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  • I M F S T A F F P O S I T I O N N O T E

    November 4, 2009 SPN/09/27

    Unconventional Choices for Unconventional Times: Credit and Quantitative Easing in Advanced Economies

    Vladimir Klyuev, Phil de Imus, and Krishna Srinivasan

    I N T E R N A T I O N A L M O N E T A R Y F U N D

  • INTERNATIONAL MONETARY FUND

    Unconventional Choices for Unconventional Times: Credit and Quantitative Easing in Advanced Economies1

    Prepared by the Research and Monetary and Capital Markets Departments (Vladimir Klyuev, Phil de Imus, and Krishna Srinivasan)

    Authorized for distribution by Olivier Blanchard

    November 4, 2009

    With policy rates close to the zero bound and the economies still on the downslide, major advanced country central banks have had to rely on unconventional measures to stabilize financial conditions and support aggregate demand. The measures have differed considerably in their scope, and have inter alia included broad liquidity provision to financial institutions, purchases of long-term government bonds, and intervention in key credit markets. Taken collectively, they have contributed to the reduction of tail risks following the bankruptcy of Lehman Brothers and to a broad-based improvement in financial conditions. Central banks have adequate tools to effect orderly exit from exceptional monetary policy actions, but clear communication is central to maintaining well anchored inflation expectations and to ensuring a smooth return to normal market functioning.

    JEL Classification Numbers: E44, E52, E58

    Keywords: Credit easing, quantitative easing, liquidity, monetary policy

    Authors E-mail Address: vklyuev@imf.org; pdeimus@imf.org; ksrinivasan@imf.org

    1 We would like to thank Olivier Blanchard, Stijn Claessens, Charles Collyns, Jorg Decressin, Hamid Faruqee, Akito Matsumoto, Andr Meier, and David Romer for helpful comments and contributions and David Reichsfeld for excellent research assistance.

    DISCLAIMER: The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.

  • CONTENTS

    PAGE

    I. Introduction ........................................................................................................................... 4 II. Options for Unconventional Monetary Policy ..................................................................... 7 III. Measures Taken by G-7 Central Banks ............................................................................ 11 IV. Effectiveness of Unconventional Policies ........................................................................ 19 V. Exit Strategy....................................................................................................................... 28 VI. Conclusion ........................................................................................................................ 32

  • 4

    I. INTRODUCTION

    1. During the escalating stages of the current economic and financial crisis, advanced country central banks faced difficult choices. Even as the signs of stress appeared in the financial system in the second half of 2007, the problems were perceived to be limited to a few isolated markets, and the main concern at the systemic level was about liquidity. Although uncertainty about the size and distribution of losses on subprime mortgage securities raised concerns about counterparty risk and increased the price of and reduced the availability of interbank financing, few people called into question the solvency of the financial system as a whole. At the same time, even as growth started to slow down, inflation spiked, driven by a significant increase in commodity prices.

    2. The central banks reacted to the ensuing financial stress by raising the scale of their liquidity-providing operations. At the same time, they sought to control the macroeconomy through conventional meansby adjusting policy interest rates. Hence, they sterilized their liquidity provision to individual institutions through open-market operations, altering primarily the composition but not the size of their balance sheets (Figure 1). Actions on the policy rate front diverged substantially during the first year of the crisis, reflecting the differences in central banks assessment of relative risks to growth and inflation and the impact of the financial crisis on the cost and availability of credit. At one extreme, the U.S. Federal Reserve (Fed) cut its policy rate quite aggressively2 to offset the impact of elevated spreads on market rates, while at the other extreme the European Central Bank (ECB) raised its main refinancing rate percentage point in July 2008 out of concern about rising inflation expectations (Trichet, 2009b).

    2 The target for the federal funds rate was reduced by 325 bps to 2 percent between September 2007 and April 2008. Also, the spread between the primary discount window rate and the policy rate was cut to 25 bps from the usual 100 bps within this time period.

  • 5

    Figure 1. Evolution of Central Bank Assets and Policy Rates

    Sources: Haver Analytics and Bank of England.

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  • 6

    3. When the crisis intensified sharply after the bankruptcy of Lehman Brothers and near-failure of several other major financial institutions in September 2008, the central banks found their traditional tools to be insufficient to deal with the collapse of aggregate demand and freezing of key credit markets. Even a precipitous reduction of policy rates close to effective lower bounds proved insufficient to stimulate the economy given the size of the shock, the offsetting impact of a drop in inflation expectations on the real rates, and the disruptions in the transmission mechanism from policy rates to private borrowing rates and the real economy. With the capital adequacy of systemically important financial institutions called into question and wholesale funding markets under stress, commercial banks tightened their lending standards considerably. Nonbank financing, particularly via private-label securitization, virtually came to a halt. Access to credit for households and businesses was severely curtailed, while its cost ratcheted up.

    4. In these circumstances, policymakers undertook a number of decisive measures to try to stabilize financial markets and institutions and prevent a severe and prolonged contraction in real activity. Steps were taken to guarantee bank liabilities, to recapitalize financial institutions, and to limit portfolio losses. Large fiscal stimulus packages were adopted to bolster aggregate demand.

    5. Central banks acted nimbly, decisively, and creatively in their response to the deepening of the crisis. They embarked on a number of unconventional policies, some of which had been tried before, while others were new. They increased dramatically the size and scope of their liquidity operations. To varying degrees, they all provided direct support to credit markets, while several of them purchased government bonds. In the process, central banks significantly grew the size of their balance sheets. In addition, some of them made a conditional commitment to keeping the policy rate low for an extended period of time.

    6. This paper examines the unconventional monetary policy actions undertaken by G-7 central banks and assesses their effectiveness in alleviating financial market pressures and facilitating credit flows to the real economy. Section II considers the menu of options for unconventional tools of monetary policy. Section III discusses the approaches pursued by major advanced country central banks to resolve the crisis. Section IV provides a discussion of the effectiveness of these approaches, by examining their i