Unconventional Policy Research Articles

Unconventional policies in state-dependent liquidity traps

We characterize optimal unconventional monetary and fiscal-financial policies against supply- and demand-driven liquidity traps within a tractable New Keynesian model featuring a cash-in-advance constraint and a monetary policy cost channel. Deposit subsidies circumvent the inflation-output trade-off arising from stagflationary shocks and supply-driven liquidity traps by enabling negative nominal interest rates. Additionally, deposit taxes facilitate modest interest rate hikes to escape demand-driven deflationary traps. Notably, discretionary and commitment policies with deposit taxes / subsidies deliver virtually equivalent welfare gains, rendering time-inconsistent forward guidance schedules unnecessary. We also derive robust and implementable optimal policy rules when the sources of shocks are unknown.

The Unforeseen Results of Unconventional Monetary Dominance

This empirical study investigates the implications of the substantial size of central banks’ balance sheets and the potential risks of their gradual normalization. Following the global financial crisis of 2008, central banks worldwide implemented unprecedented monetary stimulus measures, including large-scale asset purchases and unconventional policy tools like quantitative easing (QE). As a result, central bank balance sheets expanded significantly, reaching historically unprecedented levels in size and composition. While these measures played a crucial role in stabilizing financial markets and supporting economic recovery, concerns have arisen regarding the eventual reduction of these balance sheets and the possibility of disruptive market dynamics. This research examines the challenges and risks of normalizing central bank balance sheets. Furthermore, it explores the potential occurrence of “hard landing” scenarios, where sudden reductions in balance sheets could trigger financial market turmoil and economic downturns. By analyzing historical precedents and theoretical frameworks, this paper offers valuable insights into the intricate relationship between central bank balance sheets and the dynamics of financial markets. It provides policymakers and market participants with valuable perspectives on navigating the path toward monetary policy normalization.

Unconventional monetary policy and policy foresight

What are the effects of unconventional monetary policy interventions on the economy? Empirical studies utilizing traditional SVAR models consistently report expansionary effects on output and prices while considering only a small number of variables. This paper is the first to present both narrative and empirical evidence indicating that these models are susceptible to policy foresight, as central banks frequently announce their unconventional policies months in advance. To address policy foresight, we estimate a Bayesian FAVAR model with an extended set of information for the Euro Area. Consistent with the existing literature, we find that an unconventional monetary policy shock boosts economic activity by increasing industrial production and reducing the unemployment rate. Notably, our estimated effects are both larger and more persistent compared to previous findings. Furthermore, the shock decreases interest rates, interest rate spreads, and government bond yields, leading to an improvement in financial conditions. In a noteworthy departure from previous research, we find significant uncertainty regarding the impacts on consumer and producer prices, highlighting the need for further research.

Revisiting the effects of conventional and unconventional monetary policies

SummaryThis paper extends the discussion on the effects of the two distinctive monetary surprises in the literature. First, we show that the proxy of conventional monetary shock Granger causes the endogenous variables in the vector autoregressive model. Second, we provide evidence that the existing model can be exposed to a weak instrument problem. With our alternative model mitigating these concerns, the second monetary shock can be interpreted as unconventional monetary news in general. The estimation results show contractionary effect of the unconventional policy. We find increases in output after a positive conventional monetary surprise, suggesting an important Fed's information effect.

COVID-19 effects and home-grown policy response in Sri Lanka

The paper examines the fascinating case of middle-income Sri Lanka with pre-existing macroeconomic weaknesses hit by COVID-19. The pandemic created a public health emergency and an economic crisis in 2020, causing economic damage and dampening Sri Lanka’s development prospects. The evidence shows a sudden growth contraction, a steep rise in poverty, falling women’s employment, worsening macroeconomic imbalances, and high external debt levels rising. Rather than requesting early IMF assistance for its balance of payments problems, President Gotabaya Rajapaksa’s government opted for home-grown remedies including ultra-loose monetary policy, import controls, bilateral swaps and loans, and a ban on fertilizer imports. The unconventional policy mix temporarily mitigated economic scaring from COVID-19 and supported the economy. But the distortions introduced by prolonging this unconventional mix and the Russia-Ukraine conflict shock pushed Sri Lankan economy into external debt default, a worsening economic crisis and Rajapaksa’s resignation in 2022.

Unconventional policy instruments in the New Keynesian model

Abstract This paper analyzes the use of unconventional policy instruments in New Keynesian setups in which the “divine coincidence” breaks down. The paper discusses the role of a second instrument that, in addition to the effect of conventional interest rate policy, may enter the Phillips curve, the investment–saving (IS) curve, and the welfare function, thus influencing inflation and output. The paper presents theoretical results on equilibrium determinacy, the inflation bias, the stabilization bias, and the optimal central banker’s preferences when both instruments are available. We show that the use of an unconventional instrument reduces the zone of equilibrium indeterminacy and may reduce the volatility of the economy. However, in some circumstances, committing to not use the second instrument may be welfare-improving (a result akin to Rogoff (Journal of International Economics 18(3-4), 199–217, 1985) example of counterproductive coordination). We also show that the optimal central banker should be both aggressive against inflation and interventionist in using the unconventional policy instrument, and we analyze the optimal central banker’s preferences when social preferences would yield equilibrium indeterminacy.

EUROPEAN FINANCIAL MARKETS CONNECTEDNESS AND MONETARY POLICY COMMUNICATION STRATEGY:SPILLOVER EFFECTS FOR CENTRAL AND EASTERN EUROPE

This study evaluates the impact of unconventional policy announcements by the European Central Bank (ECB) on the interconnectedness of sovereign credit default swaps (SCDS) markets in the European Union (EU) from 2009 to 2014. The findings suggest that ECB's unconventional policy measures reduced sovereign default risk not only in Eurozone nations but also in Central and Eastern European countries. To investigate the transmission of monetary policy effects across European countries, we employ the Diebold & Yilmaz connectedness framework along with an event-study approach. Our analysis reveals robust evidence of substantial positive spillovers from ECB monetary policy measures to all EU countries, effectively shielding the SCDS market from adverse shocks. Among various policy tools, we observe that asset purchase programs enhance overall connectedness, while mixed policy measures bolster within-cluster connectedness. Furthermore, our results highlight the efficacy of specific monetary policy instruments, indicating that asset purchase programs and quantitative easing are particularly effective in reducing sovereign risk. Keywords: communication strategy, financial markets, monetary policy, sovereign risk, Central and Eastern Europe

Counterproductive evolution: the long-term effects of short-term interventionism following the Great Financial Crisis

Following the 2008 financial crisis, policymakers in advanced economies employed unconventional economic interventions that were meant to be short-term but continued for more than a decade and were followed by unconventional interventions in non-financial markets. What causal mechanisms connect short-term unconventional interventions with long-term policy change? By developing a constructivist-evolutionary framework, we suggest that employing unconventional policy ideas for the sake of securing the pre-crisis growth regime, in a volatile economic environment, has repeatedly failed policymakers’ expectations. The gap between expectations and outcomes expanded the policy space for unconventional policy ideas, and activated an evolutionary process, through which expanding ‘temporary’ interventions have been adopted in additional areas, became hard to reverse and modified macroeconomic priorities. A comparative process-tracing analysis of two case studies – the UK and Israel – demonstrates how short-term employment of innovative policy ideas and long-term change in economic policy are tightly connected via causal ideational evolutionary mechanisms.

The global spillovers of unconventional monetary policies on tail risks

This article analyzes the risk spillovers of UMPs of four major central banks on the expectations of a market crash in foreign equity markets. The empirical findings show that forward guidance measures exhibit a significant cross-border impact on tail risks. Other expansionary UMPs are innocuous on inducing risk spillovers to other economies. A classification of reversal UMPs into contractionary and tapering provides opposite conclusions: contractionary UMPs shocks exhibit a strong and negative cross-border impact on the tail risks of other economic areas, contrary to tapering announcements. Both the Fed and ECB unconventional policies induce significant risk spillovers with similar magnitudes.

Flight to Safety or Liquidity? Dissecting Liquidity Shortages in the Financial Crisis

AbstractWe differentiate the liquidity and the quality of private assets in a tractable incomplete‐market model with heterogeneous agents. The model decomposes the convenience yield of government bonds into a “liquidity premium” (flight to liquidity) and a “safety premium” (flight to quality) over the business cycle. When calibrated to match the U.S. aggregate output fluctuations and bond premiums, the model reveals that a sharp reduction in the quality, instead of the liquidity, of private assets was the culprit of the recent financial crisis, consistent with the perception that it was the subprime‐mortgage problem that triggered the Great Recession. Since the provision of public liquidity endogenously affects the provision of private liquidity, our model indicates that excessive injection of public liquidity during a financial crisis can be welfare reducing under either conventional or unconventional policies. In particular, too much intervention for too long can depress capital investment.

Economics as intervention: Expert struggles over quantitative easing at the Bank of England

Abstract How does a technocratic entity, such as a central bank, craft a key policy intervention when faced with limits to established frameworks of governance? This article explores the Bank of England’s turn to unconventional policy in 2009 drawing on a set of eighteen in-depth interviews with former members of the Monetary Policy Committee, Executive team, and staff economists, and a corpus of documents. Adopting Goffman’s ‘framing analysis’, it argues that the limits to established governance led to the temporary replacement of the New Keynesian frame with a Monetarist frame, as a result of expert struggles, with consequential outcomes on the policy intervention. As the backstage dissensus spilled over onto the frontstage, manifesting as limits to knowledge, the Bank’s ‘expert authority’ was threatened. The Bank engaged in ‘manufactured consensus’—a backstage compromise between competing frames forged into a frontstage consensus via a hybrid frame—which proved to be a fragile strategy. By throwing light on the backstage–frontstage relations of technocratic organizations, I claim that an intervention may be shaped both by internal processes as well as by the ways in which the organization seeks to handle the external demands to which those very same internal processes may give rise.

Estimating shadow policy rates in a small open economy and the role of foreign factors

Shadow monetary policy rates (SMPRs) are useful to evaluate the monetary stance when interest rates are at their lower bounds and unconventional policies are implemented. We present a methodology to estimate an SMPR for the case of a small open economy based on a structural dynamic factor model, which allows to consider the impact of foreign monetary conditions on domestic ones and identify their respective role for the domestic monetary stance. An application to Chile shows that unconventional policies drove the estimated domestic SMPR to negative levels during crisis episodes, with an important role for foreign factors. Alternative specifications that neglect small open economy dimensions yield noisy and less robust results, and imply very different conclusions about the level and drivers of the estimated SMPR.

Quantitative easing effectiveness: Evidence from Euro private assets

AbstractProponents of quantitative easing (QE) unconventional policy have rather overstated some evidence that structural time series models do not predict long‐term asset prices and yields as well as naive random walk forecasts, implying that predictions of price reversals cannot be profitable and, therefore, that QE effects are not transitory. Indeed, in this work we present evidence that naive models do not outperform structural vector autoregressive and Markov switching models in out‐of‐sample forecasting of corporate bond yields purchased by the European Central Bank, when the information set includes base money growth. It turns out that structural time series models provide additional information regarding the likelihood of price reversals, thus motivating investors to offset the effects of QE interventions if they perceive unconventional monetary policy regimes as temporary.

Interplay of multifractal dynamics between shadow policy rates and stock markets

Stock markets are generally perceived as a barometer of the economy and respond to international monetary policies even before economic activities. Many central banks have turned to unconventional policy measures in response to various financial crises such as the global financial crisis of 2007–2009 or the recent crisis caused by COVID-19. To examine the cross-correlation of overall international monetary policies with stock markets, we employ the daily shadow short rate (SSR), which has the advantage of allowing comparison across unconventional and conventional regimes. The analysis is made through a multifractal context using multifractal detrended cross correlation analysis (MF-DXA), considering daily data from 1st January 2000 to 31st March 2022 and country specific SSR and the stock markets of eight developed economies. The main empirical findings are the following: (i) all the country specific pairs of SSR with stock markets have significant multifractal characteristics (ii) the pairs of NZ-SSR/NZX50, US-SSR/DJIA, and CN-SSR/S&P TSX have the highest multifractal patterns while EU-SSR/Euro-area Index has the lowest multifractal patterns (iii) Australian and New Zealand stock markets exhibit anti-persistent cross-correlation with SSR while the remainder have persistent cross-correlation in their multifractality. Lastly, the findings of this study have several important implications for central banks and stock market participants.

Unconventional monetary policy and the stock market

We use weekly changes in the size of the Federal Reserve’s balance sheet as a policy tool that has largely been ignored in the literature to investigate the relationship between the unconventional monetary policy and stock market returns when the federal funds rate reaches the zero lower bound. Our empirical framework is based on a structural VAR that is identified using heteroscedasticity in weekly data on the components of the Fed’s balance sheet. We find evidence that the unconventional expansionary monetary policy is effective in stimulating the stock market, as it has positive and statistically significant effects on stock returns. In extending our analysis to disaggregate returns, our findings suggest heterogenous and asymmetric responses of disaggregate returns to an unconventional policy shock.

Industry effects of unconventional monetary policy, within and across countries

While conventional monetary policy causes differential impacts on industry output, how unconventional monetary policy affects industries across countries is as of yet unknown. This paper characterizes the effects of unconventional monetary policy on domestic industry output and spillover effects on foreign industry output between the US, the UK, and Japan. I set up a Bayesian global vector autoregressive model and identify monetary policy shocks using a sign restrictions identification. I find that the effects on output have substantial heterogeneity both within a country and across countries, however, the pattern of the industry-level output responses within a country and across countries are similar to each other. Regression analysis indicates that industries with lower working capital and larger firm size are associated with a large industry output response to unconventional policy, indicating the relevance of the interest rate channel and portfolio balance channel. Overall, unconventional policy can be used as another tool in the policymakers’ toolbox with similar industry impacts as conventional policy but with somewhat different transmission mechanisms.

Impact of RBI's monetary policy announcements on government bond yields: evidence from the pandemic.

We investigate how the bond market responded to the Reserve Bank of India's (RBI) monetary policy actions undertaken since the start of the pandemic. Our approach involves combining a narrative analysis of the media coverage together with an event-study framework around RBI's monetary policy announcements. We find that the RBI's actions early in the pandemic were helpful in providing an expansionary impulse to the bond market. Specifically, long-term bond interest rates would have been meaningfully higher in the early months of the pandemic if not for the actions undertaken by the RBI. These actions involved unconventional policies providing liquidity support and asset purchases. We find that some of the unconventional monetary policy actions had a substantial signaling channel component where the market perceived the announcement of an unconventional monetary policy action as representing a lower future path for the short-term policy rate. We also find that the RBI's forward guidance was more effective in the pandemic than it had been in the couple of years preceding the pandemic.

Equity market and the transmission channels of monetary policy: Before and after the zero lower bound

AbstractWe examine the effectiveness of the interest rate channel and the credit channel of monetary policy before and after the zero lower bound (ZLB), using intraday stock returns. We construct a number of industry‐specific and firm‐specific indicators to capture the sensitivity of firms' demand to interest rates (interest rate channel) and firms' financial constraints (credit channel). We find that the transmission of monetary policy has shifted across both periods. Conventional monetary policy works through both the neoclassical interest rate channel and the credit channel, while unconventional policy is propagated primarily via the credit channel which became even more effective at the ZLB. Before the ZLB the transmission channels operate primarily through target rate shocks rather than forward guidance announcements, whereas both forward guidance and large scale asset purchases were equally important for the credit channel at the ZLB. We also find strong evidence that transmission channels are asymmetric depending on the state of the stock market (bull/bear, tighter/easier credit conditions, high/low volatility), and the type of policy surprises (positive/negative). Our findings are robust with respect to a number of model extensions and alternative specifications.

Unconventional monetary policy and local fiscal policy

Following the onset of the pandemic, the Federal Reserve employed an unconventional monetary policy that directly intervened in municipal bond markets. We characterize the fiscal and macroeconomic implications of such central bank actions in a New Keynesian model of a monetary union. We assume that state and local governments are subject to a loan-in-advance constraint, reflecting that with lumpy cash flows, they often finance a fraction of expenditures by issuing short-term bonds. The municipal debt is held by financial intermediaries, who also supply credit to the private sector. Direct central bank purchases can transmit to the economy through two main channels: (1) by alleviating cash flow problems of the regional governments and (2) by accelerating lending to the private sector if credit constraints ease more broadly. By quantifying the relative importance of these channels, we highlight that the central bank’s actions lead to sizable increases in private investment but have more muted effects on state and local government expenditures. In addition, we also show the transmission of direct federal government aid through intergovernmental transfers is markedly different from unconventional policy.

The lending implication of a funding for lending scheme policy during COVID-19 pandemic: The case of Indonesia Banks

We investigate the lending implication of the PMK 70, a low-cost funding for lending scheme introduced by the Indonesian Ministry of Finance in June 2020 as a response to the COVID-19 pandemic. We utilize a quasi-experimental design of difference-in-differences to compare the lending of participating state-owned banks to the non-participating banks before and after the introduction of the policy. Overall, our findings suggest that the policy encourages participating banks to lend more than the non-participating banks during the distress period. We find no evidence that the low-cost funds lead to a moral hazard of liquidity hoarding for the state-owned banks. Our findings also highlight the important role of unconventional policies in alleviating banks’ risk aversion during downturns.