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Exiting unconventional monetary policy

Hausarbeit 2016 19 Seiten

VWL - Finanzwissenschaft


Table of Contents

1. Introduction

2. Background
2.1 Categories of unconventional monetary policies
2.2 Commonalities and differences between major central banks

3. Difficulties with the exit of unconventional monetary policies
3.1 Timing of the exit
3.2 Duration of the exit
3.3 The role of extended guidance

4. Evaluation and conclusion



During the financial crisis many central banks in the world implemented "unconventional monetary policy" measures, such as balance-sheet policies, forward guidance, and negative interest rates. Once the financial system stabilizes, the difficult process of returning back to conventional monetary policy begins. For this reason, this paper analyzes the unconventional monetary policies that were implemented by the Federal Reserve Bank (Fed), the Bank of England (BOE), the European Central Bank (ECB), and the Bank of Japan (BOJ) during their post-crisis transitions. Next, potential challenges involved in the exit will be analyzed. The analysis suggests that a transition from unconventional monetary policies should be accomplished smoothly, without exceeding inflation, harming economic recovery, or destabilizing financial markets. Furthermore, the analysis suggests to make use of forward guidance in order to prepare the market for the exit and to increase its potential speed. However, the optimal exiting policy depends largely on present and future economic conditions of the respective currency region. In order to analyze these conditions and determine the ideal exiting strategy for each central bank, further investigations need to be done.

1. Introduction

In order to stabilize financial markets during the financial crisis, various major central banks implemented monetary policies that decreased the overnight inter-bank lending rate. Once the short-term interest rates were near zero, these conventional monetary policies became ineffective (Cf. Jones/Kulish (2013) p. 2547). Interest rates below zero are difficult to implement because market participants may be motivated to convert their bank deposits into cash. In order to address this problem, central banks such as the Federal Reserve Bank (Fed), the Bank of England (BOE), the European Central Bank (ECB), and the Bank of Japan (BOJ) implemented policy measures which are broadly defined as unconventional monetary policies. These policies were supposed to provide additional instruments for expanding the money supply in order to stabilize the financial system (Cf. Fawley/Neely (2013) p. 51). Once economic prospects improve, non- conventional monetary policies are no longer needed and are even potentially harmful for the economy as they could generate inflation. However, the process of exiting from unconventional monetary policies can have negative effects on the economy such as destabilizing the financial system and leading to another crisis. This paper will investigate these challenges which are involved in exiting from unconventional monetary policies. The analysis essentially suggests to time the exit based on forecasts about the current and future economic conditions. The duration in particular should depend on the respective size and composition of the central bank's balance sheet. Furthermore, central banks should make use of extended guidance in order to prepare the markets for the exit.

2. Background

Before analyzing the issues which relate to the exit from unconventional monetary policies, the next section will describe what these measures actually are and why they were implemented.

2.1 Categories of unconventional monetary policies

Even though definitions vary, unconventional monetary policies can be divided into two main sections, as demonstrated in Table 1. The first category includes measures with which the central bank influences interest rates. The second category consists of policies which affect the central bank's balance sheets. The two types of policies can be used either independently or jointly (Cf. Borio/Zabai (2016) p. 4). The following section will further investigate these unconventional monetary policies and their likely effect on the economy.

Table 1: Taxonomy of unconventional monetary policy measures

Abbildung in dieser Leseprobe nicht enthalten

Source: Own representation based on Borio/Zabai (2016) p. 3 and Cecchetti/Schoenholtz (2011) pp. 477-8.

One category of unconventional monetary policies is interest rate policies. In order to influence long-term interest rates, the central bank could make announcements with the explicit aim of altering market expectations. This policy will be referred to as forward guidance. According to the expectations hypothesis of the term structure (EHTS), long-term interest rates are averages of the current and expected short-run interest rates in the future. Furthermore, the liquidity premium theory suggests that long-run interest rates also include a risk premium (Cf.

Jones/Kulish (2013) p. 2548). This theory suggests that the central bank can directly affect long­term interest rates by influencing expectations about future interests. Forward guidance can generally be classified by two dimensions. Its timing can either be based on economic conditions {state-contingent) or on specific dates {calendar-based). Additionally, forward guidance can either contain specific numbers {quantitative) or vague statements {qualitative). To give an example, the central bank could state that the interest rate will be unchanged until the two percent inflation target is reached (state-contingent and quantitative) or that the interest rate will not be changed in the near future (calendar-based and qualitative) (Cf. Borio/Zabai (2016) p. 17). Even though forward guidance can be effective, it might be difficult to calibrate expectations in the market and negative side effects cannot be ruled out (Cf. Cecchetti/Schoenholtz (2011) p. 476).

Another interest rate policy is negative interest rates. Due to the fact that market participants can always hold cash, negative interest rates might seem unusual or impossible to implement. However, as the central bank determines reserves, private banks have to apply them. By charging these reserves as a kind of tax, the private banks actually face negative interests. Furthermore, by arbitrage, these interest rates might be transmitted to other economic institutions. However, negative interest rate policies have a constraint, as depositors might shift into cash at some point. It is difficult to tell when exactly the shift into cash would happen; the likelihood of the shift taking place might increase the lower the interest rates are and the longer they are expected to remain at this level. Furthermore, storage and insurance costs as well as other psychological costs might determine the probability of higher cash holdings (Cf. Borio/Zabai (2016) p. 19.).

Let us now investigate balance-sheet policies. This category can mainly be subdivided into quantitative easing, credit easing, bank reserves policies, and forward guidance. The central bank could also intervene in foreign exchange markets in order to influence the financial system but this will not be considered in this paper. Quantitative easing (QE) means the central bank exceeds the supply of reserves beyond the point which would meet its target interest rate (Cf. Cecchetti/Schoenholtz (2011) p. 477). One example of a QE policy is given in Figure 1. Here, the central bank buys government bonds from a non-bank private company, such as an insurance company. This leads to a decrease in government bonds and an increase in deposits for this insurance company. In order to pay for these bonds, the central bank credits the insurance company's bank account. The central bank itself finances its purchases by granting reserves to the private bank. One can notice that this purchase increases the balance sheets of the central bank as well as the private bank (Cf. Gagnon et al. (2010) p. I and Bowdler/Radia (2012) p. 607.). Under the assumption that the increased demand for assets has a positive effect on their prices, QE stimulates the economy by lowering interest rates. Furthermore, by assuming that expansionary monetary policies reduce financial frictions such as adverse selection, QE stimulates the economy by easing credit conditions (Cf. Fawley/Neely (2013) p. 53).



ISBN (eBook)
ISBN (Buch)
577 KB
Institution / Hochschule
University of Wisconsin-Madison – Economics
Unconventional Monetary Policy Banking Finance Exit Unwinding Transition Unkonventionell Geldpolitik Economics VWL Volkswirtschaftslehre Forward Guidance Smooth Inflation Economic recovery destabilization



Titel: Exiting unconventional monetary policy