«Whatever It Takes.» An Outlook on Monetary Policy

The «Great Financial Crisis» is still being an exceptional challenge for modern Monetary theories. Furthermore, the role of central bankers has evolved from being pure technicians to assuming a psychological approach. Besides, when all the conventional measures central banks have been applying since their creation are no longer helpful, creative and insightful solutions score points in order to fulfill the targets established by every central bank.

Since their creation, Central banks have been using conventional monetary policies to achieve optimal targets of inflation and interest rates with the purpose of ensuring price stability and economic growth. Thereby, monetary policy can be expansionary when the national economy needs a boost in terms of growth, unemployment and credit constraints. And, conversely, contractionary policies are applied when inflation rates are high, in order to avoid an economic overheating.

The conventional monetary tools applied by central banks can be divided into three main groups. Among them, Open Market Operations (OMO) are undoubtedly the most recognized. Their main purpose is to give or take liquidity from the financial and banking system by manipulating the short-term interest rate and the base money by buying or selling some financial instruments, especially short-term government securities, with the aim of controlling indirectly –expanding or contracting– the total money supply.

Those operations are basically materialized by two instruments, differing in maturities. The most known tools are the Main Refinancing Operations (MRO) –also called refi rates–, which establishes the official interest rate provided by the central bank. They feature a maturity of one week, and their main purpose is related to banking liquidity management. They also have available Long-Term Refinancing Operations (LTRO), with a maturity of three months, which are used to provide medium-term liquidity to the banking sector.

Another group of conventional tools used by central banks are the Standing Facilities, with two main structures. On the one hand, the Deposit Facility, consisting on liquidity exceeds from the banking sector which are deposited in the central bank. On the other, the Marginal Lending Facility, which provides financial institutions with overnight borrowings. Both facilities interest rates usually are less competitive than market rates, used with the purpose of expanding or contracting the base money and, thus, the money supply by giving or taking money from the banking sector. As an example, if the European Central Bank increases the yield on its deposit facility and cuts down the interest rate required on its marginal lending facility, both expansionary measures, the money demand would rise, driving interest rates down especially for companies and households and, thus, boosting private consumption and investment.

The last group of conventional monetary policies within the reach of a central bank are the Reserve Requirements established for the banking sector. A fraction of customer deposits of each commercial bank, instead of lending them out, must hold as reserves in the central bank, which is remunerated at the ECB refi rate established for Main Refinancing Operations (MRO).

Conventional monetary policy instruments and channels.

All those tools reachable for central banks affect the economic climate through different channels when they are put to work. One of the most important is the bank lending channel, through which changes in monetary policy can increase –or decrease– the credit supply, especially through commercial banks. Thus, monetary policy actions may affect the amount of loans granted by banks, and thereby to the private sector in terms of consumption and investment decisions.

Also the interest rate channel plays a capital role to give or take money to/from the banking sector. Regarding an increase in key interest rates leads to an increase in short-term market rates. Therefore, the cost of capital would rise, putting a brake on investment. The private sector would increase their savings; given that they would yield higher rates. Additionally, consumption goes down, because individuals save a higher proportion of their incomes given the higher yields. This, in turn, causes demand to weaken, having effects in inflation rates as well as in the labour market.

Key ECB interest rates (1999-2015).

Yet in the early 2010s, those channels did not work anymore. The financial crisis of 2007-08 turned into a virulent financial and sovereign crisis that surprised the European Central Bank. As it had already been done in the past, a battery of expansionary measures was implemented. Exchange rates were cut down, as well as the yield of the deposit facility. By that time, however, ECB key interest rates were on the lower bound, close to 0. Therefore, there was no room for manoeuvre regarding nominal interest rates, given that they cannot be negative –there would be strong incentives to keep the money at home, instead of investing at negative yields–. The other main channel, related to bank lending, was absolutely inoperative, given that the lack of confidence among financial institutions worldwide had broken the credit supply.

In that very moment, the European Central Bank needed to go further with the policy tools they were implementing. They started considering the tools other central banks –such as the US Federal Reserve, the Bank of England and the Bank of Japan– were already applying: unconventional monetary policies.

Borrowing Rate for TLTRO II (2016), ECB.

The unconventional tools the ECB used can be divided in three groups. The first group includes Long-Term Refinancing Operations (LTRO), with maturities between 3 to 4 years, depending on the specific program. The interest rate in the case of Targeted Long-Term Refinancing Operations (TLTRO) takes a value between the MRO interest rate and the deposit facility interest rate. In the case of TLTRO II (2016) ranges from 0.00% to -0.40%. The specific rate depends on the bank’s eligible net lending: as a Targeted LTRO, the bank that is joining the program needs to proof a positive net borrowing ratio, which is useful in order to encourage a boost in the banking credit supply. LTRO programs had injected €1.3bn in total (LTROs and TLTRO I).

Asset Purchase Programmes and Long-Term Refinancing Operations (2007-2015), ECB.

The second unconventional tool used by ECB is the asset purchase program, also called Quantitative Easing. It initially covered private and corporate debt issues with the Covered Bonds Purchase Programmes (CBPP I, CBPP II, €0.8bn in total) and sovereign bonds thanks to the Securities Market Programme (SMP, €0.2bn in total). Since March 2015, it had applied the Extended Asset Purchase Programme, a fully comprehensive program that mixes several purchase programs of public and private debt issues. Besides, the ECB also launched the Asset-Backed Securities Purchase Programme, which includes all kind of financial products, such as Mortgage-Backed Securities or Collateralized Debt Obligations.

ECB Balance, Monetary Policy Operations (1999-2015). Yellow: Main Refinancing Operations (MRO). Grey: securities held for monetary policy purposes. Blue: Long-Term Refinancing Operations (LTRO).

The asset purchase programs are expected to have effects in three different ways. First, a portfolio balance effect, given that the program convert illiquid assets into cash. By doing so, investors are expected to purchase other kind of assets, such as equity, driving prices up and recovering pre-crisis levels. It would also lead market interest rates to go down, helping the private sector borrow from the markets in better conditions. Second, a fiscal effect. By pushing down market interest rates, as well as with the program itself, the ECB is seeking to reduce the cost of sovereign debt. That could affect positively public spending, launching new expansionary policies such as tax cuts or public investment. Third, an effect regarding expectations on inflation. By increasing the base money, the ECB is also signaling a higher expected inflation, which implies strong incentives to consumption and investment.

The third –and last– group of unconventional monetary policies is also related to expectations: the Foreign Guidance. The policy takes the assumption that investors and consumers anticipate expectations, and make profit of it through fixing specific dates and clearly measurable objectives. Considering that the nominal interest rate is 0, any expectation about a drop in inflation could disincentive consumption, since tomorrow I could purchase more goods with a single unit of currency than today. That is why encouraging a decrease in real exchange rates would drive a higher aggregated demand. And the only way to achieve that is by increasing inflation expectations to boost both consumption and investment. Even it is better to cut out real than nominal interest rates: if real interest rate drops, now a single unit of currency today has more value than tomorrow, so there are strong incentives to consume today and to invest in projects with higher yields than the inflation rate. If the nominal interest rate goes down, you have even less incentives to invest today, given that the market rates are expected to decrease as well. In this case, incentives are stronger to keep the money at home instead of taking risks with low yields.


Forward Guidance, ECB. Eurostoxx 50 vs. CPI Euro Area (2008-2015).

The ECB also tries to create expectations about lower short-term interest rates. An increasing inflation reflects a higher real value of a unit of currency today than in the future. Thus, the opportunity costs would rise, since you could purchase much more with a unit of currency if you spend it today than in the future, and then the cost of borrowing money would be higher. This is one of the channels through Forward Guidance can create the expectation of higher interest rates in order to promote consumption and investment.

Furthermore, it has some implications with the yield curve. If 1-year interest rates are 0% and it is expected to remain at that level during the next 3 years, this policy is also going to lower yields at different maturities, causing a drop on the yield curve. Long-term yields are the average sum of the short-term interest rates with a risk premium, considering possible volatilities in inflation and exchange rates in the future. If that volatility is low, due to the expectations created by the ECB, the yield curve would move down.

Base Money; FED, ECB, BoE, BoJ.

As a result of the huge asset purchase programs launched by the most important central banks of the international monetary system, the base money has dramatically grown from less than €2.5 quintillion (2.5×1018) in 2007 to more than €7 quintillion in 2015, without considering the Extended APP launched in 2015 and covering 2016. That is near three times more base money in eight years. No one knows the real implications of the huge amount of liquidity present in our financial markets. What we already know is that central banks should be extremely careful when launching future contractionary policies in order to take money out of the system. We could analyze the success –or not– of these different monetary policies, unconventional or not, once the world’s economy will be unequivocally back to the pre-crisis levels. But we still do not know if those pre-crisis levels were normal, or an effect of the period called «Great Moderation», with abnormally low levels of volatility. For better or for worse, history still needs to be written.

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