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.

QE, inflation, and Japan

I think the discussion on whether the implementation of QE, low-interest rates and prices in Japan is something that we are not able to answer directly. I've given some thoughts for the past 2-3 years, and for the past several days, I've been thinking that maybe that we have been asking the wrong questions, and maybe we (especially the Bank of Japan) have been looking at the wrong picture.

This whole discussion reminds me of Milton Friedman's quote:

"Inflation is always and everywhere a monetary phenomenon."

I think Friedman's right. Inflation should be a monetary phenomenon. This is assuming that more money is being pumped into the economy, while households and businesses are chasing limited goods and services, this will drive prices up.

But I also think Friedman is wrong. Maybe after the Great Moderation, there were other exogenous factors that we weren't able to quantify, such as the rise of emerging economies (especially China) and technological advancement that keep prices low.

So, does this answer why Japan's inflation so low for the past three decades? Maybe yes. The Bank of Japan had done everything within their capabilities by pushing the interest-rates low and expanding its balance sheet. In theory, this should able to stimulate aggregate demand and produce more output and push prices up. 

But if we look at the chart below, the correlation between money growth and prices is weak.

Most literature tried to answer why this happened. The one I just read by Bowman et al. (2010) hinted at two different factors but unfortunately did not emphasize in details why:

"It is possible that QEP exerted positive effects, but that these were simply overwhelmed by the drag on aggregate spending coming from severe weakness in the banking sector and balance sheet problems among households and firms."

In my opinion, it is probably fair to say that the BoJ might be underestimating these two factors. That could explain why, despite the extra-loose monetary policy, prices have stubbornly stayed low.

I should re-read Richard Koo's book then this weekend.

PS: Turned out those three papers I mentioned in my previous post will take some time to digest.

Source:

Bowman, D., Cai, F., Davies, S. M., & Kamin, S. (2010). Quantitative Easing and Bank Lending : Evidence from Japan. International Finance Discussion Paper, 2010(1018), 1–31

Filling the gap between theory and application of QE

I am still between 3-4 months away from beginning my study. Nevertheless, it will not hurt me to start early. Below are some of my initial thoughts.

Once short-term interest rates are close or at zero percent, there are several ways that a central bank can keep stimulating the economy. Those are by (i) expanding the size of its balance sheet (a.k.a quantitative easing), (ii) announce its future plans (a.k.a. forward guidance), or (iii) keep pushing the interest rates into the negative territory.

Let's focus on the first tool mentioned since it is familiar to everyone. So far, what I saw was the explanations of how quantitative easing works in theory and empirical evidence of this policy.

Nonetheless, what most literature that I found so far were not able to explain the connection between theory and empirical evidence. If I have to illustrate visually, I would draw a Venn diagram, and will look something like this:

The gap (shaded area) is something that still puzzles me.

One of the papers I read that studied Japan's experience of quantitative easing programme back in 2001 to 2006 by Tsuji (2006) did a great job of perfectly explain the theory and the effectiveness of the programme, especially its impact on the real economy. Most papers out there focused extensively on QE's impact on the financial market, and this paper is one of few that really studied its impact on the real economy. While the author was not able to connect the theory and the evidence found from the research, the author argued that quantitative easing could work via two different channels. Those are through (i) expectation channel or (ii) portfolio substitution. 

The author also pointed out three crucial papers that might answer the gap that I showed above. Those papers are:

• Bernanke, B. S., & Reinhart, V. R. (2004). Conducting monetary policy at very low short-term interest rates. American Economic Review, 94, 85–90
• Bernanke, B. S., Reinhart, V. R., & Sack, B. P. (2004). Monetary policy alternatives at the zero bound: An empirical assessment. Brookings Papers on Economic Activity, 35, 1–100.
• Tobin, J. (1969). A general equilibrium approach to monetary theory. Journal of Money, Credit and Banking, 1, 15–29.

For my next post, I will summarize these three papers.

Source(s)

Tsuji, C. (2016). Did the expectations channel work? Evidence from quantitative easing in Japan, 2001-06. Cogent Economics and Finance, 4(1).

First post

Nothing to say much for my first post. The purpose of this blog is to focus on macroeconomics and monetary policy.

To read more, head to about me.

Cheers.