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Unconventional Monetary Policy during the Great Recession: Theory, - - PowerPoint PPT Presentation
Unconventional Monetary Policy during the Great Recession: Theory, - - PowerPoint PPT Presentation
Unconventional Monetary Policy during the Great Recession: Theory, Empirical Evidence and Limitations Kilian Rieder 1 1 University of Oxford, kilian.rieder@univ.ox.ac.uk Paris Dauphine, London Campus Guest Lecture 10 April 2018 Rieder (Oxford)
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Readings
Carlin & Soskice (2015). Macroeconomics - Institutions, Instability and the Financial System. OUP. Chapters 3, 5, 7, 13. Special issue of Oxford Review of Economic Policy published in Winter 2012:
Bowdler and Radia: the definition and transmission channels of QE Breedon, Chadha and Waters: the theory and empirics of QE Martin and Milas: international evidence on QE Goodhart and Ashworth: limitations of QE
Joyce, Tong and Woods (2011). The United Kingdom’s quantitative easing policy: design, operation and impact. Bank of England Quarterly Bulletin, no. 3. Gorton and Metrick (2012). Getting up to speed on the financial crisis: a
- ne-weekend reader’s guide. Journal of Economic Literature 50(1), p. 128-50.
Goodhart (1999). Myths about the Lender of Last Resort. International Finance 2(3), pp.339-360. Freixas, Parigi and Rochet (2004). The Lender of Last Resort: A 21st century
- approach. Journal of the European Economic Association 2(6): pp. 1085–1115.
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Part I: Group exercise & discussion
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Part II: Motivation – Why and when do we need UMP?
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Central bank responses to the Great Recession
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Central bank responses to the Great Recession
What happened?
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Central bank responses to the Great Recession
What happened?
Global financial crisis starting in US: Bear Stearns, Lehman etc. Large demand shock: negative output gap, disinflationary pressures
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Central bank responses to the Great Recession
What happened?
Global financial crisis starting in US: Bear Stearns, Lehman etc. Large demand shock: negative output gap, disinflationary pressures
What did central banks do?
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Central bank responses to the Great Recession
What happened?
Global financial crisis starting in US: Bear Stearns, Lehman etc. Large demand shock: negative output gap, disinflationary pressures
What did central banks do?
Conventional monetary policy: large interest rate cuts
Usual interest decisions: ∆ 25 bp Federal Reserve: 50 bp in September 2007, followed by 50-75 bp every
- ther month until December 2008
Bank of England: starting in gradually in December 2007, big hike of 150 bp in November 2008 ECB: latecomer with first cut in fall 2008
Consequence: interest rates approach level of zero by 2009
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Central bank responses to the Great Recession
What happened?
Global financial crisis starting in US: Bear Stearns, Lehman etc. Large demand shock: negative output gap, disinflationary pressures
What did central banks do?
Conventional monetary policy: large interest rate cuts
Usual interest decisions: ∆ 25 bp Federal Reserve: 50 bp in September 2007, followed by 50-75 bp every
- ther month until December 2008
Bank of England: starting in gradually in December 2007, big hike of 150 bp in November 2008 ECB: latecomer with first cut in fall 2008
Consequence: interest rates approach level of zero by 2009
Why did central bank intervene so heavily?
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Central bank responses to the Great Recession
What happened?
Global financial crisis starting in US: Bear Stearns, Lehman etc. Large demand shock: negative output gap, disinflationary pressures
What did central banks do?
Conventional monetary policy: large interest rate cuts
Usual interest decisions: ∆ 25 bp Federal Reserve: 50 bp in September 2007, followed by 50-75 bp every
- ther month until December 2008
Bank of England: starting in gradually in December 2007, big hike of 150 bp in November 2008 ECB: latecomer with first cut in fall 2008
Consequence: interest rates approach level of zero by 2009
Why did central bank intervene so heavily?
Avoid experience of Great Depression Some important lessons from history Policy-makers aware of GD experience
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Running out of ammunition
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Running out of ammunition
Situation in 2009/2010:
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Running out of ammunition
Situation in 2009/2010:
Reaching the zero lower bound of interest rates Still severe contraction, inflation falling European debt crisis reinforces problem in Eurozone
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Running out of ammunition
Situation in 2009/2010:
Reaching the zero lower bound of interest rates Still severe contraction, inflation falling European debt crisis reinforces problem in Eurozone
Why can central banks not cut rates below zero?
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Running out of ammunition
Situation in 2009/2010:
Reaching the zero lower bound of interest rates Still severe contraction, inflation falling European debt crisis reinforces problem in Eurozone
Why can central banks not cut rates below zero?
They could, at least in theory
Example: Riksbank (Sweden), Swiss National Bank
However, negative rates unlikely to be effective everywhere or over LT
Negative interest rate: tax on depositors and investors How to avoid it? Hoard cash, e.g. at home in you cellar Why? Your cellar provides an interest rate of zero Limit to hoarding = success of negative rates if storage is costly/dangerous (e.g. insurance)
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Running out of ammunition
Situation in 2009/2010:
Reaching the zero lower bound of interest rates Still severe contraction, inflation falling European debt crisis reinforces problem in Eurozone
Why can central banks not cut rates below zero?
They could, at least in theory
Example: Riksbank (Sweden), Swiss National Bank
However, negative rates unlikely to be effective everywhere or over LT
Negative interest rate: tax on depositors and investors How to avoid it? Hoard cash, e.g. at home in you cellar Why? Your cellar provides an interest rate of zero Limit to hoarding = success of negative rates if storage is costly/dangerous (e.g. insurance)
Why not just wait and see?
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Running out of ammunition
Situation in 2009/2010:
Reaching the zero lower bound of interest rates Still severe contraction, inflation falling European debt crisis reinforces problem in Eurozone
Why can central banks not cut rates below zero?
They could, at least in theory
Example: Riksbank (Sweden), Swiss National Bank
However, negative rates unlikely to be effective everywhere or over LT
Negative interest rate: tax on depositors and investors How to avoid it? Hoard cash, e.g. at home in you cellar Why? Your cellar provides an interest rate of zero Limit to hoarding = success of negative rates if storage is costly/dangerous (e.g. insurance)
Why not just wait and see?
Large welfare costs: unemployment Deflationary trap
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Deflationary trap (I): background
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Deflationary trap (I): background
What does monetary policy normally try to achieve?
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Deflationary trap (I): background
What does monetary policy normally try to achieve?
Today, central banks try to achieve inflation target Target (πT) = rate of inflation consistent with equilibrium output and equilibrium unemployment Equilibrium output = no output gap Equilibrium unemployment = unemployment equal to NAIRU
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Deflationary trap (I): background
What does monetary policy normally try to achieve?
Today, central banks try to achieve inflation target Target (πT) = rate of inflation consistent with equilibrium output and equilibrium unemployment Equilibrium output = no output gap Equilibrium unemployment = unemployment equal to NAIRU
How does conventional monetary policy achieve this?
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Deflationary trap (I): background
What does monetary policy normally try to achieve?
Today, central banks try to achieve inflation target Target (πT) = rate of inflation consistent with equilibrium output and equilibrium unemployment Equilibrium output = no output gap Equilibrium unemployment = unemployment equal to NAIRU
How does conventional monetary policy achieve this?
Changing the nominal interest rate
Usually, interbank lending rate is targeted Nominal interest rate influences demand in economy This happens through many channels = transmission channels Demand in economy ultimately influences inflation rate
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Deflationary trap (I): figure from C&S (2015, Chapter 13, p.479)
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Deflationary trap (II)
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Deflationary trap (II)
The Fisher equation and its implications
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Deflationary trap (II)
The Fisher equation and its implications
i = r + πe What matters for economy is r; but CB can only influence i Assuming ZLB, minimum r that can be achieved is rmin = −πe
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Deflationary trap (II)
The Fisher equation and its implications
i = r + πe What matters for economy is r; but CB can only influence i Assuming ZLB, minimum r that can be achieved is rmin = −πe
Why does this matter?
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Deflationary trap (II)
The Fisher equation and its implications
i = r + πe What matters for economy is r; but CB can only influence i Assuming ZLB, minimum r that can be achieved is rmin = −πe
Why does this matter?
Scenario: very large demand shock (e.g. Great Recession) rmin might not be enough to stabilize economy Rather than recovering, economy spirals away from equilibrium Spiraling away is called “deflationary trap”
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Deflationary trap (II)
The Fisher equation and its implications
i = r + πe What matters for economy is r; but CB can only influence i Assuming ZLB, minimum r that can be achieved is rmin = −πe
Why does this matter?
Scenario: very large demand shock (e.g. Great Recession) rmin might not be enough to stabilize economy Rather than recovering, economy spirals away from equilibrium Spiraling away is called “deflationary trap”
Why does this happen (and where does this term come from)?
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Deflationary trap (II)
The Fisher equation and its implications
i = r + πe What matters for economy is r; but CB can only influence i Assuming ZLB, minimum r that can be achieved is rmin = −πe
Why does this matter?
Scenario: very large demand shock (e.g. Great Recession) rmin might not be enough to stabilize economy Rather than recovering, economy spirals away from equilibrium Spiraling away is called “deflationary trap”
Why does this happen (and where does this term come from)?
Negative demand shock → disinflationary pressure/deflation Consequence: inflation below target If shock is large, rmin might not be enough to get back to target r will raise and raise as long as deflationary pressure persists Higher r → lower demand → reinforcing initial shock Economy is in a deflationary trap (negative spiral)
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Deflationary trap (III)
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Deflationary trap (III)
Some notations to illustrate deflationary trap in a figure
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Deflationary trap (III)
Some notations to illustrate deflationary trap in a figure
Check C & S (2015) chapter 1-3
Curves (=equations)
IS curve = reflects demand situation of economy PC curve = reflects feasible output and inflation combinations for given rate of expected inflation MR curve = reflects monetary rule
Best response to given output/inflation combination... ...to get back to target as quickly as possible.
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Deflationary trap (III)
Some notations to illustrate deflationary trap in a figure
Check C & S (2015) chapter 1-3
Curves (=equations)
IS curve = reflects demand situation of economy PC curve = reflects feasible output and inflation combinations for given rate of expected inflation MR curve = reflects monetary rule
Best response to given output/inflation combination... ...to get back to target as quickly as possible.
Variables
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Deflationary trap (III)
Some notations to illustrate deflationary trap in a figure
Check C & S (2015) chapter 1-3
Curves (=equations)
IS curve = reflects demand situation of economy PC curve = reflects feasible output and inflation combinations for given rate of expected inflation MR curve = reflects monetary rule
Best response to given output/inflation combination... ...to get back to target as quickly as possible.
Variables
r real interest rate π inflation, πe expected inflation, πT inflation target y output
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Deflationary trap (III): figure from C&S (2015, Chapter 3, p.106)
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Part III: Defining unconventional monetary policy & its channels
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Definition & aims
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Definition & aims
How to get out of deflationary spiral?
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Definition & aims
How to get out of deflationary spiral?
Fiscal policy is one possibility Fiscal policy shifts IS right, might get economy out of trap... ...by creating positive output gap However, fiscal space limited in Great Recession (especially in Eurozone) UMP: first and foremost response to deflationary trap
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Definition & aims
How to get out of deflationary spiral?
Fiscal policy is one possibility Fiscal policy shifts IS right, might get economy out of trap... ...by creating positive output gap However, fiscal space limited in Great Recession (especially in Eurozone) UMP: first and foremost response to deflationary trap
What is UMP?
UMP: set of tools rather than a single tool Three main tools used by central banks
Forward guidance Balance sheet composition Balance sheet expansion
Main idea: since SR rate (i) cannot be brought down further (ZLB)... ...influence LT rates to boost economy (shift IS right) ... ...or find other additional channels to boost AD.
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Tools (I): overview
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Tools (I): overview
Forward guidance
Promise to keep rates for long time... ...to achieve a decrease in LT. Commitment to keep rates low tied to economic outcomes In technical terms: flatten far end of yield curve Problems:
Credibility Time inconsistency if “commitment to irresponsibility” needed
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Tools (I): overview
Forward guidance
Promise to keep rates for long time... ...to achieve a decrease in LT. Commitment to keep rates low tied to economic outcomes In technical terms: flatten far end of yield curve Problems:
Credibility Time inconsistency if “commitment to irresponsibility” needed
Changes in CB balance sheet composition
Freeing bank balance sheets from toxic assets Buying LT bonds Problem: limited to current balance sheet size
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Tools (I): overview
Forward guidance
Promise to keep rates for long time... ...to achieve a decrease in LT. Commitment to keep rates low tied to economic outcomes In technical terms: flatten far end of yield curve Problems:
Credibility Time inconsistency if “commitment to irresponsibility” needed
Changes in CB balance sheet composition
Freeing bank balance sheets from toxic assets Buying LT bonds Problem: limited to current balance sheet size
→ Changing CB balance sheet size: quantitative easing
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Tools (II): focus on quantitative easing
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Tools (II): focus on quantitative easing
What is quantitative easing?
(Electronic) money creation Created money balances used to purchase assets Counterparties: banks, other FIs etc. Both CB assets and liabilities increase: balance sheet expands = helicopter money!
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Tools (II): focus on quantitative easing
What is quantitative easing?
(Electronic) money creation Created money balances used to purchase assets Counterparties: banks, other FIs etc. Both CB assets and liabilities increase: balance sheet expands = helicopter money!
What makes QE different from conventional MP?
OMOs are also asset purchases, so what is different? Deployed at ZLB only, larger, riskier for CB, broader range of assets
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Tools (II): focus on quantitative easing
What is quantitative easing?
(Electronic) money creation Created money balances used to purchase assets Counterparties: banks, other FIs etc. Both CB assets and liabilities increase: balance sheet expands = helicopter money!
What makes QE different from conventional MP?
OMOs are also asset purchases, so what is different? Deployed at ZLB only, larger, riskier for CB, broader range of assets
How might QE help?
Can make forward guidance credible (“expectation channel”) Expands balance sheet size, making composition changes more effective Several direct channels
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Tools (III): some direct transmission channels of QE
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Tools (III): some direct transmission channels of QE
Portfolio re-balancing channel
QE → CB purchases assets → seller gets cash/money balance Cash does not yield return → seller reinvest money in other assets with higher return Prices on other assets rise (e.g. corporate bonds), while their (yield) interest rate falls Lower (re-)financing costs boost aggregate demand
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Tools (III): some direct transmission channels of QE
Portfolio re-balancing channel
QE → CB purchases assets → seller gets cash/money balance Cash does not yield return → seller reinvest money in other assets with higher return Prices on other assets rise (e.g. corporate bonds), while their (yield) interest rate falls Lower (re-)financing costs boost aggregate demand
Exchange rate channel
Economies are usually quite open nowadays Some re-balancing will be into foreign assets Demand for foreign currency ↑, domestic currency depreciates Depreciated FX rate → net exports ↑ → AD ↑
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Tools (III): some direct transmission channels of QE
Portfolio re-balancing channel
QE → CB purchases assets → seller gets cash/money balance Cash does not yield return → seller reinvest money in other assets with higher return Prices on other assets rise (e.g. corporate bonds), while their (yield) interest rate falls Lower (re-)financing costs boost aggregate demand
Exchange rate channel
Economies are usually quite open nowadays Some re-balancing will be into foreign assets Demand for foreign currency ↑, domestic currency depreciates Depreciated FX rate → net exports ↑ → AD ↑
Fiscal channel
QE → gov. bond prices ↑ Debt service costs for government falls Fiscal tightening more gradual More fiscal space for expansionary policy
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Quantitative easing: figure from C&S (2015, Chapter 13, p.488)
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Part IV: Empirical evidence
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Central bank balance sheet size relative to GDP
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QE had many phases: the US example
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An empirical problem
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An empirical problem
How to measure causal effect of QE?
We need a comparison case (called counterfactual) Counterfactual: how would economy look like without QE? Problem: we only observe economy|QE, not economy|no QE
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An empirical problem
How to measure causal effect of QE?
We need a comparison case (called counterfactual) Counterfactual: how would economy look like without QE? Problem: we only observe economy|QE, not economy|no QE
Illustration of empirical problem:
Economic recovery weak in US, UK and particularly in Eurozone Does weak recovery mean QE had no effect? No, we can’t tell: may have been much worse without QE
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An empirical problem
How to measure causal effect of QE?
We need a comparison case (called counterfactual) Counterfactual: how would economy look like without QE? Problem: we only observe economy|QE, not economy|no QE
Illustration of empirical problem:
Economic recovery weak in US, UK and particularly in Eurozone Does weak recovery mean QE had no effect? No, we can’t tell: may have been much worse without QE
How can we investigate QE’s effects then?
Natural experiments: e.g. similar asset classes, only one subject to QE Produce an artificial counterfactual: synthetic control case Focus on descriptive evidence re: channels (correlation)
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A survey of indicators
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A survey of indicators
“Positive” signs
Stock market boom Firms issue record sum of corporate bonds US: inflation and inflationary expectations up, no deflation FX depreciates: Sterling and Dollar apparently react to QE Government bond yields low despite ever higher debt stocks (in some cases)
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A survey of indicators
“Positive” signs
Stock market boom Firms issue record sum of corporate bonds US: inflation and inflationary expectations up, no deflation FX depreciates: Sterling and Dollar apparently react to QE Government bond yields low despite ever higher debt stocks (in some cases)
“Negative” signs
Bank lending remains subdued, especially in UK and Eurozone Some evidence that lower refinancing costs are used to build cash reserves rather than I Japanese experience not particularly encouraging
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Impact of QE: Japan and US (Williamson 2017)
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Impact of QE - US 10-year treasury yields
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Impact of QE - FX rates
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Impact of QE - Bank of England (Bridges and Thomas, 2012)
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Impact of QE - Eurozone (LT rates)
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Impact of QE - Eurozone (Financing conditions)
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Impact of QE - Eurozone (Sovereign bond yields)
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Part V: Limitations, risks & consequences
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Limitations of QE
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Limitations of QE
Channels might not work
Example: portfolio rebalacing channel Regulatory constraints Lower financing costs used to boost private sector profit, not I Response by banking system crucial More generally: buying assets might help sellers, but not the “small guys” (no further transmission to real economy)
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Limitations of QE
Channels might not work
Example: portfolio rebalacing channel Regulatory constraints Lower financing costs used to boost private sector profit, not I Response by banking system crucial More generally: buying assets might help sellers, but not the “small guys” (no further transmission to real economy)
Channels might have perverse effects
Example: fiscal channel Lower yields on gov. bonds puts pressure on institutional investors Pension funds generate less revenues Might trigger negative income effect
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Limitations of QE
Channels might not work
Example: portfolio rebalacing channel Regulatory constraints Lower financing costs used to boost private sector profit, not I Response by banking system crucial More generally: buying assets might help sellers, but not the “small guys” (no further transmission to real economy)
Channels might have perverse effects
Example: fiscal channel Lower yields on gov. bonds puts pressure on institutional investors Pension funds generate less revenues Might trigger negative income effect
More radical critique: irrelevance proposition of QE
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Risks of QE
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Risks of QE
QE is highly controversial – although CB have faith in policy
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Risks of QE
QE is highly controversial – although CB have faith in policy Inflation risk
What if recovery comes? Will inflation sky-rocket? Exit options necessary (c.f. further below)
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Risks of QE
QE is highly controversial – although CB have faith in policy Inflation risk
What if recovery comes? Will inflation sky-rocket? Exit options necessary (c.f. further below)
Crisis risk
Financial institutions receive large amounts of liquidity Thwarting restructuring and resolution of inviable institutions Moral hazard? QE could also be fueling asset price bubbles and overheating
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Risks of QE
QE is highly controversial – although CB have faith in policy Inflation risk
What if recovery comes? Will inflation sky-rocket? Exit options necessary (c.f. further below)
Crisis risk
Financial institutions receive large amounts of liquidity Thwarting restructuring and resolution of inviable institutions Moral hazard? QE could also be fueling asset price bubbles and overheating
Risk of losses
Buying at high prices, but selling at low ones? c.f. irrelevance proposition If CB losses are assumed by Treasury, potential fiscal tightening
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Risks of QE
QE is highly controversial – although CB have faith in policy Inflation risk
What if recovery comes? Will inflation sky-rocket? Exit options necessary (c.f. further below)
Crisis risk
Financial institutions receive large amounts of liquidity Thwarting restructuring and resolution of inviable institutions Moral hazard? QE could also be fueling asset price bubbles and overheating
Risk of losses
Buying at high prices, but selling at low ones? c.f. irrelevance proposition If CB losses are assumed by Treasury, potential fiscal tightening
Threat to central bank independence: QE blurs fiscal and MP
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Risks of QE
QE is highly controversial – although CB have faith in policy Inflation risk
What if recovery comes? Will inflation sky-rocket? Exit options necessary (c.f. further below)
Crisis risk
Financial institutions receive large amounts of liquidity Thwarting restructuring and resolution of inviable institutions Moral hazard? QE could also be fueling asset price bubbles and overheating
Risk of losses
Buying at high prices, but selling at low ones? c.f. irrelevance proposition If CB losses are assumed by Treasury, potential fiscal tightening
Threat to central bank independence: QE blurs fiscal and MP Threat to central bank transparency: e.g. no clear plan for exit
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How to best exit/unwind QE?
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How to best exit/unwind QE?
All these limitations and risks beg question of exit when necessary
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How to best exit/unwind QE?
All these limitations and risks beg question of exit when necessary Self-liquidation (maturing debt) solves part of problem... ...but many long-term securities were bought.
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How to best exit/unwind QE?
All these limitations and risks beg question of exit when necessary Self-liquidation (maturing debt) solves part of problem... ...but many long-term securities were bought. Some possibilities:
Reverse QE: open market sales → caveats:
Price impacts, need to be gradual Might not be always possible (depends on asset types)
Raise policy rate (stop bubble/boom) → caveats:
Might have to be substantial Leaning against the wind can have large costs
Innovation: issuing CB bonds → caveats:
Never used before
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