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The side-effects of non-conventional monetary policy

A BIS summary of research gives a nice overview on non-conventional monetary policies and their unintended systemic consequences. Current policies appear to yield diminishing returns in terms of easier financial conditions, while their costs and side effects are increasing. This leaves markets more exposed to future negative shocks. Also, the descent into negative nominal interest rates is itself a drag on profitability and health of the financial system that erodes the effectiveness of non-conventional policies.

Borio, Claudio and Anna Zabai (2016), “Unconventional monetary policies: a re-appraisal”, BIS Working Papers, No 570, July 2016.

The post ties in with the subject of systemic risks arising from non-conventional monetary policies, such as sedation, exhaustion and addiction, as summarized here.

The below are excerpts from the paper. Headings and cursive text have been added.

A brief summary of non-conventional monetary policies (to date)

“Following the Great Financial Crisis, central banks in the major economies have adopted a whole range of new measures to influence monetary and financial conditions…

  • Balance sheet policies…using the central bank’s balance sheet to influence financial conditions beyond the short-term rate… The rationale for distinguishing so sharply between interest rate and balance sheet policy is that they can be performed independently – a point which, at least until recently, was not fully appreciated outside the central banking community.
    • Typical examples of balance sheet policy include large-scale asset purchases and the supply of central bank funding (“liquidity”) at non-standard terms and conditions (e.g. at long maturities, for specific lending purposes)…
    • In the case of quasi-debt management policy, central bank operations target…the composition of such claims held by the private sector…The main intention is to alter the yield on government securities, thereby influencing the cost of funding and asset prices more generally. For example, the central bank may buy long-term government bonds and sell shorter-term bonds…
    • In the case of credit policy, the central bank targets segments of the private debt market by altering its exposure (and, by implication, the private sector’s exposure) to them. It can do so by modifying collateral, maturity and counterparty terms on monetary operations, by providing loans or by acquiring private sector assets, including equities. The main intention is to alter financing conditions for the private sector.
  • Interest rate forward guidance…actively managing expectations of the future path of the policy rate to provide extra stimulus when rates have reached their (perceived) lower bound…
    • The central bank promises to implement a policy that, once the times comes, it would not have an incentive to carry through… The notion is similar to that of Ulysses tying himself to the mast to resist the sirens’ call,
    • Forward guidance can be distinguished along two dimensions. The guidance may relate to a certain period of time (“calendar-based”) or be conditional on economic conditions (“state-contingent”); and it may contain specific numerical values (“quantitative”) or be expressed in vaguer terms (“qualitative”). For instance, the central bank may state that it will keep the policy rate unchanged for the foreseeable future (calendar-based and qualitative), or until a 2% inflation target is reached (state-contingent and quantitative).
  • Negative interest rate policy (NIRP)…setting policy rates below zero in nominal terms.
    • The central bank can determine the quantity of bank reserves in the system and there is nothing banks can do to avoid holding them – the banking system as a whole is simply stuck with them. The central bank can then charge negative interest on them – in effect, a form of tax. As banks seek, unsuccessfully, to avoid the tax, the negative interest rate spreads to other rates in the economy through arbitrage relationships.
    • This, however, does not mean that interest rates can be set at any negative level…There are technical constraints. If, in order to preserve their profitability or to avoid making losses, banks pass on the negative rates to their depositors, at some point these will shift into cash, squeezing the banks’ sources of funding.”


The impact on financial markets

“On balance, unconventional monetary policies have succeeded in influencing financial conditions, probably beyond original expectations. Their effectiveness may vary across instruments and circumstances, but…there is little doubt that they have had a lasting impact on bond yields, various asset prices and exchange rates.”

“Through what channels should large-scale asset purchases influence asset prices and financial conditions? Economists think in terms of two broad sets of mechanisms…The first operates through… altering the amount of the asset held in [private sector] portfolios [whereby]…the central bank can then affect its price and yield.  The second mechanism works by influencing market participants’ views about future monetary policy…(“signalling”).”

“A look at [a range of empirical] studies points to a number of findings…

  • There is general agreement that large-scale asset purchases did have sizeable effects on financial conditions. This is true regardless of the assets purchased – e.g. government bonds or mortgage-backed securities – and of the financial prices considered – those of the assets purchased or others, such as equities and the exchange rate. Because of the different types of programmes and the methodologies…The cumulative impact of the Fed programmes on 10-year government bond yields may have been of the order of over -100 basis points…
  • Most of the impact appears to take place on announcement, rather than once the purchases are actually executed. This is consistent with the view that markets are forward-looking, pricing actions once they are expected.”

“By contrast, views differ widely concerning the measures’ effectiveness in steering output and inflation beyond the crisis management phase. In particular, a common impression is that despite central banks having deployed the tools vigorously and beyond what was imaginable pre-crisis, output growth has remained disappointing and inflation stubbornly below objectives.”

Diminishing returns

“Originally, the monetary policy measures central banks adopted in the wake of the financial crisis were regarded as unconventional; almost a decade on, they have become commonplace…This development is a risky one. Unconventional monetary policy measures… are likely to be subject to diminishing returns. The balance between benefits and costs tends to worsen the longer they stay in place. Exit difficulties and political economy problems loom large… There are bound to be limits to how far nominal interest rates can be reduced and risk spreads compressed. And there may be discontinuities and tipping points in the behaviour of financial intermediaries and…the impact on the profitability and resilience of financial intermediaries.…As the central bank’s policy room for manoeuvre narrows, so does its ability to deal with the next recession, which will inevitably come.”

“And any side-effects tend to grow – on the profitability and resilience of the financial system, on risk-taking in financial markets and on the global balance of policies…Ultimately, this may undermine the credibility of central banks.”

“An obvious such example is the measures’ impact on the financial system’s profitability, resilience and hence ability to support the economy. We have already discussed the effect of persistently negative policy rates on banks… And such rates, and ultra-low yields more generally, also have a bigger debilitating effect on insurance companies and pension funds, whose liabilities have a longer maturity than their assets. The plight of pension funds is especially telling. It makes much more transparent the need for households to save more for retirement, which could weigh down on consumption and for sponsoring companies to replenish any underfunding, which could weigh down on investment.”

The trouble with negative real interest rates

“The experience so far suggests that modestly negative policy rates transmit to the rest of money market and capital market rates for the most part much like positive rates do. This is the case as long as contracts are sufficiently flexible to accommodate them…


“Transmission [of negative policy rates] to bank rates, by contrast, has proved more problematic. In particular, such rates have only been partially transmitted to wholesale deposit rates and so far not at all to retail deposits. Ostensibly, banks are reluctant to do so, presumably out of concerns with the reaction of depositors. Moreover, at least in one case (Switzerland), banks have actually responded by raising their mortgage rates, in all probability in order to preserve their profitability…This points to the limits of the strategy as a means of boosting financial conditions through the banking system. If policy rates do not transmit to lending rates, they cannot boost the demand for loans. If they do transmit to lower lending rates but not to deposit rates, they squeeze banks’ profits, over time possibly undermining their willingness and ability to lend. And if they transmit to both lending and deposit rates, they risk unsettling the deposit base, making it harder for banks to attract funds.”

“Negative rates may adversely affect behaviour in ways that would not be understood if one reasoned purely in real terms. Regardless of whether inflation is positive or negative, negative nominal rates are likely to be perceived as a “tax” – a more visible one than that associated with inflation, as conventionally measured.”


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