How Low Can You Go: Monetary Policy Constraints And Options For The Next Recession

The monetary policy menu

Unconventional monetary policy tools are often misunderstood by the public. The basic idea is that when overnight interest rates have already been cut to zero, a central bank can still provide further accommodation by guiding longer-term interest rates down, too.3

So what unconventional ammo do central bankers have to fight the next recession? As a starting point, we would expect interest rates to be slashed to the effective lower bound across the developed markets. Forward guidance naturally comes next—an explicit commitment to keep interest rates at zero for an extended period of time. After that comes a battery of more extreme tools that either implicitly or explicitly target the longer-end of the yield curve. Quantitative easing (QE), maturity extension programs(such as Operation Twist) and yield curve control fall into this category.

QE is a central bank’s large-scale asset purchase program. In theory, it can target a range of investment vehicles. But some jurisdictions explicitly forbid purchases of some securities. For example, the Federal Reserve Act does not allow4 the Fed to purchase corporate bonds or stocks. If you were wondering why the European Central Bank (the ECB), the Bank of Japan (BOJ), and the Bank of England (BOE) bought corporate bonds and the Fed didn’t, it was largely due to different legal constraints. Of course, with enough time, laws can be changed.

  • Negative rates are viewed unfavorably in the United States. In a series of internal memos—such as this one and this other one, the Fed staff estimated that rates could not be taken below -35bps without prompting significant cash hoarding. Further, the economic benefits of such cuts were not seen to be significant relative to the uncertainties surrounding impacts to money market funds and bank profitability. We suspect the mixed experiences with negative rates in Europe and Japan have not changed the Fed’s view.

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  • Forward guidance is a commitment to keep interest rates at the lower bound for an extended period of time. If the market believes this guidance, then the setting on overnight rates gets transmitted further out on the curve—closer to the tenors at which households and businesses actually borrow. This tool has been effective in the United States and globally and is very likely to be employed again.
  • Quantitative Easing refers to any form of large-scale-asset-purchase program. The most intuitive form of QE involves the purchase of long-dated government bonds. Very simply, as a non-economic buyer, the central bank can raise the price (aka lower the yield) of government bonds. QE also serves to strengthen the central bank’s forward guidance, because investors will not expect a rate hike for the duration of the program. QE can also engender portfolio rebalancing effects, as low sovereign yields incentivize investors to buy riskier securities, which can then lead to a broader easing of financing conditions. Where allowed, central banks can directly purchase these instruments as well, in order to improve monetary transmission. Examples of this include the Fed’s purchase of mortgage-backed securities or the ECB’s purchase of corporate bonds. The efficacy of QE is subject to debate. What we can say is that the programs have generally coincided with strong periods for risk markets. This outcome was intentional. Central bankers hoped wealth effects would stimulate aggregate spending. 
  • Maturity extension programs are in many ways just a fine-tuning of QE. The Fed’s Operation Twists are the most well-known example of this, where the central bank sells its short-term securities and invests the proceeds in longer-duration securities. Similar to other unconventional tools, the goal is to lower longer-term rates that are more impactful for the real economy. Considering the fact that the Fed minutes from May 2019 discussed this, it seems highly likely that these programs will be used again 
  • Yield curve control is an extreme version of QE, in which the central bank commits to buy whatever it takes to achieve a targeted yield level. The Bank of Japan implemented a yield curve control policy in September 2016, with its decision to target the 10-year Japanese government bond yield at around 0%. There is precedent for yield curve control in the United States and the United Kingdom as well, as both central banks capped yields in the 1940s to help finance World War II. While this action is a distant memory for most of us, Fed Governor Lael Brainard has renewed interest in the idea, proposing that the Fed could control yields out to the two-year-point of the curve. We see little value in such a proposal, given the efficacy of forward guidance at this horizon. Nevertheless, during a period of extreme stress—or for central banks like the ECB and BOJ that have very little conventional ammo—yield curve control could prove to be a valuable tool in the arsenal.
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These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

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