What is Monetary Policy? Why is it important? What frameworks can central banks deploy? What is the difference between conventional and unconventional monetary policy?
Monetary policy is like juggling six balls… it is not ‘interest rate up, interest rate down.’ There is the exchange rate, there are long term yields, there are short term yields, there is credit growth.
~ Raghuram Rajan
Monetary policy consists of actions to influence the cost of borrowing or availability of credit through changes in the monetary base and/or interest rates. The prime objective of monetary policy is price stabilisation. But, it also seeks to achieve other objectives of financial stability, stable exchange rate, low unemployment and growth of the real economy. For example, The Federal Reserve Act, 1913 of the US lists the goals of monetary policy as “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The conventional instruments at the disposal of central banks are the policy interest rate, open market operations and reserve requirements. These can be expanded to include direct instruments like selective credit control, rationing of credit, margin requirements and moral suasion. Additionally, as the main instrument of short-term interest rate becomes ineffective at the zero lower bound (ZLB), as was found during the global financial crisis (GFC), unconventional monetary policy measures like credit easing, quantitative easing, forward guidance and signalling can also be used by a central bank.
Conventional Monetary Policy: Central banks, known originally as banks of issue, have been in existence right from 1668, when the first central bank – Bank of the Estates of the Realm (subsequently named as Riksbank) – was created, followed by the Bank of England in 1694. The initial objective of setting up of central banks was to provide means of financing war or a little later to bring financial stability by reducing the occurrences of financial crises. The central function of lender of last resort, as we know today, became an objective only in the late nineteenth century. The twentieth century witnessed additional roles of price stability, stabilisation of business cycle and full employment being assigned to central banks (Bordo and Siklos, 2017). The latter half of the twentieth century was witness to increasing independence of the central banks with the nationalisation of central banks and widening of their mandate.
With most central banks having a single focus or primary objective of low and stable inflation, the conventional monetary policy framework has worked through the instrument of short-term rates, which in turn would affect long-term interest rates. IMF (2013) brings out that the monetary transmission has operated through the inter-bank market where short-term interest rate expectations and arbitrage evolve into long term interest rates. These changes in the nominal short term and long-term interest rates, in turn, impact real rates thereby influencing the economy.
Unconventional Monetary Policy: The interest rate channel of transmission gets hampered if the key interest rates/spreads, e.g., LIBOR – Overnight Indexed Swap (OIS) operating in the inter-bank market do not move along with the policy rates of the central banks. Under such a scenario, the conventional monetary policy becomes less effective. This was precisely the case when the financial crisis of 2007 resulting from the housing crash and inadequate macro prudential tools in the US quickly became a global problem after the Lehman Brothers collapse in September 2008. To counter financial market disruptions, which increased spreads substantially, central banks deployed various tools from emergency credit facilities to cut in interest rates. As the effects spread to the real economy and policy rates continued to decrease, major central banks could not go any further in their rate cuts as the rates approached close to zero. The ZLB or Effective Lower Bound (ELB), a small positive number of policy rate, was reached, breaking the relationship between the policy rates and key interest rates.
The only ostensible response is then to change long-term interest rates directly, which incidentally is not a new thought in monetary policy. Keynes (1936) argued that “The monetary authority often tends in practice to concentrate upon short-term debts and to leave the price of long-term debts to be influenced by belated and imperfect reactions from the price of short-term debts;—though here again there is no reason why they need do so.” Further, he emphasised the importance of long-term interest rates in the scenario of a liquidity trap “after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to the holding of a debt-instrument which yields so low a rate of interest. In this event, the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test”. This view was also echoed by Tobin (1965) arguing the use of Unconventional Monetary Policy (UMP) during Great Depression, “Open-market purchases of long term securities might have helped to depress their rates and to push banks and other financial institutions into more private lending”. Conventional monetary policy operates through the short-term interest rates, while the feature that makes UMP stand out, is the active use of the balance sheet by the central bank to influence market prices and conditions. UMP during the early stages after the GFC looked towards smoothening the financial turmoil through credit facilities and hence, were similar to the traditional role of lender of last resort. However, they were unconventional in terms of their breadth and scale. As the crisis morphed into the Great Recession, central banks sought to lower bank and household borrowing costs, through expanded forward guidance (time commitment to maintain low rates) and purchase of long-term private and public bonds. These were unconventional not only for the instruments chosen but also for operational targets since they signalled a low interest rate regime for longer periods than would be the case with conventional monetary policy. Thus, Joyce et al. (2012) state unconventional monetary policies can take the form of negative interest rates, suspension of inflation targeting, expansion to central bank balance sheets or influencing interest rates other than short-term rates.
References:
Bordo, Michael, & Siklos, Pierre. (2017). Central Banks: Evolution and Innovation in Historical Perspective. NBER Working Paper(No. 23847), National Bureau of Economic Research. Retrieved from https://www.nber.org/papers/w23847.pdf
IMF. (2013). Global Impact and Challenges of Unconventional Monetary Policies. IMF Policy Paper, International Monetary Fund. Retrieved from https://www.imf.org/external/np/pp/eng/2013/090313.pdf
Keynes, John. (1936). The General Theory of Employment, Interest and Money. Palgrave Macmillan. Retrieved from http://cas2.umkc.edu/economics/people/facultypages/kregel/courses/econ645/winter2011/generaltheory.pdf
Tobin, James. (1965). The Monetary Interpretation of History. The American Economic Review, 55(3), 464-485. Retrieved from http://www.jstor.org/stable/1814559
Joyce, Michael, Miles, David, Scott, Andrew, & Vayanos, Dimitri. (2012). Quantitative Easing and Unconventional Monetary Policy – an Introduction. Economic Journal, 122(564), F271-F288. Retrieved from https://EconPapers.repec.org/RePEc:ecj:econjl:v:122:y:2012:i:564:p:f271-f288
