Research Question

The focus on monetary policy operations at the zero lower bound (ZLB) has been under the economist's microscope for the past decade. However, most of the focus is solely on applying the policy and its influences on macroeconomic variable, particularly inflation, since this is what concerns most major central banks most of the time. There are many works studied this with different methodologies that yield different results.

As mentioned earlier, the focus on inflation is understandable since most major central banks are tasked to achieve stable inflation, approximately around 2.0%. Nevertheless, the focus on inflation expectation at the moment is still lacking. The good news is, the emphasis on inflation expectation is starting to pick up some momentum.

Some might ask, why inflation expectation? Inflation expectation matters because it shows how businesses behave in determining their price for their goods and services and how the labour market sets its wages.

Therefore, in this case, I am narrowing down the research focus on how monetary policy operations at the ZLB influences inflation expectation. The diagram below illustrates the thought process of the whole framework.

Debt monetization

This post is slightly different from the main purpose of this blog. Nonetheless, it is still relevant for the sake of the discussion. We all know that the COVID-19 pandemic brought significant economic losses, mainly due to lockdown that was imposed by the government, and social distancing that restricted mobility. To repair the damages, government increased spending by issuing debt. Central banks increased money supply and slashed down interest rates to ensure that liquidity is sufficient in the financial market.

We also witnessed that, practically, the central bank can also implement unconventional policies. For example, last year, Bank Indonesia and Bangko Sentral ng Pilipinas (Central Bank of the Philippines) implemented debt monetization. 

Debt monetization refers to a situation where the central bank directly buys debt issued by the government. This is much easier to explain from an accounting perspective, where when a government issues debt (government's liability), the central bank buys it, and it becomes its asset. In exchange, the central bank will issue currency (central bank's liability), and it becomes the government's asset. Technically, it sounds like quantitative easing, but with a different end goal.

This is unique, especially when central banks from emerging economies decided to implement it. Looking at this from a bigger picture, I will say that this can help central banks to avoid falling into the zero lower bound problem. 

In my next post, I will explain how this is relevant by illustrating its mechanism using the IS-LM curve and its caveats.

"Let the FX to depreciate."

This is a follow up to my previous post regarding how monetary policy can remain potent even under zero lower bound. In the post, I pointed out that there are three ways. Those are announcing its attention with a higher inflation target, letting the FX depreciate, and money-financed transfer. In this post, I shall pay attention a little bit on the second option.

As far as I know, there is only one central bank in the world that conducts its monetary policy by managing its exchange rate: the Monetary Authority of Singapore (MAS). This is unique since almost every central bank we know, managing its money supply or interest rate, is the common tool in conducting its monetary policy.

You may ask, why Singapore uses the exchange rate to conduct its monetary policy? First of all, we need to understand the nature of its economy itself.

Singapore is located in the middle of the busiest trading route globally, where Strait of Malacca is located on the west, and South China Sea in the east. Therefore, trading is the backbone of Singapore's economy even before its independence. 

According to the latest statistics by World Bank, Singapore's exports of goods and services stands at around 173 percent of GDP. Therefore it is relevant that the central bank to manage its exchange rate to avoid huge volatility or sharp appreciation or depreciation.

Source: World Bank

Therefore, this raises the question. For countries, let's say Thailand, South Korea (for the reasons I mentioned in my previous post), or perhaps Malaysia with a relatively low share of exports of goods and services per GDP, can these central banks replicate the MAS' framework? Worth pondering.

Note: Parrodo (2004) explained in detail how Singapore's monetary policy works. Click here to view the article.

There are many ways for monetary policy to remain potent under ZLB

There are several important points that I have learnt in the past few days. Most importantly, monetary policy has many ways to remain potent even under zero lower bound (ZLB). Before pursuing further, let's take a step back and understand what a central bank is supposed to do and legally obligated to do.

Firstly, a central bank has two different tools to influence the direction of an economy. Those are money supply and interest rate. Let's assume that if an economy is on a downward trend, a central bank can either increase its money supply and/or push down the interest rate. Same goes for the other way, where if an economy is overheating, a central bank can slow down its money supply into the economy and/or increase the interest rate. This is a straightforward framework.

Secondly, we need to understand what a central bank is supposed to do. A central bank is responsible for keeping prices on check and implementing necessary tools to achieve its goals. To my knowledge, only the Federal Reserve is responsible for managing price stability and achieving maximum employment.

Thirdly, let's talk about what a central bank is legally obligated to do. Let's take the Bank of Thailand (BoT) and the Bank of Korea (BoK) as examples. I choose them because these are the central banks that are most likely to encounter the ZLB problem in the future. If we look at the BoT's website here and the BoK's website here, many jurisdictions fall under these central banks, including currency issuance, financial stability, and foreign exchange stability. 

Now that I have clarified several crucial points regarding the central bank and its functions, we can now look at the ZLB problem.

In late December 1999, former Fed Chair Ben Bernanke (during this period, he was a professor at Princeton) pointed out several ways for a monetary policy to remain potent under ZLB. This was in response to the officials at the Bank of Japan on how they responded to the asset price collapsed, which eventually put Japan in a continuous battle with deflation for two decades.

In summary, these are the proposed measures:

Announce the central bank intention (a.k.a forward guidance) with a higher inflation target.

• The first part of the description is pretty similar to what we're seeing now, where the central bank announces its intention on how long the short-term interest rate to stay low. However, announcing a plan without any numerical goal is pointless. Therefore, announcing at what rate a central bank wants its inflation rate to be is plausible. This was mentioned by Krugman (1998). Bear in mind that the Reserve Bank of New Zealand was the first central bank to implement an inflation-target in its monetary policy operations.

Let the FX to depreciate.

• I would call this as a "short-cut" to get inflation rate faster to its goal. Even though this works in theory, it is hard to implement in real-world, especially if politics are involved. 

Money-financed transfers (a.k.a. helicopter drop).

• It sounds exactly as it is, where a central bank prints money (because they are legally able to do so), take the whole money into a helicopter, and fly it into a certain place, and drop the money to the public. That's probably a cartoonish way to illustrate. 

Now that I have shown how monetary policy can operate under ZLB, we need to think about whether these can be implemented in countries like Thailand and South Korea.

My next post should be about how these central banks ideally implement these policies.

Sources:

Bernanke, B. (1999). Japanese Monetary Policy: A Case of Self-Induced Paralysis?

Krugman, P. (1998). It’s baaack: Japan’s Slump and the Return of the Liquidity Trap. Brookings Papers on Economic Activity, 1998(2), 137–205.

The subject of unconventional monetary policy needs to be expanded

Recently. I found a thesis on unconventional monetary policy during the Global Financial Crisis, written by Zhang (2013). The thesis was well written, covering several crucial points including the impact of quantitative easing, forward guidance, and quantitative easing on household deleveraging.

This thesis was written in 2013 when the global economy was still recovering from the crisis. Since then, there were more unconventional policies introduced to complement the existing policies. These were:

1. Negative interest rates on reserves, implemented by the European Central Bank in response to the European Sovereign Debt Crisis, and the Bank of Japan in response to the strengthening Japanese Yen.
2. Yield curve control, which was implemented by the Bank of Japan (unsurprisingly) and recently by the Reserve Bank of Australia in response to the COVID-19 outbreak.

The end goal of these mentioned policies is similar to forward guidance and QE, which is to influence term premium and real interest rates. But not enough work on the theoretical approach on these subject, and the effectiveness of these policies, especially on yield curve control. Therefore, the subject of unconventional monetary policy needs to be expanded by focusing on those two policies I just mentioned above.

Ushinawareta Junen > Global Financial Crisis

When it comes to monetary policy operations at the zero lower bound, the first thing the struct to my mind is Japan. In my opinion, Japan is the perfect poster child of extreme monetarism, and this was evident when we look back at what the Bank of Japan (BoJ) has done for the past four decades.

In the modern economy, Japan was the first economy that introduced an aggressive monetary expansion in responding to the crisis that they were facing 30 years ago.

While most literature emphasized extensively on the how big central banks including the Federal Reserve, the Bank of England, the European Central Bank, and the BoJ responded to the Global Financial Crisis back in 2008, I genuinely believed that we need to look back at how all of these policies were implemented during the Lost Decade in Japan.

Once this is completed, hopefully, we can find out why results were different if we compare between these two periods. 

What if EMs implement unconventional monetary policies

Those unconventional monetary policies include forward guidance, altering and expanding the size of the balance sheet. When I studied extensively at the literature regarding the policies mentioned, it is evident that there are three key purposes that a central bank wants to achieve:

• To affect the term premium (short-term yield vs. long-term yield).
• Real interest rates
• Rates spread

For advanced economies like the US, the UK and Japan to have their central banks to implement those policies will not be a problem. Nonetheless, especially in the post-COVID-19 period, we rarely ask whether central banks from emerging economies can replicate the same methods.

As of this post was written, there are around 40 countries where the policy rate is below 1.00%. Most of these countries are in the Euro Area. But there are two countries where the policy rates are inches away from the zero lower bound (ZLB): Thailand and South Korea.

Even though the implementation of these ZLB policies is straightforward for major central banks, it might be different for central banks in the emerging economies since there are other factors need to be considered. The ones I could think of right now are (i) FX, (ii) yields relative to other EMs, and (iii) institutions such as the pension funds.