Unconventional Monetary Policy during the Great Recession: Lessons for Today?
The coronavirus health crisis and the measures taken by governments to curb the pandemic are having an enormous impact on the global economy. According to Morningstar, the world economy is expected to contract by 1.4% in 2020, a downward revision of almost four percentage points compared to the World Bank’s forecast released in January this year.
The response of central banks to the most serious economic threat since the 2008 financial crisis was immediate. In particular, the Fed cut the policy-rate target to near zero, lowered the interest rate on reserves by one percentage point and eliminated reserve requirements for banks. All these measures are part of the conventional monetary-policy toolkit of central banks.
However, in the present situation when the policy rate has reached the zero lower bound, traditional monetary policy based on fine-tuning the policy rate fails to stimulate the economy. In effect, monetary authorities can’t bring interest rates well below zero because, were interest rates become negative, people would turn to cash (which pays a zero interest rate), undermining the transmission mechanisms of monetary policy.
In order to overcome this problem, the US monetary authorities announced the implementation of several unconventional monetary tools aimed at achieving its dual mandate of maximum unemployment and stable prices. These tools include the purchase of Treasury securities and mortgage-backed securities (aka quantitative easing or QE) “in the amounts needed”, the use of forward guidance to influence market expectations, or the establishment of several facilities to provide credit to households and businesses (including one facility to purchase, for the first time in its history, corporate bonds). The measures announced by the ECB were similar in ambition and magnitude.
This isn’t the first time central banks resort to unconventional monetary tools. After the 2008 financial crisis, both the Federal Reserve and the ECB implemented several QE programs and started to use forward guidance in their public statements. Although the coronavirus shock is different from the Great Recession in many aspects, we can now look back and examine the effectiveness of unconventional monetary policy tools in the past. This will give us a sense of what QE and forward guidance can (and can’t) do to mitigate the impact of the present crisis and get the economy back on the path of economic growth.
Over the period 2008 and 2014, the Fed undertook three large scale asset purchase (LSAP) programs and a maturity extension program (MEP) whereby it bought around $5 trillion in Treasuries and mortgage-back securities. These purchases increased the asset side of the Fed’s balance sheet by eightfold. Contrary to conventional wisdom, the aim of QE wasn’t to increase banks’ reserves and, thereby, push financial institutions to extend more credit. This misconception led some economists and commentators to foretell an hyperinflation episode that never occurred. Instead, QE was intended to lower long-term borrowing costs for households and firms via portfolio balance effects: the purchase of Treasuries depresses yields, pushing investors to buy close substitutes such as corporate bonds. This is turn should have a positive impact on aggregate demand via an increase in investment.
Was QE effective in achieving this goal? Certainly. In a recent paper published in the American Economic Review, Ben Bernanke, former Chair of the Fed, concludes that “most evidence supports the view that [the effects of QE on long-term yields] were economically significant and persistent.” National Bureau of Economic Research Kenneth Kuttner quantifies these effects: QE reduced 10-year Treasury yields by 150 basis points.
Did this affect corporate debt as suggested by portfolio balance effects theory? And more importantly, did QE have a positive impact on the economy as a whole? Evidence suggests that it did both. It encouraged the issuance of corporate debt, pushing corporate yields down and easing financial conditions for firms. This in turn helped the economy recover more quickly, pushing long-term-debt dependent firms to increase investment and lowering the unemployment rate by around 1 percentage point.
The other unconventional monetary tool employed by the Fed to try to get the economy back on track after the 2008 economic shock was forward guidance. In fairness, forward guidance, the communication by monetary authorities of the future path of the policy rate, wasn’t entirely novel. As pointed out by Bernanke, during Greenspan mandate, the Fed made use of forward guidance when it promised to keep the policy rate low “for a considerable period of time”. However, since 2008, the Fed has used it in a more explicit and systematic way.
The objective of forward guidance is to exercise a downward pressure on long-term interest rates by making explicit statements about future monetary policy. Forward guidance is based on the so-called expectations hypothesis of the yield curve. According to this theory, the yield of long-term bonds is determined by both current and future short-term interest rates. This means that, if monetary authorities can influence future short-term rates, this will have an impact on the long end of the yield curve today, producing the same portfolio balance effects described above. Although it is difficult to isolate the effects of forward guidance from those of QE, the evidence available indicates that forward guidance succeeded in lowering long term rates. Furthermore, forward guidance was effective in stimulating the U.S. economy, having a positive impact on both inflation and employment.
As shown, unconventional monetary policies were effective in boosting the economy in the past. However, this doesn’t necessarily mean that they will work this time. Today’s situation is quite different from the 2008 financial crisis. The coronavirus crisis isn’t the result of an aggregate demand shock, which means that past monetary-policy prescriptions may not work this time.
Yet there are two reasons to be optimistic. First, central banks are resorting to new unconventional monetary-policy tools that adapt better to the current situation. For instance, the Fed has created a lending facility to help small businesses keep people on payrolls during the lockdown. Second, this time we don’t need monetary stimulus to boost aggregate demand. Instead, and as pointed out by Krugman, we have to put the economy in an induced coma and wake it up after the pandemic has passed. This shouldn’t be that difficult as long as monetary and fiscal authorities do their part and provide assisted breathing to both firms and households until the storm is over.