In a recent response to questions, The Reserve Bank of Australia has listed six options of unconventional monetary policy that is considered in an event of extreme policy implementation. Westpac economists have also talked about potential unconventional monetary policy tools applicable to the NZ case here – this is worth a read, but is a different list!
In this post I would like to outline the RBA’s options and hopefully make them easy to understand.
As discussed in my post on uncertainty, investment, and monetary policy we are thinking about “unconventional” actions when the neutral interest rate is set below zero. Or relatedly, there is a liquidity trap.
These options usually used when adjusting the OCR (Official Cash rate) has failed to generate sufficient planned expenditure – and so output is below “potential” and inflation is below “target”.
- Negative interest rate (a negative Official Cash Rate)
The first solution to this problem is to try to set the interest rate to its appropriate negative neutral level. This isn’t the idea that savers pay lenders – as we aren’t really talking about their interest rate – but it is with regards to the cash rate. The cash rate sets the interest payment/fee for retail banks in their settlement cash accounts.
By setting this at a negative rate the retail banks will continue to use settlement bank accounts, and the theory is that imposing a penalty rate for this settlement cash will convince retail banks to boost lending at a lower retail interest rate. Retail interest rates are and still will be positive here – so the idea it is a “negative interest rate” is a bit misguided.
However, there is a constraint in all of this – it is hard to get banks to set deposit rate too close to zero (as savers can hold cash), and related to that it is hard to get them to reduce their necessary margin to lend. As a result, the negative OCR can only get interest rates so low [Unless of course we found a way to tax money holdings].
The negative interest rate is in RBNZ’s list as a preferable tool, as the Bank believes that the interest rate lever work well in NZ and most closely corresponds to standard monetary policy.
- Forward guidance
Forward guidance is a communication tool that central bank uses to shift households and investors expectation on interest rates in the future. This is a popular option for economists, but the idea of “flattening the yield curve” is a bit counter-intuitive. I’ve discussed how we can think about this previously here.
- Buying government bonds.
This relates to the idea of Quantitative Easing. Purchasing government bonds stimulates activity in three ways:
- Swapping a liquid asset for an illiquid asset,
- Driving down yields (and up asset prices) for a private asset
- Making it costly for the central bank to increase rates to quickly – thereby making forward guidance “credible”.
If the central bank buys directly from Treasury, or arguably holds the bonds to maturity, then this can be seen as a form of “monetizing debt”. However, they buy assets and then sell them back in the future is is not!
As a result, such purchases can be seen as simply “open-market operations” of the form central banks used to set policy through. And when “monetization” occurs consistent with broad central government and central bank coordination during a zero lower bound episode.
- Providing longer-term funding to banks to support credit creation
This method is closely linked with conventional/original Quantitative Easing motive where the central bank increases money supply by giving liquidity support to banks. This method was used by different central banks especially after the Global Financial Crisis, as central banks would use this tool if there is huge financial market dislocation in the economy. When the banking sector collapsing due to a crisis, central bank tries to achieve its financial stability goals by providing cheap funding to boost commercial banks’ activity and revive the credit flow in the economy.
Given NZ is not in that severe “crisis” situation, these tools seem unlikely to be implemented by the bank.
- Supporting financial conditions more broadly by purchasing private sector assets, such as mortgage-backed securities, corporate bonds or – in a few cases – even equities.
This is the case when central bank starts purchasing private assets. At an extreme this could be the Bank deciding to buy a “fridge” or an “air-conditioner” from the households. This option was already used by Japan three years ago, and was part of QEIII.
The bank prefers using this tool when providing cheap funding to commercial banks doesn’t boost demand and the bank sees direct intervention to households’ expenditure more promising.
- Foreign exchange intervention, by driving the currency lower
Currency intervention can be done in two ways: sterilized and unsterilized intervention. However, in order to consider forex intervention as an unconventional monetary policy, the bank needs to use unsterilized intervention.
This distinction is discussed in this recent post on sterilization. In this instance it is solely with regards to its traditional mean, which is with respect to the forex market.
What is missing
The RBA provided a good list of possible interventions – but every one of these leaves the central bank without any friends. They need to find ways to fiddle with liquidity and interest rates to try to get the private sector spending.
However, if there is really a significant shortfall in spending there is another way – fiscal policy. And the possibility of fiscal policy at the ZLB, with a central bank that coordinates its actions, is a powerful one.
When it comes to “money financing” this recent article by Jordi Gali is very useful – expect a post soon trying to explain what is going on!