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Conventional and unconventional monetary policy

Conventional and unconventional monetary policy

Conventional Monetary Tools

One of the responsibilities of central banks is to control money circulation in the economy. This is achieved through the implementation of various monetary tools that are referred to as conventional monetary instruments. These tools have been used by the central banks ever since they were established. When the rates of inflation increase, the central bank has to enact conventional monetary tools which will help in tightening the money supply in the economy.

Open Market Operations

These are financing operations which are conducted by the central bank through tender invitations with both short and long-term maturity. These tenders make it possible for commercial banks to borrow funds from central banks. Commercial banks use securities and treasury bills as collateral to obtain loans from central banks (Bernanke, pg.34). At the time of tendering, each commercial bank will state its rate, and the one that will offer the highest will win the tender. The amount of money that will be distributed to commercial banks will be defined in advance in order to control the supply of money in the economy. In the context of this conventional monetary policy, there are weekly tenders, 3-month tenders, and long-term tenders which have a maturity period of up to 3 years. This is the commonly used monetary policy that allows the central bank to regulate the amount of money in circulation in the interbank market.

Standing facilities are widely used in the context of conventional monetary policy. The central bank sets the lending rate at which commercial banks can obtain short-term loans. On the other hand, there is the deposit rate, which is the interest rate at which commercial banks pay their loans to the central bank.

Minimum reserves are also part of the conventional tools used by the central bank to control money supply in the economy. Based on circumstances, the central bank can decide to increase or decrease the amount of money commercial banks set aside as a reserve. These reserves can take different forms such as cash, securities, or monetary instruments.

There are a number of conventional tools at the disposal of the central bank that can be used to guide its monetary policy. When there is limited money in supply, it is the obligation of the central bank to implement appropriate conventional tools to address the issue. In such a case, the central bank can lower its policy rate levels. This will allow commercial banks to borrow more funds from the central bank and lend it to other agents such as households and businesses at a lower cost. On the same note, the central bank can reduce its minimum reserve requirements of commercial banks. This implies that commercial banks will have more money funding purposes.

On the other hand, when the central bank wants to reduce the money supply, it has the option of increasing its policy rates. This means that the cost of borrowing will be higher for both commercial banks and other economic agents. Therefore, the ability of commercial banks to create more money will be reduced. The outcome will be the same if minimum reserve requirements for central banks are increased by the central bank. In the event that conventional tools are sufficient to regulate the money supply, the central bank will opt for non-conventional tools to ensure that its objective is achieved.

Non-Conventional Monetary Tools

During abnormal times, there is a high likelihood that conventional tools may not be effective in facilitating the achievement of the central bank’s money control objectives. This may be due to a powerful economic shock requiring the nominal rates to be brought down to zero. At this point, it may not be possible to lower policy rates further, and thus, an economic stimulus should be undertaken, and it can only be done through non-conventional monetary instruments. On the other hand, non-conventional monetary tools will be required when the interest rate is above 0 and the monetary policy in the transmission is impaired. When the central bank experiences such a circumstance, it may choose to respond directly to the transmission process by implementing non-conventional measures.

The experiences of the past hard economic times reveal that when the global financial system is in crisis, non-standard measures are highly needed even before policy rates are reduced to their lowest levels. During the 2007 financial crisis, central banks across the globe intervened to offer more liquidity to financial markets (Mishkin, pg.45). At the initial stages of the crisis, it appeared that conventional measures would be sufficient. Despite the fact that markets were not operating as usual, tensions in the euro area were addressed by supplementary refinancing operations. However, as the crisis intensified, things changed. Within a short time, market liquidity was drying up. Consequently, there was a drastic loss of confidence among market participants. The euro area market was about to collapse. There is no doubt that in this situation, lowering policy rates have not been sufficient. This is based on the fact that whenever the monetary transmission channel is extremely affected, conventional measures will not be effective. Under this circumstance, any decision should take into consideration the extraordinary situation that is being witnessed in the money markets. Therefore, there are non-standard measures that can be undertaken by the central banks when an extraordinary situation emerges. The most important factor to consider when undertaking non-standard monetary measures is the risk of hindering the operation of markets by triggering interference.

Unconventional tools entail the policies that directly aim at the cost and availability of external sources of finance to commercial banks, households, and businesses. These sources may be in the form of loans, equity, and fixed-income loans from the central bank. Unconventional policies can be implemented in a number of ways. Direct quantitative easing is the common approach that is used when the central bank intends to widen its balance sheet. In most cases, central banks purchase long-term bonds from commercial banks. Banks have an important role to play when it comes to quantitative easing. For instance, if the main objective is to issue loans to the private sector, the central banks will be expected to buy government from financial institutions. The extra liquidity that will be yielded will then be directed to the private sector in form loans. Across the globe, various central banks have been involved in quantitative easing. The Bank of Japan is a perfect example of central banks that have applied direct quantitative easing as a non-conventional measure. The Bank of Japan employed this measure between the year 2001 and 2006. The implementation of this measure resulted in a change in the operational target of operational markets from the uncollateralized policy rate to a specified balance in the current account within the Bank of Japan. In addition, this measure entailed the purchasing of Japanese government bonds from commercial banks to meet the target current balance at the central bank. It also involved public commitment. Due to this high-level commitment to these financial operations, CPI did not drop on a sustainable basis. Therefore, the Bank of Japan managed to address an economic crisis effectively through the deployment of non-conventional measures (Blinder et al). There are important lessons that can be drawn from Japan’s experience with quantitative easing. First, it can be noted that the direct effect of quantitative easing is a flattened yield curve. This enhances long-term financing, especially to the private sector. On the other hand, it can be learned that the success of quantitative easing depends on the participation of the entire banking system.

Direct Credit Easing

This is another way through which non-conventional measures can be implemented in an economy. This is a policy that is concerned with liquidity shortages and its implementation forces market segments to purchase corporate bonds and securities. The effectiveness of implementing these measures that focus on wholesale financial markets relies on financial sources from households and firms. This is an attractive policy in serious banking distress. There are crucial considerations to pay attention to when applying this non-conventional measure. Purchase of privately issued securities should be monitored to evade distorted allocation with regard to firms and industries. In addition, the size of the issue is another aspect that is kept in check. This is because it may be easy for large firms to benefit from the central bank’s purchase of securities but extremely difficult for small firms to access such opportunities.

Since the year 2007, the Federal Reserve has maintained a high profile type of credit easing. Through this policy, the Fed has come up with many lending programs with the objective of offering liquidity and enhancing the performance of key credit markets. For example, the Term Auction Facility was established to ensure that financial institutions are in a position to access short-term credit. Recently, the Fed together with the US Treasury Department started to purchase asset-backed securities through enterprises sponsored by the government. However, it is too early to conclude whether these measures have been effective.

Application of Monetary Policies

Application of non-conventional policies requires critical evaluation of the market operations. In an environment where there are extremely low-interest rates, liquidity will benefit borrowers while penalizing lenders. On the other hand, most of the non-conventional measures that are implemented are designed to enhance lending and encourage savers to own long-term assets (Smaghi). Therefore, the effectiveness of these measures relies on the ability to return to their lending activities as well as give short-term and long-term loans to households and firms. This is regarded as a beneficial approach rather than holding more money in their reserves in the central bank. There is no doubt that increasing the policy rates, especially deposit rates, will definitely undermine the incentive of the banking sector to lend money to households and firms. On the same note, the increasing interest rate may discourage savers from buying long-term assets. From this situation, it can be argued that the objective of non-standard measures is to restore efficient functioning of money markets. Increasing interests may be considered a hindrance to the recovery of money markets. When the economy starts to normalize, it will be possible to unwind unconventional measures. However, this will be a steady process, and it may take a long time before all the measures are withdrawn. Part of the unwinding will have to happen automatically when the measures employed by the central banks start to appear unattractive as conditions in the money markets start to normalize. In most cases, lending institutions offer liquidity at a premium, and this makes lending attractive when money market recovers from a financial crisis. Based on this situation, the central bank’s balance sheet will start to shrink automatically since the demand for its funds will obviously decrease.

On the other hand, it is the responsibility of the central bank to tighten up the operation of money markets. However, this move will depend on the maturity of the assets that had been purchased during the implementation of unconventional measures. Therefore, tightening of the economy is done with caution to ensure that strict measures are not enforced in the middle of the recovery process. On the same note, measures that are associated with assets usually take time to mature. This implies that it may pose challenges when trying to withdraw them from the operation.

Personal Opinions

The central bank and commercial banks play an important role in the economy. As already mentioned, commercial banks participate in money creation, and, thus, they influence the money supply in the economy. Commercial banks lend money to the private sector in terms of loans depending on the interest rates that have been defined by the central bank. When there is an economic crisis, the central bank has to respond promptly. In their response, central banks apply conventional or unconventional measures which they consider appropriate (Turner, pg.293). Based on my understanding, conventional measures seem to operate well when the crisis lasts for a short period. However, in the long run, conventional measures may force the central bank to lower its policy rates to zero. This is the time when unconventional measures become extremely vital. However, I have noted that the implementation of unconventional measures will call for due consideration of the performance of money markets. This is because once such non-standard measures are put in place, challenges will be experienced in withdrawing them. Therefore, in a deep recession, unconventional measures have to be undertaken because conventional policies are not sufficient. Quantitative easing influences the yield curve with the objective of stimulating housing markets which are usually funded by long-term mortgage debts. When QE indicates that it is going to fail, the central bank is in a position to take further unconventional measures with the potential of making the situation better than it was before. This can be achieved by purchasing shares of stocks on the open market. Therefore, it is up to the central bank to signal to the public that it has intentions of keeping low interests rates for a long period. This situation will affect the decision of money lenders and savers. In fact, the latter will consider investing or spending their money instead of being penalized for saving in the long term.

As a person who is interested in saving and making investments, I have learned a lot about the operation money markets. I have now known that it is the central bank that decides which measures to employ during an economic crisis. As an investor, there are conventional measures that may be appropriate for my investment decisions, while others may discourage me. Therefore, when making financial decisions, I will have to take into consideration the type of measures that are being deployed by the central bank. In serious economic situations, I will recommend the implementation of unconventional measures. I believe that such policies are effective in facilitating the recovery of money markets without necessarily decreasing interest rates to their lowest bound. Unconventional measures used by the central bank make it possible for the private sector to access credit facilities that will help in recovery.

Conclusion

Usually, central banks enact monetary policies with the objective of controlling the money supply and the rate at which the economy grows. In most cases, this is done through conventional tools such as interest rates, bank reserve requirements, and OMOs. However, in severe economic situations, interest rates approach zero, and lowering them further may not be appropriate as commercial banks will get concerned with their liquidity. This means that unconventional measures have to be brought in to facilitate the process of economic recovery. Unconventional measures may be effective in different circumstances where conventional tools will not work efficiently. There are some measures that present important opportunities with regard to offering appropriate incentives and being reversible easily. On the other hand, some tools pose more risks when they are implemented, and the central banks have to take due consideration adopting them. There are pros and cons of each tool that is implemented. It is the responsibility of the central bank to ensure that the negative effect is mitigated and the public benefits from the implementation. The smooth operation of money markets is the main objective of central banks. Therefore, they will do all it takes to ensure that the money supply is controlled.



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