Practical Monetary
Policy I:
Unconventional
Policies
PhD Course in Monetary
Economics
19 May 2015
Deputy Governor Martin Flodén
Overview

Background: recent monetary policy

Money and operational frameworks

Forward guidance & liquidity traps

Unconventional policies

Negative interest rate

Quantitative easing

Helicopter money
Background: Recent
monetary policy
Inflation too low
Annual percentage change
6
United Kingdom, CPI
United States, CPI
5
Euro Area, HICP
Sweden, CPIF
4
6
5
4
3
3
2
2
1
1
0
0
-1
-1
-2
-2
-3
-3
07
08
09
10
11
12
13
14
15
Sources: Eurostat, U.K. Office for National Statistics, U.S.
Bureau of Labor Statistics and Statistics Sweden
Inflation expectations have fallen
Percent, money market participants
Source: TNS Sifo Prospera
Policy rates
Percent
Note. ECB refers to Eonia.
Sources: Bank of England, ECB, Federal Reserve Bank
of New York and the Riksbank
Long-term interest rates are low
10-year interest rates, per cent
Sources: National central banks, Reuters
EcoWin and the Riksbank
Central banks’ balance sheet totals
Per cent of GDP
70
70
Bank of Japan
Bank of England
60
60
Federal Reserve
ECB
The Riksbank
50
50
40
40
30
30
20
20
10
10
0
0
07
09
11
13
15
Sources: National central banks, Reuters
EcoWin and the Riksbank
Expansionary monetary policy

Repo rate reduced by one percentage point last year


To -0.10% in February
To -0.25% in March

Forecast of future repo rate reduced substantially

Bond purchases




SEK 10 bn announced in February
SEK 30 bn announced in March
SEK 40-50 bn announced in April
Total around 3 percent of GDP
Money and
operational
frameworks
What is monetary policy?
(Goodfriend, 2009)
”Monetary policy consists of open market
operations that expand or contract highpowered money (bank reserves plus
currency) by buying or selling treasury
securities.”
”Pure monetary policy works by
varying the aggregate quantity
of bank reserves to influence
the spread between the federal
funds rate and interest paid on
reserves.”
”Interest on reserves policy consists of varying interest that
a central bank pays on bank reserves, holding monetary
policy … fixed.”
Interest on reserves

Let 𝑖 denote the central bank’s policy rate and let 𝑖 𝑟
denote interest paid on reserves (no interest on cash).

If 𝑖 𝑟 = 0 and 𝑖 > 0


If 𝑖 𝑟 = 0 and 𝑖 = 0


A change in 𝑖 must be accompanied by a change in highpowered money (open market operations), and vice versa
High-powered money can vary even if 𝑖 is held constant at zero
If 𝑖 𝑟 ≡ 𝑖 ≥ 0

High-powered money and 𝑖 can be determined separately
The Riksbank’s operational framework

No reserve requirement

𝑖 𝑟 = 0 on cash, but 𝑖 𝑟 = 𝑖 on ”voluntary” reserves
Forward guidance
and liquidity traps
Forward guidance: What is it?

Information about policy rule?

Commitment to deviate from normal policy rule?

Why?

How? Time inconsistency?
Information about policy rule

Central banks must forecast their own policy rate


Previously: often produced economic forecast assuming
constant policy rate. But how?
Should this forecaste be published?
Communication to escape liquidity traps?

Communication as a commitment device

Why?

Can it work?
Eggertsson & Woodford (2003)
PC:
IS:
𝜋𝑡 = 𝜅𝑥𝑡 + 𝛽𝐸𝑡 𝜋𝑡+1
𝑥𝑡 = 𝐸𝑡 𝑥𝑡+1 − 𝜎1 (𝑖𝑡 − 𝐸𝑡 𝜋𝑡+1 − 𝑟𝑡𝑛 )
Normal regime: 𝑟𝑡𝑛 = 𝜌 > 0
Deflationary regime: 𝑟𝑡𝑛 = 𝑟 𝑑 < 0, exit with Pr = 𝛼, never
return.
In normal times, MPR: 𝑖𝑡 = 𝜌 + 𝜙𝜋 𝜋𝑡 , and 𝜙𝜋 > 1.
See also Eggertsson (2006) and Eggertsson (2008)
Eggertsson & Woodford (2003)
Under discretion, solution to normal regime is 𝜋𝑡 = 𝑥𝑡 = 0
and 𝑖𝑡 = 𝜌.
Solution to deflationary regime is then 𝑖𝑡 = 0 and
𝜋𝑡 = 𝜒𝜅 𝑟 𝑑 <0
𝑑 <0
𝑥𝑡 = 1−𝛽(1−𝛼)
𝑟
𝜒
where 𝜒 = 𝜎𝛼 1 − 𝛽 1 − 𝛼 − 𝜅(1 − 𝛼) and where the
solution assumes that 𝜒 > 0.
Eggertsson & Woodford (2003)
=0.99, =1, =1, =2/3
Inflation
0
Output gap
0
-2
-5
-4
-6
-10
-(1-*(1- ))/
-/
-8
-10
-15
-12
-20
-14
-16
-25
-18
-20
0
0.1
0.2
0.3
0.4
Persistence: 1-
0.5
0.6
0.7
-30
0
0.1
0.2
0.3
0.4
Persistence: 1-
0.5
0.6
0.7
Eggertsson & Woodford (2003)
Simplify: 𝛼 = 𝜎 = 1, and assume deflationary regime in t =
1.
Discretionary solution is then 𝜋0 = 𝜅𝑟 𝑑, 𝑥0 = 𝑟 𝑑, 𝜋𝑡 = 0, and
𝑥𝑡 = 0, for 𝑡 ≥ 1.
Suppose cb can commit to 𝑖1 = 𝜌 − 𝜖. Then
𝜋0𝑐 = 𝜅 1 + 𝜅 + 𝛽 𝜖 + 𝜅𝑟 𝑑 , 𝑥0𝑐 = 1+𝜅 𝜖+𝑟 𝑑, 𝜋1𝑐 = 𝜅𝜖, 𝑥1𝑐 = 𝜖,
𝜋𝑡 = 0, and 𝑥𝑡 = 0, for 𝑡 ≥ 2.
Eggertsson & Woodford (2003)
Loss function: L = 12
𝛽 𝑡 (𝜋𝑡2 + 𝜆𝑥𝑡2 ).
Compare discretion (𝜖 = 0) to “commitment” (𝜖 ≥ 0):
2L(𝜖) = 𝜅 1 + 𝜅 + 𝛽 𝜖 + 𝜅𝑟
𝛽𝜆 𝜖 2
𝑑 2
We immediately see that L′ 𝜖
+𝜆
𝜖=0
1+𝜅 𝜖+𝑟 𝑑
2
+ 𝛽 𝜅𝜖
< 0 (because 𝑟 𝑑 <0)
So, try to commit to keep rate low long to get out of
liquidity trap!
2
+
Forward guidance: How?


Forecast of policy rate

New Zealand (1997), Norway (2003), Sweden (2007)

Scenarios in inflation reports
At zero lower bound: for how long?

BoJ, Fed, BoE, BoC, …
Forward guidance


Time or state contingent?

Time contingent: Fed 2008-2012, ECB 2013-, …

State contingent: Fed 2012-, BoE 2013-
Triggers or thresholds?
Forward guidance: Fed
Source: IMF (2013a), Table 1
Forward guidance: BoE
”At its meeting on 1 August 2013, the MPC agreed its intention not to
raise Bank Rate from its current level of 0.5% at least until the headline
measure of the unemployment rate had fallen to a ‘threshold’ of 7%
subject to the conditions below.”
Knockouts:
• Medium-term inflation forecast above 2.5%
• Medium-tem inflation expectations not well anchored
• Stance of monetary policy is a significant threat to
financial stability, and other policies cannot mitigate
this
Source: BoE (2013)
Forward guidance: BoE intentions


Clarity about the MPC’s view on the appropriate tradeoffs

How fast to reduce slack in the economy?

Risks to overriding objective of price stability?
Reduces uncertainty about the future path of monetary
policy

Reduces the risk that market interest rates rise prematurely
Source: BoE (2013)
Unconventional
policies
Unconventional policies

Negative repo rate

QE: Purchase government bonds, or other assets

Helicopter money (next class)
Negative repo rate

Theory: limit because of cash

In practice: lower than zero is possible

Broad transmission

No direct losses on the Riksbank’s balance sheet

Administrative & technical problems for banks and
markets?
Negative repo rate

Transmission rather normal



Technical problems?




Interest-rate channel
Exchange-rate channel
FRN market: yes
IT systems: some
Cash: not yet
Other?





Media attention
Outflow from money-market funds
Search for yield, asset prices
Banks’ margins
Pension funds
Interest rates
Percent
Source: SCB and the Riksbank
Interest rates
Percent
Source: SCB and the Riksbank
Banks
Net interest income
SEK Million (includes 2015Q1)
Return on equity
Percent
Large Swedish banks
European banks
Source: Banks and SNL Financial
Quantitative easing


Neutrality?

Expectations hypothesis: 1 + 𝑖𝑡,𝑡+ℎ =
(1 + 𝑖𝑡+𝑗 )

Other fundamentals (risk and term premia, …)
Restoring financial market intermediation

Provide liquidity, shift risks, …

Signaling

Portfolio rebalancing?

Higher ”money supply”?
1/ℎ
Swedish QE not unique, but in a
special context

Financial markets work well

Term and risk premiums are low (or negative)



Public debt is low


Bonds overpriced according to our repo rate forecast
Negative effect on Riksbank profits
Small outstanding stock
Variable rates dominate

In particular for mortgages
Pace of bond purchases
Percent of GDP
12%
12%
ECB-total
ECB-government bonds
Sweden
10%
10%
Sweden, specified range
8%
8%
6%
6%
4%
4%
2%
2%
0%
Oct 14
0%
Jan 15
Apr 15
Jul 15
Oct 15
Jan 16
Apr 16
Jul 16
Source: ECB and the Riksbank
The Riksbank’s balance sheet
Swedish
government
bonds 10
billion
Notes & coins
80 billion
400
300
Forex 215
billion
Gold- and forex
458 billion
200
MP claim 17 bil.
100
Gold- and forex
166 billion
MP liability 53
billion
Notes & coins
109 billion
Equity
65 billion
31/12 2004
Other 25 billion
Equity
95 mdr
Other 9
billion
30/9 2014
39
The Riksbanks balance sheet
700
700
600
+90
Banknotes
and coins
Securities in SEK
500
600
500
+90
Deposits
400
300
400
Gold and
Foreign exchange
reserve
300
Foreign currency
loan
200
200
Other
100
100
Equity
0
Other
Assets
0
Liabilities and equity
Source: The Riksbank
The banks' deposit and lending requirements at the
Riksbank, and the repo rate
SEK billion and per cent
500
5
400
4
300
3
200
2
Fine tuning (left scale)
Certificates (left scale)
100
1
Repos (left scale)
Repo rate (right scale)
0
0
-100
-1
00
02
04
06
08
Note: Negative figures mean that the banks borrow liquidity from the
Riksbank, positive figures that the banks make deposits.
10
12
14
Source: The Riksbank
What can then be achieved with QE in
Sweden?

Lower long-term interest rates?



Support to fiscal policy?




No risk premiums to remove
Lower borrowing costs if long rates fall
But smaller dividends from Riksbank if our profits fall (if we buy overpriced assets)
Exchange-rate


Less clear when premiums are initially low
Less clear if purchases are not in line with our repo rate forecast (then weak signaling effect)
Could prevent appreciating spillover from ECB’s bond purchases
Other issues




How much can we buy on a small market for government bonds?
Buy mortgage bonds when we are concerned about excesses in credit to households?
Are interest-rate effects larger if we announce long-term plans for the bond purchases?
How do long-term rates transmit when the economy is dominated by variable rates?
Preliminary impact of expansionary
measures in Sweden

Short-term interest rates have fallen


… because of lower repo rate
Long-term interest rates have fallen relative to German rates

… because of several measures

Inflation and inflation expectations seem to have turned up

February decision (repo cut and bond purchases)




The lower repo rate had a clear impact
Demonstrated that zero was not the floor
Initial communication that we could cut much more, mitigated in minutes
March decision (repo cut, bond purchases, lower repo forecast)
(unscheduled meeting! after positive data outcomes!)


Lower term premiums
Stabilized the exchange rate
Interest-rate difference, Sweden-Germany
0,6
0,5
1,2
2 year
5 year
1
10 year
0,4
0,8
0,3
0,6
0,2
0,4
0,1
0,2
0
0
-0,1
-0,2
-0,2
Oct 14
-0,4
Nov 14
Dec 14
Jan 15
Feb 15
Mar 15
Apr 15
May 15
SEK/EUR
9,7
9,7
SEK/EUR
9,6
9,6
9,5
9,5
9,4
9,4
9,3
9,3
9,2
9,2
9,1
9,1
9,0
Oct 14
9,0
Nov 14
Dec 14
Jan 15
Feb 15
Mar 15
Apr 15
May 15
Source: The Riksbank
2-year yield decomposition
Average of models JSZ and JSZ + BRW
Source: The Riksbank, based on Joslin, Singleton and Zhu (RFS,
2011) and Bauer, Rudebusch and Wu (JBES, 2012)
5-year yield decomposition
Average of models JSZ and JSZ + BRW
Source: The Riksbank, based on Joslin, Singleton and Zhu (RFS,
2011) and Bauer, Rudebusch and Wu (JBES, 2012)
Breakeven inflation
3,0
3,5
2,5
3,0
2,5
2,0
2,0
1,5
1,5
1,0
1,0
0,5
0,5
0,0
-0,5
-1,0
-1,5
0,0
Nominell ränta
Real ränta
Inflationskompensation
-0,5
-1,0
-1,5
Source: The Riksbank
CPI, CPIF and CPIF excluding energy
Annual percentage change
Note. The CPIF is the CPI with a fixed mortgage rate.
Sources: Statistics Sweden and the Riksbank