terms of scope and depth from those in the US or other advanced
economies where a more market-based financial system prevails, a consideration that is too
often overlooked. This is the main reason why our policy response so far has been tailored to
the specific nature of Europe's financial structure. A few figures will give an idea of the
differences in the financial systems of the US and the euro area. For example, at the end of
2007, the stock of outstanding bank loans to the private sector amounted to around 145% of
GDP in the euro area, but only to 63% in the United States. By contrast, outstanding debt
securities - a measure of the depth of financial markets - amounted to 81% of GDP in the
euro area as against 168% in the United States.
The ECB operations have eased financing conditions for the private sector and allowed
banks to refinance loans more easily than would otherwise have been the case. The
evidence on the extent of these policy measures on market interest rates and money market
conditions is quite encouraging. While the spread between the thre