Unconventional monetary policy in the current crisis

8 June 2009

(Extract from pages 6-7 of BIS Quarterly Review, June 2009)

In response to the global financial turmoil and the subsequent sharp downturn in economic activity, major central banks have cut policy rates aggressively and initiated several measures that have been loosely referred to as unconventional monetary policy. This box provides an overview of such measures and highlights how they can be viewed within the overall context of monetary policy implementation.

A framework for reviewing unconventional monetary policy

The conduct of monetary policy comprises two core elements: i) signalling the desired policy stance, nowadays generally done through announced targets for very short-term interest rates; and ii) liquidity management operations, defined broadly to encompass various aspects of the operating framework - related to the terms and conditions under which central bank liquidity is provided - that supports the desired stance by keeping the relevant market rate consistent with the policy rate. Typically, liquidity management operations are designed and implemented carefully to ensure that they influence only the specific market rate targeted by policy. As such, they play a supportive role, neither impinging upon nor containing any information relevant to the overall stance of policy.

In certain situations, however, liquidity management operations are accorded an elevated role and used deliberately to influence specific elements of the monetary transmission mechanism. The basic thrust of this complementary approach involves the active utilisation of liquidity operations to influence certain asset prices, yields and funding conditions over and above the impact of the policy rate. In this case, liquidity operations no longer simply play a passive role but become an integral part of the overall monetary policy stance. Since on these occasions such operations generally result in substantial changes in central banks' balance sheets - in terms of size, composition and risk profile - they can be referred to as balance sheet policy.1

The various forms of balance sheet policy can be distinguished by the particular market that is targeted. The most common, familiar form is foreign exchange intervention. Here, purchases or sales of foreign currency seek to influence the exchange rate separately from the policy rate. In the current crisis, balance sheet policy has also been employed to target term money market rates, long-term government bond yields and various risk spreads. While the justification, underlying mechanics, channels of influence and balance sheet implications are analogous to the case of foreign exchange intervention, the choice of market is atypical and in some cases unprecedented. It is the latter that renders recent central bank actions "unconventional", not the overall approach of seeking to influence specific elements of the transmission mechanism over and above the policy rate. From this perspective, "quantitative easing" and "credit easing", as used, respectively, to describe operations by the Bank of Japan during 2001-06 and the Federal Reserve in the current episode, can be viewed as simply references to a particular kind of balance sheet policy.2

An important feature of balance sheet policy is that it can be implemented regardless of the prevailing level of the policy interest rate. Foreign exchange interventions, for example, are routinely carried out in this manner. So long as central banks possess the capacity to carry out offsetting operations on reserve balances, neither the expansion of asset holdings nor their composition will necessarily impinge on central banks' ability to maintain interest rates close to target.3 This separation also holds in reverse. Unwinding balance sheet policy and shrinking the central bank's balance sheet are not preconditions for raising interest rates. For example, central banks that pay interest on excess reserves simply have to raise this rate along with the policy rate to effect a tightening of monetary conditions. As such, discussions of exit strategies can also be delineated along the two separate dimensions of the appropriate level of interest rates on the one hand and the desired central bank balance sheet structure on the other.

Overview of central bank responses

In the current crisis, there have been two broad categories of balance sheet policy (see table). The first group of measures, prominent early on in the crisis, centred on alleviating strains in wholesale interbank markets. In particular, to reduce term spreads, the provision of term funding was increased considerably and a number of initiatives introduced to address potential impediments to the smooth distribution of reserves. These included the broadening of eligible collateral and counterparty coverage, the lengthening of the maturity of refinancing operations, and the establishment of inter-central bank swap lines to alleviate funding pressures in offshore markets (mostly with respect to dollar funding). In addition, many central banks introduced or eased conditions for lending out highly liquid securities, typically sovereign bonds, against less liquid market securities in order to improve funding conditions in the money market.

The second group of policy responses, which received more emphasis as the turmoil in financial markets deepened, focused on directly alleviating tightening credit conditions in the nonbank sector and easing broader financial conditions. Prominent measures included the provision of funds to non-banks to improve liquidity and reduce risk spreads in specific markets - such as commercial paper, asset-backed securities and corporate bonds - as well as direct purchases of public sector securities to influence benchmark yields more generally.

On the whole, such interventions by central banks have helped to ease severe liquidity strains and have been associated with tangible improvements in a number of key markets (as noted in this Overview). Ultimately, however, the effectiveness of central bank actions in attenuating the impact of the crisis and restoring the functioning of markets depends on the extent to which they have a catalytic effect on private sector intermediation. Thus the ultimate success of central bank interventions depends on the appropriate design and forceful implementation of policies that address directly the fundamental weaknesses in bank balance sheets.

1 See Chapter VI in the BIS's 79th Annual Report, June 2009 (forthcoming).
2 Quantitative easing aims to ease overall monetary conditions through the expansion of bank reserves, leaving the corresponding asset to be acquired unspecified. Credit easing, on the other hand, focuses on influencing specific market segments through interventions in the relevant asset class, with no particular reference to how such operations are funded on central bank balance sheets.
3 Indeed, many Asian central banks that intervened actively in foreign exchange markets in recent years have been able to attain their official interest rate targets despite sizeable expansions in their balance sheets.