John Murray: When the unconventional becomes conventional -
monetary policy in extraordinary times
Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the Global
Interdependence Center, Philadelphia, Pennsylvania, 19 May 2009.
The original speech, which contains various links to the documents mentioned, can be found on the Bank of
Canada's website.
* * *
Good afternoon. The financial turbulence that began in the U.S. subprime-mortgage market
in August 2007 reached maximum intensity towards the end of 2008, and enveloped the
entire global economy. Strains that had previously been concentrated in a few major financial
centers turned into a full-blown crisis, affecting both industrial and emerging-market
economies through trade, financial, and confidence channels.
Policy-makers reacted quickly, applying unprecedented monetary and fiscal stimulus as the
gravity of the situation became clear. For central banks, this involved pushing target interest
rates to historic lows and providing emergency liquidity on an extraordinary scale. Although a
number of "green shoots" have recently appeared and the global economy is no longer
deteriorating at an accelerating rate, we remain in the midst of the deepest and most
synchronous contraction of the postwar period.
Many central banks have tested the limits of their traditional monetary policy instruments and
have turned to so-called "unconventional" measures. Others are giving unconventional
measures serious consideration. These instruments are unfamiliar and there is a great deal
of confusion over exactly what they are and how they work. Some observers believe that
they will be largely ineffective, making a deflationary spiral inevitable. Others worry that they
will be too effective, or will be left in place too long, leading to an inflationary spiral. Either
way, unconventional monetary policy instruments are regarded by many as a decidedly risky
option.
The main purpose of my presentation today is to address these misconceptions and to
alleviate some of the unnecessary concerns that have arisen about the use of
unconventional monetary policies. First, I will explain what central banks mean when they
refer to unconventional measures, and how these measures differ from conventional
monetary policy measures. Second, I will review the principles that have been developed to
help guide the use of such instruments, if it is deemed necessary. Finally, I will examine their
potential effectiveness in the light of recent experience.
While it's too early to draw strong conclusions, the experience to date with unconventional
measures has been largely positive. I'll give some examples to support my upbeat
assessment later in these remarks. But I'll begin with a few comments about recent economic
developments, and the remedial policy actions that have been undertaken.
Recent economic developments
A G-7 colleague has cleverly summarized the experience many of us are living these days as
"redesigning an airplane while flying it." Sometimes it may feel this way; however, this does
not do justice to the coherent policy frameworks and careful planning that help guide many of
the policy measures that we are implementing. The unprecedented economic times in which
we live and work have forced us to be increasingly creative. Every major industrial country is
now in recession, as are many emerging-market economies. Those EMEs that are still
growing have witnessed a marked deceleration in real economic activity, and any hopes of
"decoupling" have long since disappeared. Concerns about stagflation, which dominated
policy debates as recently as eight months ago, have largely dissipated, replaced by
concerns of deflation. Headline inflation in advanced economies has fallen dramatically,
reflecting the collapse in commodity prices and widening output gaps, and is expected to dip
briefly below zero in many countries.
It is important to note that despite the dire news, a recovery is still in prospect, aided by
aggressive policy actions. The Bank of Canada recently published its spring Monetary Policy
Report, where we outlined our views on current economic conditions and the near-term
outlook. In a special annex to the Report, we also presented a framework for unconventional
monetary policy and how this could be applied, if necessary.
These are exceptional and unsettling times; anything that can be done to reduce uncertainty
and instill confidence is particularly welcome. It was with this in mind that the Bank of
Canada decided to add the special annex to its last Report. Our framework for conventional
monetary policy, based on a flexible exchange rate, an explicit inflation target, and clear
accountability has served us well, and will continue to guide our future actions. The annex
builds on this foundation, providing a clear contingency plan for unconventional measures
and for dealing with some extraordinary challenges.
Monetary and fiscal policy responses
Policy-makers in Canada, the United States, and elsewhere have moved with exceptional
speed and determination to support financial markets, restore growth, and re-equilibrate the
real economy. Authorities have provided extraordinary assistance to the financial sector in
the form of emergency liquidity, balance sheet guarantees, asset purchases, and
recapitalization as appropriate. Ambitious and concerted discretionary fiscal measures have
also been initiated and, together with automatic fiscal stabilizers, will help lift aggregate
demand.
Equally impressive and timely action has been undertaken by monetary authorities through
aggressive cuts to policy interest rates (see Chart 1) These short-term rates are now close to
zero - the lowest level that nominal interest rates can go. Attempts to push nominal rates
persistently below zero are bound to be ineffective, since investors always have the
alternative of converting their securities into cash. Indeed, the effective lower bound (ELB) for
policy interest rates, as I shall explain in a minute, is likely to lie somewhat above zero. This
suggests that most major central banks have already reached the maximum dosage of their
conventional monetary policy medicine. This doesn't mean, however, that central banks are
out of ammunition.
Conventional monetary policy and the effective lower bound
In more conventional times - that is, when banks and financial markets are fully operational -
the process of monetary policy transmission follows a reasonably direct and well-understood
path. The first step involves a careful monitoring and forecasting of economic activity and
inflation. Second, the central bank must decide whether more or less macroeconomic
stimulus is needed. For many central banks, this is guided by an explicit (or implicit) inflation
target, since keeping inflation low, stable, and predictable is generally accepted as the best
contribution that a central bank can make to the economic well-being of its nation's citizens.1
The value of having such a clear and credible target will be explored in more detail a little
later in these remarks.
Third, if action is necessary, the central bank will either lower or raise its target interest rate,
depending on the circumstances. From there, the monetary impulse is transmitted to other
financial instruments with longer maturities, including the interest rates charged by banks on
loans. While few transactions are actually conducted at the target rate, the interest rates that
they influence further out the yield curve do have a material effect on the borrowing and
lending decisions of households and businesses.
Once the target interest rate approaches zero, conventional monetary policy has gone just
about as far as it can go. Nominal interest rates, as noted earlier, cannot fall below zero, and
most central banks would aim to stop slightly above this level, leaving a small positive margin
or buffer. Pushing policy rates too low can lead to problems in financial markets and restrict
the flow of credit at the very time central banks are trying to restore it.
For these and other reasons, policy-makers are often reluctant to drop their target rate much
below 25 or 50 basis points, the effective lower bound or ELB for many central banks.
Unconventional monetary policy instruments
Once the ELB has been reached, monetary policy can continue to ease, but other means
must be found to increase the flow of credit and to lower interest rates out the maturity
spectrum. Three basic mechanisms have been identified for this purpose.
1. Conditional statements about the future path of policy rates
The first mechanism is a conditional commitment regarding the future path of the policy
interest rate. In normal times, this type of interest rate guidance is usually kept to a minimum
or expressed in very general terms. In extraordinary times - such as we now face - it may be
necessary to be more explicit and make a clear conditional commitment to keep the target
overnight rate low for an extended period. Using this approach, central banks can influence
interest rates well out the yield curve, because long-term rates are largely a reflection of
expected future short rates. While it may not be possible to lower the overnight rate any
further, expectations at longer maturities can still be shaped by conditionally committing to
keep the overnight rate low.
For this mechanism to work, the conditional commitment must be credible, and inflation
expectations must remain well anchored. Canada's positive experience over the past 18
years with an inflation targeting framework is especially helpful in this regard. Inflation
targeting has reduced the risk of deflationary expectations, permitted aggressive policy
action in response to the current crisis, and will no doubt make it easier to exit from any
unconventional policies that are introduced.
2. Quantitative easing
The second unconventional mechanism is quantitative easing. It is sometimes referred to
pejoratively, and mistakenly, as "printing money." Quantitative easing occurs whenever a
central bank purchases private or public sector securities by expanding its reserve base.
These purchases directly affect the yields of the securities that are bought, putting downward
pressure on their interest rates and upward pressure on their prices. They also inject
additional central bank reserves into the financial system, which deposit-taking institutions
can use to generate additional loans.
All quantitative easing is, by definition, "unsterilized." Although this is correctly viewed as
unconventional, it closely resembles the way monetary policy is described in most
undergraduate textbooks, and is broadly similar to how it was conducted in the heyday of
monetarism.
3. Credit easing
Credit easing is the third mechanism, and is a term reserved exclusively for central bank
purchases of private sector assets in segments of the market where dislocations and credit
constraints appear to be most severe. It is designed to ease credit conditions by stimulating
more active trade in certain assets and through a process of portfolio substitution.
Sterilized purchases of private sector assets can be effected either by selling existing assets
on the central bank's balance sheet - essentially swapping "good" assets for "bad" - or by
creating additional central bank reserves and then sterilizing, or mopping up, the extra
reserves by selling new government securities.2 Credit easing can also be combined with
quantitative easing, in which case the purchase of private assets will remain unsterilized and
the reserve base will expand.
Four guiding principles
Although the three unconventional monetary policy instruments I have just described have
been studied extensively, real-world experience with them in recent times is limited. Any
decision to use them necessarily involves some risk and uncertainty. To deal with these
challenges, the Bank of Canada has identified four key principles that would guide its actions
whenever these unconventional measures are employed. These principles can be
summarized in four words: focus, impact, neutrality, and prudence.
1. Focus
Any unconventional action initiated by the Bank must have as its primary objective the
achievement and maintenance of the Bank's 2 per cent inflation target. Restoring the normal
functioning of financial markets and the flow of credit would be important considerations, but
only to the extent that they help to achieve the ultimate objective.
2. Impact
Decisions regarding which unconventional instruments to use, and when, would depend on
current and prospective economic conditions, as opposed to a mechanical game plan. In the
case of credit easing, consideration would be given to the severity of the market failure, the
ability of the Bank to correct it, and its importance for the functioning of the real economy.
Financial markets that were under the most extreme pressure would not necessarily be given
priority. The impact on output and inflation would be the determining factor.
3. Neutrality
Unconventional monetary policy measures would also be implemented in a manner that
minimized the chances of distorting other markets or producing unintended consequences
elsewhere. This would imply operating in as broad a market segment as possible and
avoiding targeted assistance to specific industries or firms.3
4. Prudence
The fourth principle - prudence - can be exercised in several ways. One is to minimize the
risks that unconventional policies might pose for the central bank's balance sheet and hence,
taxpayers' pockets. Credit and quantitative easing can subject a central bank to market risk,
especially if it is holding long-term instruments and interest rates begin to rise more than
expected. Ironically, this rise could be a sign that the unconventional policies were working.4
Credit easing could also subject a central bank to credit risk, since it involves the purchase of
less-creditworthy instruments. Some of these risks can be mitigated through careful
screening, the imposition of a minimum credit rating, and dealing in shorter-term instruments.
But this will not always be possible if the central bank wants to achieve a particular effect.
Prudence of a slightly different sort is also needed to ensure the unconventional measures
that have been put in place can be reversed or undone without undue market disruption or
threat to the central bank's macro objectives. Some short-term and short-dated assets can
easily roll off the central bank's balance sheet as they mature. Longer-term assets, in
contrast, might have to be sold off slowly or held to maturity.5
Some useful indicators
Central banks monitor a number of economic and financial indicators in the normal course of
events; but in uncertain times, the need for a diversified and vigilant approach is even
greater. Changes in interest rate levels and spreads before and after any unconventional
measure has been introduced can serve as a rough barometer of its impact - a sort of crude
event analysis. Anecdotal information drawn from surveys of businesses, households, and
financial institutions can also help central banks monitor changes in the pricing, terms and
conditions of debt financing and borrowing. The surveys of senior loan officers conducted in
most advanced economies are examples of this.
The growth of various credit and money aggregates can also be used as a rough guide. Of
course, since movements in credit and money can be driven by either demand or supply
factors, it won't always be clear which way the real financial linkages are running. Moreover,
relationships between money, credit, and the real economy are seldom stable, even in
tranquil times. In periods of high volatility and very low interest rates, the instability becomes
even more extreme. As a result, price and interest rate measures are likely to prove more
reliable.
Many central banks have constructed summary measures to judge the ease or tightness of
financial conditions in their markets. These financial conditions indices (FCIs) are empirically
based and include a number of different indicators, each weighted by its estimated impact on
GDP growth. Some representative indices for Canada and other countries are shown in
Charts 2 and 3. Although one shouldn't assign too much importance to a particular FCI level,
large changes in an FCI probably indicate a significant easing or tightening.
At the Bank of Canada, we have brought all of our credit measures together on a single web
page. This collection, which we have dubbed our Credit Dashboard, can be viewed at:
http://credit.bank-banque-canada.ca/index.php/about.
Are unconventional monetary policies working?
The basic question remains: Does unconventional monetary policy actually work? There is
good reason to believe that if these measures are implemented vigorously and with the clear
support of authorities, they will be successful. Initial results for the unconventional policies
recently employed by Canada, Japan, the euro zone, the United Kingdom, and the United
States are certainly promising. However, any assessment of the effectiveness of these
measures must necessarily be treated with considerable caution.
•
First, these are early days, and we don't have a great deal of evidence to draw on.
•
Second, several policies are often initiated simultaneously, so it is difficult to gauge
the impact of any particular one.
•
Third, spillover effects from one market to another could be significant but difficult to
detect.
•
Fourth, short-run and long-run effects could differ enormously and will depend
importantly on the initial conditions in the economy and how the policy is applied.
•
Fifth, lower spreads and interest rates may reflect weaker demand as opposed to an
easing in credit conditions. Attempting to draw definite conclusions is therefore risky.
It is also important to remember that each country's economic and institutional circumstances
are different and may require a different approach to unconventional monetary policy easing.
No single formula will suit all cases. This is reflected in the different strategies recently
adopted by a number of countries. Switzerland, for example, lacks deep markets in
government and private-sector securities, and has decided to conduct quantitative easing via
unsterilized intervention in the foreign exchange market. Japan's financial markets have not
been as seriously affected as those in many other advanced countries, but its banks have
needed significant support, so most of Japan's unconventional efforts in the past year have
been focused on banks.6
The United Kingdom has concentrated most of its quantitative easing in the market for
government bonds or gilts, since commercial paper and corporate bond issuance are not as
significant. The focus in the United States is quite different again. Greater emphasis has
been put on quantitative easing using private sector assets.
Canada has not been subject to many of the imbalances and vulnerabilities that have
affected other countries, and has had less need for unconventional measures. The Bank of
Canada has not engaged in credit or quantitative easing, but has made a conditional
commitment regarding the future path of the target interest rate. At the Bank of Canada's last
fixed announcement date we lowered the target overnight rate to 25 basis points - consistent
with our estimate of the effective lower bound - and committed to keep the rate there until
the end of the second quarter of 2010, conditional on the inflation outlook. This conditional
commitment was buttressed by a decision to offer term purchase and resale agreements out
to a one-year maturity, with set maximum and minimum bid rates.7
So, how have all of these diverse actions fared? Here is a brief and tentative summary of
how the unconventional measures adopted by Canada and other industrial countries have
performed so far.
•
Conditional commitments - Several countries have made conditional commitments
indicating that they are prepared leave their target interest rates at or near the ELB
for an extended period. All of them appear to have had some effect on market yields,
at least at the time of the announcement. Canada has made the most explicit
commitment of the major industrial countries and has backed its words with actions.
The result has been significant and lasting, in the form of a 10- to-20-basis-point
decline in implied yields on government bonds out to one year (see Chart 4).
• Quantitative easing - Experience here is more limited, but targeted unsterilized
purchases of corporate debt and commercial paper in Japan and the United Kingdom
appear to have reduced spreads and increased issuance. Unsterilized purchases of
government securities in the United Kingdom and in the United States led to sharp
declines for a short time when these programs were first announced, but yields have
since reversed. Authorities believe that this does not reflect the waning influence of
the programs, but rather the arrival of more positive economic news and other
developments that would have triggered even larger upward movements had the
programs not been in place.
•
Credit easing - Borrowing costs and interest rate spreads in almost all markets have
improved for a variety of reasons, but significant changes in specific markets can be
linked directly to the introduction of certain central bank (and government)
crediteasing programs. These include, among others, the Government of Canada's Insured
Mortgage Purchase Plan (IMPP); the U.S. Federal Reserve's purchases of GSE
direct obligations and mortgage-backed securities (MBS); and the U.S. Commercial
Paper Funding Facility (CPFF) (See Chart 5).
The early results, along all three unconventional policy channels, are generally encouraging.
Conclusion
I would like to leave you with four main messages: First, central banks are not out of
ammunition; unconventional monetary policy measures can be effective. Second, while their
use is subject to somewhat greater uncertainty than traditional tools, unconventional
measures are more fresh than frightening. In many cases, they are direct extensions of what
we do in the normal course of business. Third, prudent strategies are available to minimize
the credit and interest rate risks borne by the public sector and hence, the taxpayer. Fourth,
extra care will be taken to achieve an orderly exit, guided by the clear monetary policy
frameworks that most central banks now have in place. This will help to minimize the
chances of a premature and destabilizing "exit," and also guard against a sharp rise in
inflation.
Stated more simply, the risks of either a deflationary collapse or an inflationary spiral have
been greatly exaggerated. Central banks will not forget to shut off the liquidity taps when
additional stimulus is no longer required. But we shouldn't get ahead of ourselves. We must
first reach a point where growth is self-sustaining and we are confident that our inflation
objective can be reached.
BIS Review 61/2009
BIS Review 61/2009
BIS Review 61/2009