Non-Conventional Monetary Policies

The operational frameworks of central banks have changed fundamentally in the wake of the great financial crisis. Non-conventional monetary policies have become the new normal in all large developed economies. Their main forms have been balance sheet expansion and risk premium compression through asset purchases and targeted lending, forward guidance in respect to future monetary policy, and changes to collateral rules. Future non-conventional policies could team up with fiscal expansion to create versions of “helicopter money”. Non-conventional policies have created new systemic risks, arising from [i] prolonged sedation of financial markets through containment of asset price volatility, [ii] exhaustion of scope for further monetary stimulus in future crises and [iii] addiction of economies to cheap funding.

A brief reminder of (what used to be) non-conventional monetary policy

Prior to the great financial crisis 2008-09, monetary policy in most developed economies operated mainly through short-term interest rates on special lending and borrowing facilities. The rough conceptual reference was the “Taylor rule”. A central bank would adjust its policy rate in accordance with changes in expected underlying inflation and economic growth. Exchange rates, money, and credit aggregates were widely monitored but not usually targeted directly.

The great financial crisis and the European sovereign crisis necessitated a transformation of the operational frameworks, mainly for two reasons:

  • Policy rates approached their lower bounds but natural real rates of interest had also dropped to around zero, for both cyclical and structural reasons (view post here) and failed to recover after the crisis (view post here). Trapped at their lower bound policy rates lost the power to stabilize financial conditions in the face of further actual or potential adverse shocks. The consequence was a growing risk of inflation expectations becoming de-anchored (view post here) making economies particularly vulnerable to declines in goods and asset prices. Threats to price stability are asymmetric and skewed towards deflation (view post here) because unduly tight monetary policy is harder to correct and unduly easy policy. Moreover, there is a distinct risk of self-fulfilling dynamics: inflation expectations shift lower, real rates rise, debt burdens increase and consumption and pricing power soften (view post here). Economies are vulnerable even to shocks that were previously thought of as favorable, such as declines in import prices or labor costs (view post here).
  • The systemic financial crises 2008-2012 obstructed monetary policy transmission and challenged central banks’ ability to stabilize financial conditions for non-banks. The popular concern was that monetary easing would be like “pushing on a string”: accommodative conventional monetary conditions no longer translated reliably into accommodative financial conditions for the economy as whole.

The “new normal” non-conventional monetary policies that evolved after the great financial crisis can be condensed into four principal categories:

  • Forward guidance for policy rates means conditional or unconditional pre-commitment to future monetary policy rate levels.  This policy uses institutional credibility to influence interest rates at longer maturities (view post here). All major developed market central banks have used explicit forward guidance since the great financial crisis.
  • Quantitative easing denotes the expansion of the monetary base (central bank deposits and cash), typically through the purchase of government securities. The Bank of Japan was the first large modern central banks to deploy “QE” when it started buying JGBs (Japanese government bonds) in size in 2001. Quantitative easing on its own is not “printing money” because it constitutes an exchange of financial claims rather than purchase of goods and services against un-backed currency. It is distinct from the idea of helicopter money that is explained below. Moreover, not all central bank balance sheet expansions have been quantitative easing: a large part of ECB operations during the great financial and euro crises simply reflected the intermediation of a dysfunctional money market (view post here).
  • Qualitative easing refers to the purchase of various types of assets for the purpose of risk premium compression, particularly the reduction of interest rate term premia and credit spreads. Qualitative and quantitative easing are often conjoined. One of the most powerful channels of non-conventional monetary policy is duration extraction, i.e. the combination of central banks’ balance sheet expansion and duration extension (view post here). Combined quantitative-qualitative easing also aims at compressing credit spreads. Thus, the ECB’s “Public Sector Purchase Programme” buys sovereign risk of very different quality (view post here).  An example of pure qualitative easing would be the Federal Reserve’s “Maturity Extension Program”, which aimed at reducing term premia, and the  ECB’s “Security Market Program”, which initially sterilized liquidity effects and hence only aimed at reducing longer-dated bond credit spreads and term premia.
  • Collateral policies manage supply and pledgeability of collateral assets, which has greatly gained in importance since the great financial crisis (view post here) due to the expansion of collateralization in market transactions (view post here). Collateral policies influence financial conditions through the secured lending channel, for example by reducing risks of collateral shortages and secured funding constraints (view post here). For example, the broadening of eligible securities in ECB refinancing operations increased the pledgeability of collateral of euro area banks (view post here). Also, the U.S. “Term Securities Lending Facility” increased the supply of Treasury general collateral to primary dealers at the height of the great financial crisis.

Some economists also classify negative nominal interest rates as a non-conventional policy. Modestly negative rates have been introduced in several developed countries and seem to transmit to the rest of money market and capital market rates for the most part much like positive rates do. However, negative policy rates bear risks for the profitability and functioning of the financial system (view post here) and seem to have downside limits at present. It has technically become possible to reduce policy rates even deeply negative (view post here). One approach would be to levy a variable deposit fee at the central bank cash window to enforce value decay of paper currency relative to electronic money (view post here).  However, a new policy of this type would require considerable economic pressure and preparation.

If current non-conventional monetary policies fail to secure inflation targets or to avoid deflation, some form of debt monetization or “helicopter money”, i.e. direct monetary transfers to non-banks, may be considered as policy option (view post here). The barriers for this in the U.S., the euro area and Japan are high but not insurmountable. This policy could work through fiscal expansion backed by outright central bank funding or restructuring of sovereign debt currently held by central banks. “Helicopter money” should have a more direct impact on actual inflation and long-term inflation expectations than central banks’ operations with the financial system (view post here).

“The problem with QE is that it works in practice, but it doesn’t work in theory.”

Ben Bernanke, Federal Reserve Chairman, 2014

The impact on systemic risk

The three systemic consequences

Non-conventional monetary policies have altered the nature of systemic risk. Markets have learnt to rely upon these policies and their effects are pervasive across the risk spectrum. Some systemic consequences have already become apparent. One can condense these into the issues of “sedation”, “exhaustion” and “addiction”:

  • Sedation: Non-conventional policies suppress market volatility by design and compromise the financial system’s capacity to manage risk.  Empirical evidence suggests that central banks have long used policy rates to stabilize financial markets in times of distress (view post here).  However, after the great financial crisis central banks’ grip on market volatility has become tighter. Near-zero policy rates with forward guidance have suppressed short-term rates volatility and, thereby, helped to dampen equity return volatility (view post here). Moreover, policy interventions now affect prices in a broad range of securities markets, particularly in long-term bond markets (view post here). Protracted suppression of volatility typically fosters undue leverage through endogenous market dynamics, such as “collateral amplification” (view post here). Constrained volatility also creates a false sense of the robustness of conventional statistical risk metrics (view post here) and may even impair investment professionals’ personal resilience in the face market distress (view post here).
  • Exhaustion: Non-conventional policies become less effective over time. Yields, credit spreads, and term premia all have effective lower bounds and the more compressed they become, the less incremental economic support can be provided through reducing them (view post here). Also, yield compression cannot easily be reversed in times of economic improvement, because low-yield periods naturally come with enhanced leverage (view post here) and economic vulnerability to monetary tightening (view post here and here). This drives the scope for yield, term and credit premia compression naturally to a point of exhaustion.
    Moreover, there are constraints on the volume of central bank interventions. Liquidity issues have become an increasing concern as central banks have taken a sizeable share of some types of bonds from the market. Legal limitations can arise from restrictions on the eligibility of securities for central bank interventions and prohibitions of outright government financing (view post here).
    Finally, ultra-low and or even negative real interest rates pose risk to profitability and financial health of the financial system (view post here). Asset purchases flatten the yield curve and reduce banks’ returns on maturity transformation and credit risk.  Beyond, negative monetary policy rates undermine financial transmission, because they encourage cash hoarding and reduce the profitability of traditional banking. This danger increases with depth and duration of negative interest rate policies. This has necessitated the creation of tiered reserve systems in some countries (view post here). Tiered reserve systems effectively exempt a part of banks’ excess reserves from negative rates, allowing negative interest rates to go deeper and longer.
    Meanwhile, life insurance companies and defined-benefit pension funds, whose liabilities typically have a longer maturity than their assets, have come under pressure from deteriorating funding ratios and net cash flows (view post here). This pressure could become worse if interest rates refuse to recover and financial markets suffer new deflationary shocks.
  • Addiction: Financial institutions have overtime become more dependent on non-conventional ‘life support’, particularly on cheap funding and explicit credit market stabilization programs.
    Global financial leverage further increased after the great financial crisis, notwithstanding declining debt service capacity of public and private borrowers due to diminishing expected nominal GDP growth (view post here). Central banks can alleviate acute liquidity stress but cannot easily de-lever the financial system.  As a consequence of high leverage, institutional credit and money markets have remained fragile, i.e. vulnerable to self-reinforcing dynamics between asset prices and funding conditions (view post here). Also, the financial system has much greater exposure to government bond yield risk than in the past (view post here), as highlighted in episodes of government bond yield surges, such as the Japanese bond yield rise in 2013, the U.S. treasury sell-off (“taper tantrum”) in summer 2013 (view post here) and the German government bonds sell-off (“bunds tantrum”) in spring 2015. This is in line with numerous historical examples of easy monetary policy leading to financial booms and subsequent crises (view post here).
    There is also evidence that the financial system has adapted to low fixed income yields and suppressed volatility by expanding explicit and implicit short volatility strategies (view post here). Short-volatility positions bear explicit or implicit volatility, “gamma” and correlation risks and include popular strategies such as leveraged risk parity and share buybacks. Their expansion probably created two dangerous feedback loops. The first is a positive reinforcement between interest rates and volatility that will overshadow central banks’ attempts to normalize policy rates. The second is a positive reinforcement between measured volatility and the effective scale of short-volatility positions that has increased the risk of escalatory market volatility spirals in the future.

A reversal of the monetary policy cycle can lead to a disproportionate adjustment in global long-term yields. Research suggests that the term premia in global government bond markets have broadly turned negative in the 2010s, a historic shift that was fostered by policy support for a global duration carry trade (view post here). There is also evidence that monetary policy has precipitated structural shifts in interbank and high-grade bond markets that escalated demand for “safe bonds” and compressed yields further (view post here). Also, some studies suggest that inflation risk premia have turned negative (view post here and here) in large developed countries, with significant spillover to other countries. Conversely, quantitative estimates suggest that a rebound of term premia in a large dominant market, like the U.S., would put upward pressure on borrowing costs in virtually every economy around the globe, whether its local financial stability can withstand it or not (view post here).

There are hopes that macroprudential measures might offset the addictive quality of ultra-easy monetary policy in the developed world, as they rein in financial risk-taking (view post here). However, macroprudential policies are largely new and untested, have worked best as a complement (not offset) to monetary policy. Also, they often focus on specific sectors only, such as banking and housing (view post here).

“We do see that real estate dynamics or high household debt levels in some countries signal the risk of increasing imbalances…they relate to the continued very high level of household indebtedness and the low level of mortgage collateralisation…That being said, monetary policy is not the appropriate tool for addressing local and sectoral financial risks. Rather, targeted macroprudential policies, which can be tailored to local and sectoral conditions, are the right answer.”

Mario Draghi, March 2017