Unconventional Monetary Policy Overview

Unconventional Monetary Policy

• Central banks use unconventional monetary policy tools when interest rates approach the effective lower bound (e.g., 0.10 percent for the RBA).
• These tools include:
  • Negative interest rates
  • Extended liquidity programs
  • Asset purchases (quantitative easing)
  • Forward guidance
• Extended liquidity programs and asset purchases are balance sheet tools, affecting the RBA's balance sheet.

RBA Balance Sheet

• The RBA balance sheet has significantly changed since March 2020 due to unconventional policy implementation.
• Total size increased from 190billionto190 billion to 190billionto437 billion.
• ESA balances increased from 32billionto32 billion to 32billionto245 billion.
• Australian investments increased from 89billionto89 billion to 89billionto331 billion.

Negative Interest Rates

• Negative interest rates involve charging interest for storing money, essentially taxing money storage.
• Several countries implemented negative policy interest rates during the global financial crisis (e.g., Denmark, Sweden, Switzerland).
• Negative policy rates were generally not passed on to consumers and firms by banks, and actual market interest rates remained positive.
• The RBA did not utilize negative interest rates during the global financial crisis or the coronavirus crisis.

Extended Liquidity Programs

• Extended liquidity programs expand lender of last resort facilities to help financial institutions navigate temporary market illiquidity.
• These programs aim to prevent fundamentally sound institutions from failing, especially those playing a systemic role.
• Extended liquidity programs involve:
  • Expanding the range of accepted collateral, including lower-quality collateral
  • Expanding the set of eligible counterparties
• They make funding available at lower than usual costs.

Asset Purchases (Quantitative Easing)

• Asset purchases involve central banks buying assets in an open market operation.
• This can be seen as a form of "printing money" as the central bank expands its balance sheet, creating new money to purchase assets.
• This process was traditionally used to set policy interest rates before the shift to repurchase agreements (repos).
• The US Federal Reserve and other central banks, but not the RBA, significantly increased asset purchase programs during the global financial crisis.
• These programs aimed to increase demand and decrease interest rates on a broad range of assets, including risky and longer-term safe assets.
• Asset purchase programs can be conducted by setting either quantity targets or price targets.

Forward Guidance

• Forward guidance refers to communication of monetary policy, aiming to reduce uncertainty and make current policy more effective.
• There are two types:
  • Time dependent: commitments not to change policy until a certain date
  • State dependent: commitments not to change policy until certain conditions are met
• The effectiveness of forward guidance depends heavily on the central bank's credibility.

Unconventional Monetary Policy in Australia

• Australia did not use unconventional monetary policy during the global financial crisis, relying primarily on conventional monetary and fiscal policy.
• The RBA's cash rate did not approach the zero lower bound during this period.
• However, unconventional monetary policy was utilized in response to the COVID-19 pandemic.

Australian Monetary Response to Covid

• The RBA implemented several unconventional policies during the COVID-19 pandemic:
  • Cash rate target set at 0.1 percent, with a corridor floor at 0.10 percent.
  • Extended liquidity programs, including the $200 billion Term Funding Facility (TFF) offering 3-year loans at 0.25 percent.
  • Asset purchases through Yield Curve Control, targeting a 0.25 percent interest rate on 3-year government bonds.
  • Forward guidance communicated through public statements about the timing of interest rate increases.

Ongoing Challenges for Monetary Policy

• Monetary policy faces ongoing challenges, including:
  • Unwinding unconventional measures:
    • Gradual increase in the cash rate from 0.1% to 4.35% in November 2023.
    • Closing of the Term Funding Facility and discontinuation of Yield Curve Control.
  • Forward guidance communication:
    • RBA struggled to communicate effectively between its forecasts and state-dependent policy, leading to criticism.
  • Monetary-fiscal interactions:
    • Large-scale balance sheet changes necessitate close coordination between Treasury and the Reserve Bank, blurring traditional distinctions.

New Challenges for Monetary Policy

• The evolution of the global economy poses new challenges for monetary policy, including:
  • The need for a broader theoretical framework that incorporates monetary and fiscal policy, inflation, and economic activity in both the short and long run.
  • Addressing the limitations of the Keynesian model, which focuses on short-run demand-side dynamics and lacks a place for monetary policy.
  • Analyzing the interactions between demand and supply shocks.
  • The development of the Aggregate Demand – Aggregate Supply Model to address these challenges.

Unconventional Monetary Policy

• Tools used to stimulate economic activity and lower interest rates when traditional monetary policy is insufficient.
• Used because of the "zero lower bound" on interest rates.
• Include negative interest rates, extended liquidity programs, asset purchases, and forward guidance.

Negative Interest Rates

• Banks are charged interest to store money, effectively a tax.
• Implemented in some countries during the Global Financial Crisis, e.g., Denmark, Sweden, and Switzerland.
• Not used by the RBA in response to the Global Financial Crisis or the COVID-19 pandemic.

Extended Liquidity Programs

• Designed to increase market liquidity by making funds available at lower than usual cost.
• Include expanding the range of collateral accepted and the set of eligible counterparties.

Asset Purchases (Quantitative Easing)

• Involve the central bank purchasing assets in an open market operation, often financed by creating new money.
• Used to increase demand for and drive down interest rates on a wide range of assets, including risky assets and longer-term safe assets.
• Implemented through setting quantity targets or price targets.

Forward Guidance

• Refers to communicating the central bank's intentions regarding future monetary policy.
• Includes time-dependent commitments (policy unchanged until a certain date) and state-dependent commitments (policy unchanged until certain conditions are met).
• Goal is to reduce uncertainty about future policy and increase the effectiveness of current policy.

Australian Monetary Response to the Global Financial Crisis (GFC)

• Did not use unconventional monetary policy.
• Relied on conventional monetary policy and fiscal policy.
• Cash rate did not approach zero lower bound.

Australian Monetary Response to COVID-19 Pandemic

• Cash rate target set at 0.1 percent.
• Extended liquidity programs: $200 billion Term Funding Facility (TFF) provided loans at 0.25 percent.
• Asset purchases: Yield Curve Control program targeted a 0.25 percent interest rate on 3-year government bonds.
• Forward guidance: Central bank communicated intention to keep interest rates low until inflation was sustainably within the 2-3 percent range and full employment was achieved.

Unwinding Unconventional Measures

• Cash rate increased from 0.1% to 4.35%.
• Term Funding Facility closed to new applications in June 2021 and matured in June 2024.
• Yield Curve Control discontinued in November 2021.
• Forward guidance communication strategies continue to evolve.

New Challenges for Monetary Policy

• Inflation
• The changing nature of work
• The impact of climate change
• The need to strengthen the financial system
• The need to address inequality and social mobility
• The need to manage the impacts of technological change

Aggregate Demand – Aggregate Supply Model

• A theoretical framework that incorporates monetary and fiscal policy, analyzes interactions between inflation and economic activity, and distinguishes between demand and supply shocks.
• Replaces the Keynesian model, which has limitations in dealing with these issues.

Unconventional Monetary Policy

• Conventional monetary policy tools rely on RBA’s cash rate target, which has an effective lower bound of 0.10 percent
• As the cash rate approached this lower bound, countries explored unconventional monetary policy tools
• Negative interest rates: Instead of earning interest, depositors pay fees to store money effectively, acting as a “tax” on storing money
• Extended liquidity programs: Expand the range of collateral accepted and eligible counterparties for lender-of-last-resort facilities, making funding available at lower than usual cost
• Asset purchases: The outright purchase of assets in an open market operation, expands the central bank’s balance sheet, creating new money and using that money to purchase assets. Also known as quantitative easing
• Forward guidance: Communication of monetary policy which can be time-dependent or state-dependent, aiming to reduce uncertainty about future policy and increase the effectiveness of current policy

RBA Balance Sheet Changes

• The RBA balance sheet has changed dramatically, reflecting the implementation of unconventional policy
• Total size of the RBA's balance sheet tripled from 190billion(March2020)to190 billion (March 2020) to 190billion(March2020)to437 billion (August 2024)
• ESA balances increased significantly, from 32billionto32 billion to 32billionto245 billion during the same period reflecting the shift from traditional to unconventional policy

Australian Monetary Response to the Global Financial Crisis

• Did not utilize unconventional monetary policy, mostly relying on conventional monetary policy and fiscal policy
• The cash rate did not approach the zero lower bound during this period

Australian Monetary Response to Covid

• Cash rate: Target set at 0.1 percent with a corridor floor at 0.10 percent
• Extended liquidity programs: $200 billion Term Funding Facility (TFF) provided 3-year loans at 0.25 percent with varying collateral requirements based on loan type and borrower size
• Asset purchases: Yield Curve Control targeted a 0.25 percent interest rate on the 3-year government bond (AGS) through secondary market auctions, increasing ESA balances
• Forward guidance: Assured continuation of low interest rates until “progress was made towards full employment and that we were confident that inflation will be sustainably within the 2-3 percent range”

Challenges of Unwinding Unconventional Measures

• Cash rate: Increased from 0.1% to 0.35% in May 2022, with subsequent rises to 4.35 percent in November 2023
• Extended liquidity programs: Term Funding Facility closed to new loans in June 2021, and the last loans matured in June 2024
• Asset purchases: Yield Curve Control discontinued in November 2021
• Forward guidance: Criticized for difficulty in communicating the difference between forecasts and state-dependent policy

New Challenges for Monetary Policy

• Requires a new theoretical framework to analyze interactions between inflation and economic activity in both short and long run
• The aggregate demand – aggregate supply model is needed to incorporate monetary and fiscal policy and differentiate the effects of demand and supply shocks

Unconventional Monetary Policy

• Due to the Reserve Bank of Australia's (RBA) corridor system, the effective lower bound for the cash rate target is 0.10%.
• When the cash rate approached this lower bound, unconventional monetary policy tools were used, including:
  • Negative interest rates
  • Extended liquidity programs
  • Asset purchases (quantitative easing)
  • Forward guidance
• Extended liquidity programs and asset purchases are considered balance sheet tools.

RBA Balance Sheet

• The RBA's balance sheet has significantly changed, reflecting the use of unconventional policies.
• Total size increased from 190billioninMarch2020to190 billion in March 2020 to 190billioninMarch2020to437 billion in August 2024.
• ESA balances grew from 32billionto32 billion to 32billionto245 billion, while gold and foreign exchange slightly increased from 100billionto100 billion to 100billionto103 billion.
• Australian investments saw a dramatic increase from 89billionto89 billion to 89billionto331 billion.

Negative Interest Rates

• Instead of earning interest, money stored would be charged interest.
• Effectively a tax on storing money.
• Used in some countries like Denmark, Sweden, and Switzerland during the global financial crisis, with the most negative rate at -0.75% in Switzerland.
• These negative rates were mostly not passed on to consumers and firms.
• Not used by the RBA in response to the global financial crisis or the coronavirus crisis.

Extended Liquidity Programs

• Liquidity refers to how easily an asset can be converted to cash.
• Liquid assets can be bought or sold with little to no price impact.
• Central banks often have lender of last resort facilities to help financial institutions during times of temporary market illiquidity.
• Extended liquidity programs help prevent financial institutions from failing during times of illiquidity.
• These programs expand the range of collateral accepted and eligible counterparties, making funding available at a lower cost.

Asset Purchases (Quantitative Easing)

• Involves the outright purchase of assets in an open market operation.
• Purchases are paid for by crediting ESA balances, increasing the amount of money in the system.
• The central bank expands its balance sheet, creating new money to purchase assets.
• Traditionally, this was used to set policy interest rates.
• During the global financial crisis, central banks, like the US Federal Reserve, significantly increased asset purchases, buying high-quality assets like government bonds from traditional counterparties.
• They also purchased low-quality assets, like risky mortgage-backed securities, from a broader range of institutions.
• The goal is to increase demand and drive down interest rates across a range of assets.
• There are two ways to conduct these programs: setting quantity targets or setting price targets.
• The term "quantitative easing" originates from the Bank of Japan's use of these policies during the late 1990s.

Forward Guidance

• Refers to communication about monetary policy.
• Can be time-dependent or state-dependent.
• Reinforces the central bank's commitment to its unconventional policies, reducing uncertainty about future policy.
• Its effectiveness depends on the central bank's credibility.

Australian Monetary Response to the GFC

• Unconventional monetary policy was not a dominant feature of Australia's response to the global financial crisis.
• The RBA relied on conventional monetary policy and fiscal policy.
• The cash rate did not approach the zero lower bound during this time.

Australian Monetary Response to COVID-19

• Cash rate targeted at 0.1%.
• A $200 billion Term Funding Facility (TFF) was introduced with 3-year loans at 0.25%.
• Yield Curve Control was implemented, targeting a 0.25% interest rate on 3-year government bonds.
• Forward guidance emphasized a commitment to low interest rates for an extended period.

Ongoing Challenges for Monetary Policy

• The conceptual distinction between monetary and fiscal policy has become less clear with large-scale balance sheet changes.
• Monetary and fiscal policy must be coordinated carefully.

Unwinding Unconventional Measures

• The cash rate was increased from 0.1% to 4.35% over time.
• The Term Funding Facility was closed to new loans and matured in June 2024.
• Yield Curve Control was discontinued in 2021.
• Forward guidance has been subject to criticism for its communication effectiveness.

New Challenges for Monetary Policy

• The RBA's response to inflation is a significant challenge.
• The need for a new theoretical framework to incorporate monetary and fiscal policy is emphasized.
• The Aggregate Demand-Aggregate Supply model is proposed as an alternative framework.

Explore the tools and implications of unconventional monetary policy used by central banks when interest rates hit the lower bound. This quiz covers the RBA's balance sheet changes, negative interest rates, and asset purchasing strategies. Test your understanding of how these policies affect the economy.