Post on 05-Jan-2016
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Questions for the UK’s Monetary Policy
Regime after the Crisis
A. DurréΦ, C. ManeaΨ, A. PaulΩ and Huw PillΦ
Φ Goldman Sachs, Ψ Universitat Pompeu Fabra, Ω University of Oxford
Annual MMF UK Monetary and Financial Conference
London, 25 September 2015
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Background #1
• In light of the magnitude of the crisis, the debate about the optimal monetary policy reaction between practitioners and academics has centered on three options:
Option 1 – Changing the inflation objectiveOption 2 – Intensifying the use of negative
interest ratesOption 3 – Making the unconventional policy
measures conventional
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During the crisis CBs chose to use extensively their balance
sheets …
2006 2007 2008 2009 2010 2011 2012 2013 2014 20150
10
20
30
40
50
60
70Federal Reserve
ECB
Bank of England
Bank of Japan
assets % of GDP
failure ofLehman
Source: IMF
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… with now assets representing a considerable
share of public debt…
ECB FED BoE BoJ0
10
20
30
40
50
60
% GDP % Public debt
9.1%8.2%
45%
At the end of Sept. 16
At the end of 2017
Source: ECB, Federal Reserve, Bank of England, Bank of Japan, Eurostat
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Background #1
• Bank of England alike other major CBs has been obliged to increase their intermediation role during the global financial crisis (GFC)
• Several causes with various degree of severity:
Sizeable market frictions: Markets seizing up amid solvency concerns of counterparties
Liquidity hoarding among market participants reflecting asymmetric information and adverse selection phenomena
Financial instability having the potential to lead to macroeconomic instability/fragility
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Background #2
• Developments during the GFC showed that liquidity and credit shock are correlated, so that it is difficult to disentangle them in practice
• As a result, CBs growingly used their balance sheet as an additional monetary policy tool during the crisis in order to:
To replace malfunctioning market segments/restore confidence among market participants
And/or to ease further monetary policy stance in a zero-lower bound environment
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In practice: private money market …
Saver
Borrower
Bank 1
Bank 2 Bank 3
Bank 4 Bank n-1
Bank n
A
B
c1
c2
c3
Cn-1
Source: Durré and Pill (2012)
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… replaced by central bank intermediation
Saver
Borrower
Bank 1
Bank n
A
B
CBBALANCE SHEET
recourse to deposit facility
borrowing at repo operations
Source: Durré and Pill (2012)
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Considerations #1
• In normal (pre-crisis) times: Capital market frictions are second order (of small
magnitude on average) Central bank can just focus on the satiation of banks’
liquidity needs (Friedman rule) against good collateral (Bagehot principle) with narrow policy objective and balance sheet
Efficient market assumption is a workable approximation
Our assertion: CB balance sheet is not relevant: financial quantities in general (and size / structure of central bank balance sheet in particular) irrelevant: “money does not matter”
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Considerations #2
• In crisis times: Financial frictions become very large and very
disruptive Capital markets are dysfunctional leading to
heightened financial stress and the CB must pay more attention to financial stability
Shocks are interrelated so that liquidity shocks cannot be disentangled from solvency shocks
Our assertion: CB balance sheet is relevant: size and structure matter for macro outcomes and policy transmission
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Considerations #3• In the post-crisis times:
Debate on normalisation will necessarily focus on both the sequencing and the pace…
… but also the optimal/neutral design of the CB balance sheet
This will require to define what is optimal / “neutral” structure and size of central bank balance sheet
Our assertion: CB balance sheet will matter again:
It will be ‘bigger’ than pre-crisis, which will depress ‘neutral’ policy rate (other things equal)
Keeping outright holdings of ‘safe’ assets will allow less distortionary market maker of last resort functions in the future
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Approach #1
• We construct a New-Keynesian model in line with the Woodford framework to capture the main ingredients of the GFC, i.e.: The market dynamics leading to a “sudden stop”
in flow of financing The two rationales of unconventional measures:
substitutes for private market activityalternative measures to ease further financial
conditions of the private sector when conventional measures are exhausted
The changing relationship between the government and the central bank
Approach #2
• We start with the framework used in Gertler and Karadi (2011) in which: a proper interbank market is introduced the central bank can implement both
conventional (Taylor rule) and unconventional (credit easing) measures
stress conditions leading to a sudden stop in interbank transactions are specified following Heider, Hoerova and Holthausen (2015)
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Approach #3
• Within this framework, we analyse the impact of three types of shocks on the CB balance sheet: “Pure” liquidity shock “Pure” credit shock “Mixed” shock for which liquidity and credit
components cannot be disentangled
• and their implications in terms of: Interactions between monetary and fiscal
policies Central bank independence
Small New-Keynesian model
A continuum of households divided into two groups: bankers and workers
0 1
Central Bank
Government
Con
soli
date
d
bala
nce
sh
eet
Non-financial corporations
3 types: Intermediate
goods firms Capital goods
firms Retail firms
PERFECT COMPETITIO
N
MONOPOLISTIC COMPETITION
Banks
Retail market
Seignorage
Interbank market
Small New-Keynesian model
A continuum of households divided into two groups: bankers and workers
0 1
Central Bank
Government
Con
soli
date
d
bala
nce
sh
eet
Non-financial corporations
3 types: Intermediate
goods firms Capital goods
firms Retail firms
PERFECT COMPETITIO
N
MONOPOLISTIC COMPETITION
Banks
Retail market
Seignorage
Interbank market
Results #1
• Liquidity shock the CB must satiate liquidity needs of banks
(Friedman rule principle) change of the CB balance sheet is not
relevant and monetary policy remains immune from fiscal policy
Results #1 - Liquidity shock
• Positive shock on the demand for banknotes of households
• Welfare optimal to be satiated by the Central Bank (no real effects)
Results #2
• Credit shock This is a fiscal responsibility the CB could step in through quantitative
easing which is not à priori problematic as long as the government behaves in a Ricardian way (and/or the fiscal limit is not reached)
Results #2 – Credit shock• Negative shock on
the willingness of households to make one period deposits at banks
• Unconventional monetary policy (outright purchases of risky assets) helps to stabilize the macroeconomy
Results #3
• Mixed shock Grey area where the CB cannot disentangle the
exact (liquidity vs. credit) nature of the shock Even it can do ex ante, history shows that both
shocks are structurally correlated Therefore, the CB may have interest to
intervene on the basis of financial stability considerations
When intervening, the impact on CB balance sheet is quite significant but limit more the negative impact of shock on output
Results #3’
• Mixed shock However, in the long run, this may have strong
as:(a) It can force the CB over time to behave in a non-
Ricardian way subject to the existence or not of state guarantees (e.g. losses of credit easing measures not supported by the fiscal authority)
(b) Such situation will gradually endanger price stability, with potential erosion of CB independence
CB balance sheet becomes subject to consolidation with that of
government
Results #3• Real shocks leading
to a credit (via an increase the default probability of investment and banks and a decrease the value of private assets) have a lower impact on real output and inflation if smoothed by unconventional measures
• But unconventional measures have a bigger impact on balance sheet via accumulation of excess liquidity
Open issues #1
• Past crises show that it can be hard to detect the exact nature of shock
• Risks to (financial and macroeconomic) stability imply pro-activity of central banks
• This pro-activity increases risk exposure of CB balance sheet over time
Open issues #2
• More pro-active CBs in the future is likely to change operational framework and the institutional arrangement with fiscal authority with the risk to revisit central bank independence
• Such change will permanently affect the design of the CB balance sheet and the “new normal” level of the neutral policy rate in the future
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Targeted Asset Purchases (e.g. ABS) = ‘Pure’ Quantitative Easing + Credit Easing (Qualitative Easing)
Assets:
Liabilities:
C
QE works by flattening the (risk-free) yield curve:- ‘Portfolio balance’ effect - Signalling low rates for longer
(temporary)
Credit easing works through lowering credit spreads in a particular market by reactivating or replacing the impaired market (e.g. money market).
A
U A A C R
R CA
A C R
R
U A A C R
A C R
Assets:
Liabilities: Assets:
Liabilities:
(Substitute for conventional easing)
(Complement to conventional easing)
Private bank reserves(required and excess)Currency and
notes in circulationConventional assets (e.g., Treasury debt)
Unconventional assets (e.g., ABS)
Central Bank balance sheet
Central Bank balance sheet
Central Bank balance sheet
Before:
After:
Impact on Economy
Impact on Economy
Motivation for large balance sheet: Allows central bank to deliver targeted ‘credit easing’ without necessarily stimulating the economy through QE.
Yield
Maturity
10yr yield = E[∑3M] + Term Premium
Open issues #2 (cont’d)
ReferencesDurré, A. and H. Pill (2012). “Central bank balance sheets as policy
tools,” BIS Papers 66, pp. 193-213.Giannone, D., M. Lenza, H. Pill and L. Reichlin (2012). “The ECB and
the interbank market,” Economic Journal 122, pp. 467-486.Giannone, D., M. Lenza, H. Pill and L. Reichlin (2011). “Non-standard
monetary policy measures and monetary developments” in J. Chadha and S. Holly (eds.) Interest rates, prices and liquidity, pp. 195-221 (Cambridge University Press, Series on Macroeconomic Policymaking no. 1).
Gertler, M. and P. Karadi (2011). “A model of unconventional monetary policy,” Journal of Monetary Economics 58, pp. 17-34.
Goldsmith-Pinkham, P. and T. Yorulmazerand (2010). “Liquidity, bank runs, and bailouts: Spillover effects during the Northern Rock episode,” Journal of Financial Services Research 37, pp. 83-98.
Heider, F., M. Hoerova and C. Holthausen (2015). “Liquidity hoarding and interbank market rates: The role of counterparty risk,” Journal of Financial Economics, forthcoming.
Joyce, M.J., A. Lasaosa, I. Stevens and M. Tong (2010). “The financial market impact of quantitative easing,” Bank of England Working Paper 393.
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