AFCA Working Paper
Unconventional Monetary Policy: Objectives & Options
Expert｜Vishnu Varathan, Fellow of Asian Financial Think Tank；Head of Economics & Strategy for Asia ex-Japan of Mizuho Bank
Advent of the “Unconventional” into Mainstream
“Unconventional” is the new normal for monetary policy. With global policy rates effectively at zero, the main “conventional” policy rate tool for most global central has been exhausted. But global central banks’ policy rates effectively reaching the zero bound limitation – in other words, “running out of space” – is not the only reason to reach into the more creative fringes of monetary policy. In fact, it is not even the main reason for the advent of “unconventional” policies into the mainstream.
Instead, the limitations of the conventional policy rate tool – related to the “liquidity trap” problem – frustrating the ability to effectively address the challenges of deeper economic downturns that has not only elevated “unconventional” policies (with wider and more varied tools, Figure 1)to the mainstream, but thrust them into the forefront of policy.
So how do unconventional policies circumvent the problems that otherwise jam up conventional policy easing? Mainly via four key channels.
(1)Transmission: Where conventional policy sets short-term policy rate relying on market forces/financial intermediaries to “transmit” the reduction to long-term rates, QE-type measures directly lower long-end risk-free rates, and along with it “term premium” with direct (government bond) asset purchases. This not only hastens, but also enhances, transmission; especially helping by-pass capital/liquidity constraints that may otherwise impede “conventional” conduits of transmission.
(2)Access: Extended liquidity operations (ELO) make this key distinction between conventional and unconventional policies. Conventional policy rates merely lower the price of money, but unconventional policies mitigate fettered access to money; using targeted facilities (e.g. TLTROs), extended collateral and expanded counter-parties.
(3)Risk substitution: This goes beyond the reach of conventional policy, which only seeks to calibrate the “risk-free” rate. Whereas QE-type direct asset purchases help stimulate investor appetite for riskier assets via the so-called portfolio re-balance channel, while some applications of ELO help secure extend preferable rates of funding/finance; in effect reducing the credit/risk premium.
(4)Confidence/Uncertainty: Finally, where credit demand is stifled by confidence deficit, unconventional policies help revive confidence with QE (boosting asset prices/wealth effects), ELO (providing cash backstop) and assurances of continued policy support; all of which diminish uncertainty about the outlook.
Table 1. The Framework of Unconventional Tool Channel
Sharper Tools …
The upshot is that compared to the “blunt” tool that conventional monetary policy is by definition - adjusting just a single rate (price of money) to allow for these to filter through the economy (via financial intermediaries and markets) - unconventional policy tools are far sharper. More specifically, unconventional tools have significantly increased range, appreciably enhanced reach, may be more finely calibrated and can be deployed flexibly in combination with dynamic fine-tuning for desired results (Figure 2).
… Nuanced Applications …
There is a certain allure to the fact that unconventional monetary policy tools, which are not mutually exclusive, are even able to interact to potentially accentuate the intended policy easing effects when used by deft hands. And this relies upon knowing the mechanics (as outlined briefly in Table 1).
Straight off the bat, a growing consensus on unconventional policy that appears to be emerging is that negative rates, while arguably not denied relevance as part of a much wider suite of policies in some cases, will be constrained in a wider application.
Tellingly, only ECB, (a select few European central banks) and BoJ have resorted to negative rates. And even then have signaled limits to how negative rates may go given the detrimental impact on banks as well as harder to predict financial distortion accompanied by accentuated risks of by misallocation (of resources), which will ultimately be counterproductive.
That said, the application of asset purchases and extended liquidity policies have proliferated in scale and breadth. And this is likely to continue central banks deal with unprecedented pandemic risks which inevitably result in a double whammy of cash-flow seizure (from revenue shocks) and balance sheet shocks.
… and Necessary Backstops …
And this will validate central banks stepping up as both lender of last resort (providing emergency facilities to alleviate credit/liquidity crunch) and buyer of last resort (directly purchasing assets to help improve risk appetite); by exploiting a “full range of tools” in the words of the US Federal Reserve (Fed).
Imaginably, the monetary calculus will be that resuscitating a global economy suffering convulsions of supply and demand shocks amid negative wealth effects will require decisive policy action to prevent a cash crunch from spiraling into a solvency crisis as well as avert financial market meltdown – with cross-default risks threatening to magnify the feedback loops between these risks. In short, the policy incentives are stacked to pull all stops given the “house of cards” type risks; residing at the at the various corners of the funding and asset markets but with long-reaching interactions and dependencies.
All said, there is just no denying that the need of the moment is for unconventional policies to be exploited as necessary so as to avert a greater catastrophe.
… But Cut Both Ways
But unconventional policies come at a high price, and can thus cut both ways. After all, the first lesson of economic is that there is no free lunch. And the real question that remains is who will be paying for the monetary policy largesse - necessary or otherwise.
The broad brush is that central bank asset purchases and liquidity infusions with the resultant increase in money supply amid ultra-low interest rates will, as a first order effect, lead to asset price inflation (Figure 3 overleaf).
Alongside financial repression (savers being penalized) as governments secure low borrowing costs, this will more likely than not exacerbate wealth disparity. So it will not be an exaggeration to suggest that central bank largesse unchecked will sow the seeds of even greater social discontent.
What’s more, asset price distortions and risk premiums artificially suppressed for a prolonged period may inadvertently amplifying financial market imbalances and excesses over time. In the worst case, ironically setting the stage for the next financial meltdown, if not crisis.
Costs of, and Risks from, Unconventional Policies
Fact is, despite the best of intentions, asset purchases alongside unprecedented credit and liquidity extensions will prejudice outcomes such that it favours some more than others. And some of the risks worth assessing on the go pertain to; i) distortion; ii) debt monetization/helicopter money”; iii) debasement, and notably; iv) exit risks.
Distortion Risks: Excessively large QE-type policies may induce “once bought considered broken” type of pricing mechanisms malfunction (“broken”) in financial markets. In addition, artificially and excessively compressed term and credit premium set the stage for the next financial crisis, while worsening wealth disparity
“Printing Press” Risks: At its most extreme, asset purchases that result in more permanent blow-out in the size of central bank balance sheets may be construed as backdoor debt monetization (for government bond buying) and/or “helicopter money” (should this involve direct purchases of corporate bonds/equities). And if the central bank is seen as a “printing press” for debt it may have potentially large destabilizing shocks if not managed.
The “red lines” for debt monetization involves primary market purchases as well as sheer quantum (and relative holdings) of government debt by the central bank.
Debasement Risks: This is related to, but distinct from, the “printing press” risk insofar that excessive balance sheet expansion resulting in significant money supply growth will raise concerns about currency debasement, pressuring exchange rates. The greatest danger from this, is a pernicious, self-feeding currency sell-off-capital flight spiral.
Exit Risks: Perhaps most worryingly, over time, addiction to such expansive policies could compromise central banks’ ability to exit unconventional policies. Apart from the ever-present threat of being held ransom by markets hall of mirrors effect.
All said, policy vigilance and timely calibration will be imperative to ensure that the cure does not end up worse than the disease. At this point though, while the high price of unconventional policies is unavoidable; and certainly justified to defuse an ugly financial market dislocation that may inadvertently deepen a recession into a depression.
Some are More Equal than Others
But as central banks the world over look to the Fed, for policy cues, it must be worth noting that “some are more equal than others“ in the Orwellian sense. Fact is, the Fed’s “exorbitant (reserve currency) privilege“ means that it has a much wider berth than any other central bank to indulge in unconventional policies. Specifically, extended balance sheet expansion (via both asset purchases and ELO expansion) may at some point soften the USD, but not destabilize it in a way that threatens the Fed’s policy calculus. This is because of the USD’s “network“ effects that result in demand for USD to buy USD-denominated assets in tandem with the Fed as markets “follow the Fed“.
In sharp contrast however, EM central banks are acutely exposed to “printing press“ risks, if markets lose confidence in the ability and willingness to EM central banks to reverse asset purchases and expanded liquidity facilities. This will invariably show up most prominently as debasement risks with the currency subject to increased volatility and instability. Sell off in the EM asset markets (due to debt monetization risks) will also lead to pernicious capital outflow-currency sell-off spiral.
As such, EM central banks which are most measured and targeted in extended liquidity facilities and careful not to blur the lines between well-defined asset purchases and outright debt monetization - for which alarm bells are set off by if government bonds are mopped up from the primary market - may reap the most policy benefits over time. Point being, best to secure policy doors before the macro-stability horse bolts. And wider policy objectives should be the horse that pulls the policy option carriage.
Expert Biography:
Vishnu Varathan, Fellow of Asian Financial Think Tank, Head of Economics & Strategy for Asia ex-Japan of Mizuho Bank based in Singapore. Apart from publishing macro/FX views and speaking at conferences, Vishnu engages with central banks, sovereign wealth funds and policy think tanks in Asia. He is regularly involved in “closed door” discussions with Singapore’s Finance, Trade & Industry and Labour Ministries, as well as policy think tanks such AMRO (ASEAN+3 Macroeconomic Research Office) and Institute of Policy Studies. A media regular, he is often invited to be on CNBC, Bloomberg, BBC, Reuters TV, CNA for his macro insights. Prior to joining Mizuho, Vishnu was Asia Economist with Capital Economics, and headed EM Asia Macro/FX research at 4CAST. Vishnu has a Masters degree in Economics from the University of Sydney.
AFCA was founded in May 2017. It is the first international financial social organization initiated by China. The think tank (AFTT) under AFCA is composed of more than 100 domestic and foreign experts from 49 countries and regions. Currently, there are 57 domestic experts and 100 foreign experts. With the philosophy of "market location, global perspective, problem orientation, in-depth observation, and smart solution", AFTT has developed AFCA working paper, Asian Financial Observation, Financial Development Report for the Guangdong-Hong Kong-Macao Greater Bay Area, and other bilingual products, conducted Quarterly Seminars, AFTT Annual Forums and other high-level financial activities, sending a strong Asian message constantly on the international stage.