Unconventional Monetary Policies - Term Paper Example

Unconventional Monetary Policies Introduction With the looming financial crisis, central banks from different advanced economies have been forced to settle for unconventional monetary policy measures in an effort to counter the economic risks and financial stability. In the wake of policy rates approaching and ultimately getting stuck in their lower bounds, such central banks have had their balance sheets replace the interest rates as the instrument of the main policy. The result of the above move was that the estimated models over the economic crisis period with short term interests rates that the instrument for the monetary policy are unsuitable for the analysis of the monetary policy following the crisis. Although there exist theoretical literature with regards to unconventional monetary that have blossom in the past, there has been limited empirical analysis on the impacts an effectiveness of the policy. This is evident following the fact that it is only Japan that has been in a position to table its data on its experiences while using monetary policy since 1999. In relation to quantitative easing and depression between the years 2001 and 2006, some analysis conducted on the experiences of the United States with unconventional monetary policy and zero interest rates are just emerging. This means that most of the empirical analyses on unconventional monetary policies have been carried out with a wide range of macroeconomic models like the vector auto-regression models (VAR). This raises concern on the validity of such outcomes and the critically depend on the modes extent to capture the underlying economy behavior. Considering the nonlinearity and complexity of the economy, it is better to look at the outcomes of such models with a skepticism deal. Analyses on unconventional monetary policy are important as they greatly impact other methodological problems. There exists a number of evidence that show the different central bank’s announcement affect future policies on market expectations now that the participants of the market consider the monetary policy directions to be a major influence on the markets and interests rates path. Some of the studies conducted earlier were mainly based on casual inspection and has contradicting results on the yield curve witnessed in Japan. Recent studies have had an approach that is more formal as they show significant impacts of the yield curve commitment effect while employing different methodologies. Significant commitments imply that such markets expect its rates to remain very low for a period of at least a year. Different nations have adapted different policies in relation to the unconventional monetary policy. Historical Evidence The balance sheets of different banks on policies before the financial crisis were in such a manner that they did not aim at influencing the respective banks macroeconomic conditions. For example, the quantitative easing of the Bank of Japan has been considered as being ineffective at the zero lower experienced from 2001 as the central bank sheets were on the global financial crisis and monetary policy shifts that were exogenous similar to the commodity prices conditioning importance as an indicator used in conventional monetary policy identification. A shock monetary policy that is expansionary results in both temporary and significant rise in prices and output, the increase turning out to be robust to several model specifications perturbations. The impact of the unconventional monetary policies on price level in the past has been observed as to weaker and less persistent. Results from central bank balance sheets of different countries including Japan, UK and the United States show that panel estimates fail to obscure significantly across the heterogeneity of different countries. More specifically, there are no major observable differences across different nations in relation to the effects of macroeconomic shocks to the balance sheets of different central banks regardless of the several varying measures employed by different countries in an effort to deal with the economic crisis (Bacchetta 78) Quantitative easing Quantitative easing has been observed to positively affect interest rates and economic activities. It has also been identified as to greatly affect the commitment level of different nations. This is in relation to the expectation theory of the interest rates that is normally determined by the level of CABs. A good example is the fact that the market expectations in such countries are promoted by the interest rate rather than the risk expected. In addition, commitment level is viewed as being more functional incase the amount of CABs increases and can also be strengthened by that fact. However the two factors at some point may not correlate that well as point considering the fact that the interest rates are more affected by the CAB level compared to its impacts on commitment level. The Japanese bond yields have been observed to reduce and are lower than expected levels but this mechanism did not prove that difference between the ability of the commitment effect and the CAB level. It has been further proved that the strange growth in the rate curve is not influenced by the rise in the speculated level of the current account balances. This implies that the increase in the quantitative money value was not created or affected by the reduction of deflation and the low economic level. This means that the quantitative easing was merely contributed by the level of commitment. The ample provision of liquidity discouraged many banks from funding constraints and also shrink credit spreads. In addition, the increase of CAB levels greatly contributed to the reduction of bank credit spreads in the interbank market. The yield curve was flattened by the fact that the CAB level increased to control the operations. From the analyses, it can be inferred that the credit spreads were reduced by both the commitment effect and the quantitative easing but they could not affect the quantity of the speculated contributions. How the CAB level affects the bond yield is not easily determined because the bond yield was reducing before the CABs started gaining in 2002 and also it rose in mid 2003 while at that time the rise in CABs was fixed until 2004 . However the bond yield marked a significant rise in 2005 before CABs experienced a fall in 2006. Moreover CABs generated a big rise in 2009 but this did not affect the bond yield in any way (Bacchetta 80). During the global financial crisis the bank of England was the only bank that applied the quantitative easing because it had set a target of 75 billion pounds for reserve deposits and it gained 125 billion after five months (Bloom 650).This attributed to the fact that the sterling London interbank offered a rate and the base rate. This was substantial evidence to prove that the increasing in quantitative easing reduced the credit spreads. The bank applied the policies of quantitative easing and qualitative easing but it based mostly on the reserving of deposits. This was achieved narrowly by purchasing of UK government bonds rather than short –term paper. These purchases significantly reduced the gilt yields and interbank rate spreads (Bloom 666). Considering QE policies in macro models in the US and Japan in determining the impacts of on output and inflation. The increase in the CABs had a positive impact on the output and the inflation in both the countries. However, the impacts were less in Japan than in the US. With the application of the similar approach for Japan it was seen that the output increased but not on the prices in Honda ,Kuroki and Tachibana. The creation of an equitable price proved the best way by which the QE policy could impact the output. This implies that port-folio balance was the best means of transmission. Different models were applied in an effort to certify the impact of the monetary base on the money and prices. However, there exist no vital changes were observed as because credit transmission mechanism was not functioning at that time .Evidence to prove that yen was weakened by the QE policy did not sail through.. In summary the QE policy had little significant impact on the commitment effect on interest rates ,output and inflation. Suffice the evidence shows that the credit spreads have been facilitated by the QE policy. Qualitative easing reduces the credit spreads because it only targets a specific market assets. Notably, the Bank of Japan experienced very minimal growth in the year 2001-2002 during the previous recession because it failed to apply the policy of quantitative easing. This concludes that the bank of Japan lacks trust in the mechanism because the main purpose of the easing is to strain the financial sector. Between August 2001 and October 2002 the Bank of Japan generated a significant increase in its output purchases of JGBs because of applying the QE policy. The application the quantitative easing following the increase in purchases may not necessarily have an effect on the portfolio rebalancing. More so, an increase in the output purchases, with time caused a reduction in the yields of JGB. This occurrence was believed to have been caused by the decline in the US bond yields at that time. However, Japanese experienced a vital rise in the bond yields with the increase of the US bond yields that promoted its quick economic recovery even if its overall bond purchases stacked to as high as 1.2 trillion yen per month (Bis 34). Notably in December 2008, the Japanese bond yields rose without any changes in the US bond yields despite the fact that it experienced a significant increase in the purchases further to up to 1.8 trillion yen per month by February 2009. This implies the purchases may have affected the rise in bond yields but the level of the impact is still uncertain. This operations could proved by the fact that Japanese had a huge size and the liquidity of the bond market was high thus the effect was facilitated (Bis 40). In order to meet the funding for the speculated central bank reserve deposits, the Bank of England adopted a large scale mechanism of purchasing the UK government bonds also known as gilts from the 2009 in march. This showed a significant correlation between the government bond and the level of reserve deposits. The increasingly tendency of purchasing paid off with the accumulation of 17 % of the sum tradable government bond in the four months (Bis 41) . However between March and July 2009 the bond yields generated a sudden rise by about 30 basis points. This meant that the effects had little impacts. In reference to the account basis movement in US and the European bond yields at that time, this has been strongly attributed to the announcement of the QE policy that had a significant impact on the reduction of the gilt yields from 35-60 basis points an important but not a notable decrease (Bis 42). The reduction of credit - related financial stresses was facilitated by the application of qualitative easing. Advanced countries like Canada, Yuan and Zimmerman applied the use of dynamic general equilibrium to verify the impact of the monetary easing and the changes of loan to deposit in terms of the available credit. They discovered that for one to counteract a credit crunch, the individual should better apply the direct easing of loan standards than the conventional monetary easing. The central bank on the other hand used exchange programs to sooth the reduction in spreads between the US federal fund purchases and sales and European Eurodollar deposit in interbank markets. The bank of England took up a significant motive to announce that it will offer unlimited dollar liquidity to the banking sector in an effort to greatly reduce the funding pressures in the interbank market that were at rise that time. The establishing of an asset price has been observed to significantly help the Federal Reserve in purchasing an unlimited amount of a specific asset like a treasury security at a fixed price. But the federal Reserve can purchase a long lived asset if it intends to use it in future. However the federals recent move to purchase US Treasuries has proved futile. In reference to the first six months of 2009 the holdings of the treasury security gained by 36% and US $ 172 billion but this did not facilitate the rise in bond yields at the same period. This was so because the 10 year bond yield only rose from 2.2% to 3.6% (Brunnermeier 2220). The federals main goals of holding mortgage loan rates were not achievable because the rates were extremely high. The yield in bond was not affected by the decline in the level of Fed’s holdings of Treasuries between the late 2007 and mid 2008. The reduction in the bond yield in terms of bond purchase announcements by the Fed and the BoE lasted for only a short while. The huge size and liquidity of the US Treasury market has greatly contributed to this with a total value of US$ 6.8 trillion in March 2009 in comparison to the Fed’s purchasing operations that were targeted to be US $ 300 billion only 4.4 % of the total (Brunnermeier 2230). Quantitative Easing/Credit Easing Potential Risks Potential Drawbacks To The Banks And Economy When QE is repeated over and over again, it may become ineffective in the long run as the transmission channels to the economic activities making it clogged. The bond channel operations do not work well in a situation where the bond yields are quite low and the credit channel no longer work when the banks hoard velocity and liquidity collapses. This implies that those interested in borrowing prime households and high grade firms don’t need or want to while those who are in need of non-prime households and highly leveraged firms are not in a position to following the credit crunch. In addition, the stock market channel that result in asset reflation fooling the works of QE in the short term in case there is no recovery in the growth. The reduction witnessed in the real interest rates through a rise in the inflation expected when QE that is open ended is implemented, risks end up stoking the inflations expectations. In relation to the GE transmission channel on foreign exchange, the weakening of the currency following the monetary easing, is considered ineffective in a number of central banks that are in pursue of QE at the same point of time. When such happens, QE is rendered a zero-sum game, now that not all the currencies will fall or not all balances will improve at the same time (Brunnermeier 2229). The result of the above situation is a war of QE as proxies to the war of currency. In advanced economies, QE results in excessive flows in capital to emerging markets that are experiencing difficult policy challenges. The intervention of the sterilized foreign-exchange is meant to keep high domestic interest rates as well as feeding the inflows. However, interventions that are unsterilized or domestic interests rates that are reduced lead to excessive liquidity that are in a position to feed domestic inflation and credit and asset bubbles (Bernanke 880). In the same case, the forging of intervention as well as permitting the currency to increase eliminates external competiveness, resulting in external deficits that may be dangerous. Despite this realization, capital controls imposition on inflows has proved to be difficult and in some cases leaky. Macro prudential control measures on credit growth are of great importance but can also be ineffective if used to stop asset bubbles in low interest’s rates situations continue to underline liquidity conditions. Persistent QE may result to asset bubbles in the spill-over countries as well as the location of its implementation. Such bubbles may take place in equity markets, commodity markets, housing markets, credit markets and bond markets. Although there have been justifications of QE effectiveness in growth and weak economic fundamentals, maintaining the rates too low can in the long run feed such bubbles. A good example is the US Federal Reserve that took place between 2000 and 2006 that aggressively reduced the federal rates to as low as 1% in the 2001 recession followed by a subsequent recovery that was weak and then maintained law rates hence fueling housing or subprime or credit bubbles (Bernanke 870). QE can also result in the creation of hazard problems through the weakening of the incentives by the government to pursue the economic reforms that are required. It may also in some cases delay the required fiscal austerity incase large deficits happen to be monetized and through maintaining low rates thus preventing the market from striking discipline. The current QE exit can be seen as being tricky as it is either too late or too slow hence resulting to a credit or inflation bubbles. In case the exit takes place through the selling of long term assets bought during QE, there will be a rapid increase in the interest rates which may choke off the possible recovery, leading to large financial losses for long-term bond holders (Borio 60). In case the exit takes place through a rise in interest rates affected on excess reserves, then the ensuing loss reflected on the balance sheets of central banks could remain significant. Policies in the recent years are getting more and more unconventional and this is with little clarity on unintended consequences, short-term effects and long term impacts. The fact still remains that QE as well as other unconventional monetary policies have associated short-term benefits that are important. But incase such policies remain in use for too long, there will be severe side effects with very high long-term costs. Conclusion Most central banks in advanced economies have formulated efficient monetary policy measures to safeguard the risks posted in there depression of economy and recent financial crisis due to the alarming growth in global financial crisis. The central bank opted to alternatively replace the interest rates as the main policy instrument despite the fact that the policy rates remained subdued to effective lower bounds. This necessitated a change in the models used previously to rectify the crisis in the monetary policy to suit the effectiveness of the monetary policy if the crisis occurs later. The choice of the most suitable econometric approach used in verifying the impact of the macroeconomic on the central bank and balance sheet policies in times of financial crisis when the interest rates were as minimal as zero proved a difficulty. The only tangible evidence showed the impact of unconventional monetary policy measures on the financial market applying the use of high-frequency data. A number of documents have taken a mandate to assess the macroeconomic impacts on the policies Different bank from different countries undertook several measures on credit easing that include commercial paper outright purchases, Special Funds-Supplying Operations to Facilitate Corporation Financing and corporate bonds outright purchases (Borio 62). Such measures were so evident in the Bank of Japan, the Central of the United States and the Central Bank of the UK. Such measures indicate the wide spread of the CP and Euroyen deposits over the financing bills that had declined following the global financial crisis in the early 2009. However, despite the two being considered together, the Euroyen deposits spread remained significantly more relevant compared to the CP. This exposed the financial position residual concerns of the central banks from different countries. From the above analysis, it is evident that credit easing or qualitative easing has proved not to be that effective with regards to the manner in which they impact different governments bond yields levels. However, credit easing or quantitative easing has been recognized as being effective in the reduction of other financial products spread rates over those short term risk free rates (Borio 67). This mostly takes place when there are concerns on the solvency and liquidity lead to a credit critical situation that in most cases prevents given markets from operating normally. This implies that the central banks of different nations are in a position to successfully deal with the arising logjams from a funds scarcity in a selected segment. However, the above does not provide enough evidence to prove that the above measures can impact the expectations of inflation or the credit demand at the macroeconomic level. Different nations when looked at in isolation showed different policies like the Fed in the United States markets proved to be significant in the relieving stress in global markets (Bacchetta 34). The macroeconomic effectiveness of unconventional monetary policies that were employed by different banks following the financial crisis were analysis through looking at the shock effects of the different central banks balance sheet on price level and output with the use of different models such as VAT model on different advanced economies such as Japan, United Kingdom and the United States. From the above analyses, it is evident that there was an exogenous increase in the balance sheets of different central banks at the zero lower bound which resulted to a temporary increase in the price levels and economic activities. The qualitative pattern findings on the output of such policies were observed to be similar to those that had been earlier obtained on the interests rates shock effects, while at the same time the price level reactions by different countries was less persistent and weaker. The study indicates that different nations did have obscure consideration heterogeneity across different nations in the macroeconomic consequences disrespectful of different calibration and design. This can be attributed to the fact that different central banks came up with these policies in accordance to the specific and varying requirements of their respective financial economies and sectors. This implies that the unconventional monetary policy measures employed by different central banks following the global financial crisis offered temporary solutions to their respective economies. However, this should not be confused to mean that an extension in the balance sheets of the central banks will generally have positive impacts on the macro economy of the selected country. The effectiveness of the unconventional monetary policy measures was determined in this study by actively applying such measures in the countering of economic and financial tail risks in different setups witnessed in different countries. Though the findings were from different nations, the effectiveness of the unconventional monetary policy was observed to assume a general trend. Works Cited Bacchetta, Wincoop. Explaining Sudden Spikes In Global Risk, Mimeo: University of Lausanne, 2010. Print Bernanke, Mihov, “Measuring monetary policy”, The Quarterly Journal of Economics, 2000, 113(3), 869-902 Bis, Bank for International Settlement 82nd Annual Report, 2012, Basel, Switzerland. Bloom, Mankiv. “The impact of uncertainty shocks”, Econometrica, 2009, 77(3), 623-683 Borio, Disyatat, “Unconventional monetary policies: An appraisa”, The Manchester School, 2010, 78, 53-89 Brunnermeier, Pederson, “Market liquidity and funding liquidity”, Review of Financial Studies, 2009, 22(6), 2201-2238 Read More