Throughout periods of paramount economic crisis, conventional monetary policy tools may no longer be affective. Hence, unconventional monetary policy may be employed to kick-start economic growth and spur demand.
Normally, when a nation’s economy grows rapidly to the point that inflation increases to dangerous levels, the central bank will put in place restrictive monetary policy to tighten the money supply. As a result, there should be a reduction in money in circulation as well as new money that enters the system.
Raising the target interest rate makes borrowing more expensive, thus reducing the demand for cash and cash instruments. Also, the bank may increase the level of reserves that both commercial and retail banks must keep on hand which, in turn, limits their ability to generate new loans.
When a recession occurs, these policy tools can be operated in reverse order to constitute a loose monetary policy. Interest rates are lowered, reserve limits are loosened, and instead of selling bonds in the open market, they are purchased in an exchange for new money to be in circulation.
The unconventional side
In times of deep recession or economic crisis, conventional monetary tools become limited in their usefulness. Nominal interest rates are close to zero and bank reserve requirements cannot be made too low as it would result in bank default. In addition, once interest rates are close to zero, the economy could fall into a liquidity trap.
What is the solution? The central bank would have to expand its money supply through Open Market Operations. However, in periods of crises government securities are deemed as being safe for investors and hence their price is beefed up which limits their effectiveness as a policy tool.
This is why the central bank resorts to Quantitative Easing (QE) i.e. purchasing other securities in the open market. The types of securities purchased during a round of QE are typically bonds or debt instruments owned by financial institutions including mortgage backed securities.
Should all else fail, a central bank can take the more unconventional route of trying to prop up equity markets by actively purchasing shares on the open market. In fact, to some degree, central banks around the world did engage in equity markets during the years after the financial crisis.
Above and beyond the aforementioned, the bank can attempt to institute a negative interest rate policy, whereby instead of paying interest on deposits, depositors will have to pay for the privilege of keeping money at a bank. This is to promote people spending or investing rather than hanging on to their money. That being said, savers will suffer the consequences.
Sum and substance
Central banks endorse monetary policy to change the size of the money supply and its rate of growth. Normally done through interest rate targeting, setting bank reserve requirements, and engaging in open market operations with government securities. In periods of severe economic downturn, these tools become limited as interest rates approach zero and commercial banks could suffer from liquidity problems.
When the latter happens, the unconventional route of QE is applied. When QE is not enough, the bank has to enter other markets and signal to the market that it will engage in an expansionary policy for a long period of time or even resort to implementing a negative nominal interest rate, as otherwise the economy would continue to deteriorate.
Disclaimer:
This article was issued by Maria Fenech, investment manager support officer at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.