Friday, May 22, 2009

Unconventional Monetary Policy

The Bank of Canada posted a speech by John Murray (deputy governor) on the need for unconventional monetary policy during the current economic crisis. Three instruments he highlights are the following:

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. 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.

I find the first one particularly interesting. It implies the Bank's commitments to future interest rates, thereby reducing much of the speculation we observe around, for example, U.S. Federal Reserve announcements.

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