Which are the various channels of transmission of monetary policy? How can conventional monetary policy be transmitted? How does unconventional monetary policy differs in the channels of transmission of monetary policy?
Monetary policy transmission encompasses the whole continuum of interest rates; of course, the central bank only determines the overnight policy rate.
~ Urjit Patel
We discussed the monetary policy frameworks in an earlier post. We learned that most central banks’ target short-term interest rates which in turn impact the term structure of interest rates thereby influencing consumption, savings and investment decisions and ultimately impact macroeconomic areas. Transmission of monetary policy is particularly strong through the interest rate channel in developed countries (Bernanke & Blinder, 1992), while for emerging economies, credit channel is known to prevail over others (Mishra & Montiel, 2012). In the realm of unconventional monetary policies, the channels of transmission differ as interest rates reach Zero Lower Bound (ZLB) or Effective Lower Bound (ELB).
Conventional Monetary Policy: Cevik and Teksoz (2013) list the following six transmission channels of monetary policy:
- Interest Rate Channel: Change in policy rate spreads to bank lending and deposit rates affecting business and household spending.
- Credit Channel: Monetary contraction drives down bank reserves and inhibits the bank lending thereby hampering bank-dependent borrowers to undertake production.
- Exchange rate Channel: Higher interest leads to an appreciation in domestic currency driving down external demand for domestic output.
- Balance Sheet Channel: Expansionary monetary policy can affect a real change in money balances of households and firms that rely on borrowed funds leading to increased consumer demand.
- Asset Prices Channel: Monetary expansion leads to increased demand for equities, thereby leading to higher equity prices and higher investment.
- Expectations Channel: Central bank commitment, credibility and predictability to its actions are important.
The above channels of transmission are not mutually exclusive and every country may have a predominance of one channel over others, which may change over time based on various factors like the degree of monetisation, the extent of borrowing from formal channels, monetary policy instruments being used, financial market development, fiscal position and stance and degree of integration with the world.
Unconventional Monetary Policy: The global financial crisis and sovereign debt crisis of Europe created highly dysfunctional inter-bank markets leading to a collapse of the ABS market in the US in 2008 and sovereign bond market of peripheral euro area countries in 2011. The collapse of credit markets, liquidity crunch and policy rates in various countries reaching the ZLB, unconventional monetary policies were adopted to counteract the hampering of conventional monetary policy transmission mechanisms. We discuss four transmission channels of unconventional monetary policy propounded by various economists:
1) Portfolio Substitution/ Rebalancing Channel: A liquidity trap situation can arise at the ZLB where deposits at bank and investment in short-term bonds are perfect substitutes with little credit risk and zero interest. However, bank deposits and investments in long terms bonds are not perfect substitutes (Joyce, Miles, Scott, & Vayanos, 2012) due to the prevalence of preferred habitat arising from the need of pension and mutual funds and other investors to match maturities as well as due to the pricing of duration risk. As a central bank purchases gilts and their price increases, investors in gilts will replace them with other cheaper and slightly riskier long-dated securities like foreign bonds, high rated corporate bonds, or blue-chip stocks and the process will continue as investors will continuously shift to cheaper and riskier assets until all asset prices reflect the changes in the aggregate supply of assets. This is the portfolio rebalancing channel whose effectiveness, apart from imperfect substitutability, depends on the degree of substitutability among assets (Radia & Bowdler, 2012). Thus, effectiveness will be more when money is less substitutable for government debt and risky assets are more substitutable for government debt.
2) Signalling Channel: Central bank purchases are like signals which point towards the likely path that the central bank will take concerning monetary policy. These central bank purchases give a signal of intent and commitment to maintaining a loose monetary policy even when policy rates are at ELB. Further, through its economic outlook and forward guidance, it can signal low policy rates well into the future. Central bank purchase announcements or forward guidance can lead to expectations of reduced policy rates, arising from poor economic outlook, then the average expected overnight rate will reduce and through it the long term interest rates (Neely, 2015). Also, time inconsistency problem is alleviated by signalling effect since the purchase of risky assets by a central bank will communicate a longer than expected loose monetary policy since raising interest rates would make the central bank suffer capital losses on its portfolio (Szczerbowicz, 2015).
3) Liquidity Channel: Investors will demand a liquidity premium when an economy witnesses financial market stress due to paucity of demand which will make it difficult to liquidate the asset when required. Central bank purchases may be more effective in more illiquid asset markets rather than in gilts which are usually highly liquid. Although there is evidence to the effect of liquidity channel, the size and persistence of the effect is not understood, along with the difficulty of separately identifying portfolio balancing, signalling and liquidity effects of a specific asset purchase (Radia & Bowdler, 2012). Liquidity provision by central banks or unconventional policies creating excess liquidity in the market reduces liquidity premium in the interbank market. Further, key interest rates like LIBOR and Euro Interbank Offered Rate (EURIBOR) can be reduced, which has a direct impact on stimulating private spending since they majorly form the basis of lending to private parties (Pattipeilohy et al., 2013).
4) Bank Funding Channel: This channel also operates only under conditions where banks are facing a paucity of liquidity like the liquidity channel. When there is liquidity deficiency, banks will limit their lending activity and use the resources for their requirements. Central bank asset purchases will lead to an increase in banks’ deposits as well as reserves at the central bank. In the scenario, the increase in deposits and reserves exceeds its liquidity requirements, the banks would be more willing to grant loans or avoid a contraction in lending activities or prevent a fire sale of its less liquid assets.
References:
Bernanke, B., & Blinder, A. (1992). The Federal Funds Rate and the Channels of Monetary Transmission. The American Economic Review, 82(4), 901-921.
Cevik, S., & Teksoz, K. (2013). Lost in Transmission? The Effectiveness of Monetary Policy Transmission Channels in the GCC Countries. Middle East Development Journal, 5(3), 1350018-1350011-1350018-1350021. doi:https://dx.doi.org/10.1142/S1793812013500181
Joyce, M., Miles, D., Scott, A., & Vayanos, D. (2012). Quantitative Easing and Unconventional Monetary Policy – an Introduction. Economic Journal, 122(564), F271-F288.
Mishra, P., & Montiel, P. (2012). How Effective Is Monetary Transmission in Low-Income Countries? A Survey of the Empirical Evidence. IMF Working Paper(143).
Neely, C. (2015). Unconventional Monetary Policy had Large International Effects. Journal of Banking & Finance, 52, 101-111. doi:https://dx.doi.org/10.1016/j.jbankfin.2014.11.019
Pattipeilohy, C., van den End, J. W., Tabbae, M., Frost, J., & Haan, J. (2013). Unconventional Monetary Policy of the ECB during the Financial Crisis: An Assessment and New Evidence. DNB Working Paper(381).
Radia, A., & Bowdler, C. (2012). Unconventional monetary policy: the assessment. Oxford Review of Economic Policy, 28(4), 603-621. doi:https://dx.doi.org/10.1093/oxrep/grs037 Szczerbowicz, U. (2015). The ECB Unconventional Monetary Policies: Have They Lowered Market Borrowing Costs for Banks and Governments? International Journal of Central Banking, 11(4), 91-127.
