MONETARY POLICY

Master 1
Pr Jean-christophe Poutineau
University of Rennes 1- France
 Chapter 4
New challenges 2:
Unconventional monetary policy
• challenges for monetary policy and central banks
• Central banks now have a much greater focus on financial stability in
addition to targeting inflation.
• But by Tinbergen’s Law, if an authority has N policy targets it needs at
least N policy instruments, so we have seen central banks augment
their arsenal of policy instruments with macroprudential tools
• This question was covered in the previous chapter
• The other main challenge has been the ability of conventional
monetary policy to mop up in an aftermath of a financial crisis and
stimulate the economy into sustainable recovery.

• We will cover this aspect In the current chapter

Road map
• Conventional vs Unconventional policies Financing investment
• Why UMP?
• Typology of UMP

• QE (quantitative easing)
• Definition
• Mechanism
• Experiences
• Economic consequences
• Exit strategy

• FG (forward guidance)
• FG in general
• FG in practice
• Empirical assessment
• Risks
I – Conventional vs Unconventional policies
• Main differences

• Conventional policy :
• one form
• one main objective
• clear theoretical foundations
• empirical relevance
• Unconventional policy :
• Takes many forms
• pragmatic reaction of CB (no benchmark model)
• different targets
• empirical evidence is scarce
A. Why implement unconventional policy measures?

• In Normal times : By steering the level of the key interest rates,

• the central bank manages the liquidity conditions in money markets
• Affects the provison of loans (through their cost)
• pursues its primary objective of maintaining price stability (medium term).
• This has proved
• to be a reliable way of providing monetary stimulus to the economy
(downturns)
• containing inflationary pressures (upturns)
• How interest rate decisions affect money supply
• Conventional monetary policy was also based on substantial evidence
on how short term official interest rates affected the economy.
• Knowledge of that transmission mechanism meant that the setting of
interest rates could be done with an awareness of what quantum of
interest rate changes were necessary to deliver an appropriate
response.
• No such evidential basis yet exists for unconventional monetary
policy.
• Conventional monetary policy has quantitative consequences
• By Buying/selling securities from the banking system, the CB
influences the level of reserves that banks hold in the system.
• In normal times, these fluctuations in the volume of reserves are
merely a by-product and are not a focus or target of policy itself.
• Instead, fluctuations in reserves are a means to achieve desired
changes in interest rates.
New territory

• Unconventional approach of monetary policy based on two situations:

• The exclusive use of unconventional policies

• The complementary use of unconventional policies in line with conventional

policy
• First a zero lower bound on interest rates and a disconnection
between official rates and market rates meant that conventional
monetary policy ceased to be effective in the aftermath of the
financial crisis.

• monetary policy became about much more than setting a price – the
policy rate – and focus turned to the size of central bank balance
sheets.

• The introduction of unconventional actions was due to a practical

response to circumstances rather than driven by intellectual
developments,
• Second, non-conventional measures may be warranted even when
the policy interest rate is above zero if the monetary policy
transmission process is significantly impaired.

• Under these circumstances, central banks have two (not necessarily

mutually exclusive) alternatives, namely
• (i) to reduce the short term nominal interest rate even further than in normal
conditions,
• (ii) to act directly on the transmission process by using non-conventional
measures.
• Recent eurozone experiences have shown that non-standard tools
might be needed even before policy rates have been cut to their
lower bound.

• Shortly after the collapse of Lehman Brothers, the spread between

the three-month Euribor and the overnight interest rate EONIA –
which in normal times would on average be around 10 basis points –
rose to an all-time high of 156 basis points on 13 October.

• Market liquidity virtually dried up, and the sudden loss of confidence
among market participants threatened to have a lasting effect on the
orderly functioning of the euro area money market.
• Interest rate spread
• Under these circumstances, easing monetary policy by simply
lowering official interest rates would not have been enough.

• Whenever the transmission channel of monetary policy is severely

impaired conventional monetary policy actions are largely ineffective.
B. Typology of unconventional measures

• The unconventional tools include a broad range of measures aimed at

easing financing conditions.

• the central bank can influence the cost of credit is by affecting market
conditions of assets at various maturities – for instance, government
bonds, corporate debt, commercial paper or foreign assets.

• All of these measures have one element in common: they are

designed to improve financing conditions beyond the very short-term
interbank interest rates.
• Broadly speaking, the additional monetary stimulus when the policy
interest rate is at zero can be achieved in three complementary ways:
• (i) by guiding medium to long-term interest rate expectations,
• (ii) by changing the composition of the central bank’s balance sheet, and
• (iii) by expanding the size of the central bank’s balance sheet.
Quantitative Easing
• When the central bank decides to expand the size of its balance
sheet, it has to choose which assets to buy.
• In theory, it could purchase any asset from anybody.
• In practice, however, quantitative easing has traditionally focused on
buying longer-term government bonds from banks.
• The idea is twofold:
• first, sovereign yields serve as a benchmark for pricing riskier privately issued
securities. When long-term government bonds are purchased, the yields on
privately issued securities are expected to decline in parallel with those on
government bonds.
• Second, if long-term interest rates were to fall, this would stimulate longer-
term investments and hence aggregate demand, thereby supporting price
stability.
• This is where banks play a critical role in the success of any
quantitative easing policy.

• If the aim is to ensure that new loans are provided to the private
sector, central banks should mainly purchase bonds from the banks.

• The additional liquidity would then be used by the banks to extend

new credit.
• However, banks may choose to hold the liquidity received in exchange
for the bonds in their reserves at the central bank as a buffer.

• This risk can be minimised if the central bank conducts this type of
operation only at the lower bound – that is, when it has fully
exploited the standard interest rate channel.

• At the lower bound the remuneration of deposits is null (or almost

null) and there is hence little or no incentive for banks to park excess
reserves with the central bank.
• Deploying a policy of quantitative easing at a policy rate different
from the lower bound may necessitate a larger expansion of the
central bank’s balance sheet and thus increase the risk exposure of
the monetary authority.

• When banks stop intermediating loans, this policy no longer works.

• Quantitative easing is successful if it narrows the market spreads

between the rates paid on selected credit instruments and policy
rates, thereby limiting the risks of a liquidity shortfall and encouraging
banks to extend credit to higher interest-paying parties.
• Qualitative easing

• quantitative easing, concerns an expansion of a central bank's

balance sheet,
• qualitative easing, is the process of a central bank adding riskier
assets to its balance sheet:
• Quantitative easing is an increase in the size of the balance sheet of
the central bank through an increase in its monetary liabilities (
base money), holding constant the composition of its assets.
• Qualitative easing is a shift in the composition of the assets of the
central bank towards less liquid and riskier assets, holding constant
the size of the balance sheet (and the official policy rate and the rest
of the list of usual suspects).
• Credit easing
• In introducing the Federal Reserve's response to the 2008–09
financial crisis, Ben Bernanke distinguished the new program, which
he termed "credit easing", from Japanese-style quantitative easing.
• "credit easing"—resembles quantitative easing in one respect: It
involves an expansion of the central bank's balance sheet.
• However, in a pure QE regime, the focus of policy is the quantity of
bank reserves, which are liabilities of the central bank not the nature
of the balance increase (eg, for the Boj, the overall stance of its policy
was gauged primarily in terms of its target for bank reserves).
• In contrast, the Federal Reserve's credit easing approach focuses on
the mix of loans and securities that it holds and on how this
composition of assets affects credit conditions for households and
businesses

• Credit easing involves increasing the money supply by the purchase

not of government bonds but of private-sector assets, such as
corporate bonds and residential mortgage–backed securities

• In 2010, the Federal Reserve purchased $1.25 trillion of mortgage-

backed securities to support the sagging mortgage market. These
purchases increased the monetary base in a way similar to a purchase
of government securities.
• Forward guidance
• Faced with sluggish economic activity and limited room for
manoeuvre, several central banks have adopted more explicit
communication on their future policy orientation in the form of
forward guidance.
• This has served to reassure market participants and the general public
that central banks will preserve their monetary accommodation
against the backdrop of persistently low growth, employment and
inflation.
• In designing their forward guidance, central banks have been guided
by the particular features of their respective economies and the
specificities of their mandates.
• We are now going to study in more details the two main versions of
Unconventional monetary policy :

• II – Quantitative easing

• III Forward guidance

II- Quantitative easing
• Definition
• Channels
• Experiences since 2007
• Economic impact: efficacy and risk
• Unwinding
A - Definition
• Quantitative easing (QE), also known as large scale assets purchases is
an expansionary monetary policy whereby a central bank buys
predetermined amounts of government bonds or other financial assets in
order to stimulate the economy
• A central bank implements quantitative easing by buying specified
amounts of financial assets from commercial banks and other financial
institutions, thus raising the prices of those financial assets and lowering
their yield, while simultaneously increasing the money supply
• This differs from the more usual policy of buying or selling short-term
government bonds to keep interbank interest rates at a specified target
value
• Expansionary monetary policy to stimulate the economy typically
involves the central bank buying short-term government bonds to
lower short-term market interest rates.

• However, when short-term interest rates reach or approach zero, this

method can no longer work.

• In such circumstances, monetary authorities may then use

quantitative easing to further stimulate the economy by buying assets
of longer maturity than short-term government bonds, thereby
lowering longer-term interest rates further out on the yield curve
• A central bank enacts quantitative easing by purchasing—regardless
of interest rates—a predetermined quantity of bonds or other
financial assets on financial markets from private financial institutions

• This action increases the excess reserves that banks hold to facilitate
an expansion of private bank lending;

• Additionally, if the central bank also purchases financial instruments

that are riskier than government bonds, it can also lower the interest
yield of those assets (as those assets are more scarce in the market,
and thus their prices go up correspondingly).
As simple graphical presentation of QE
• The phrase ‘Quantitative Easing’ was initially introduced by the BoJ to
signal a shift in focus towards targeting quantity variables.

• With interest rates at their Zero Lower Bound, the Bank of Japan
aimed at purchasing government securities from the banking sector
and thereby boosting the level of cash reserves the banks held in the
system.

• The hope was that by targeting a high enough level of reserves,

eventually this would spill over into lending into the broader
economy, helping drive asset prices up and remove deflationary
forces.
• The BOJ had maintained short-term interest rates at close to zero since
1999.
• According to the Bank of Japan, the central bank adopted quantitative
easing on 19 March 2001.[
• Under quantitative easing, the BOJ flooded commercial banks with excess
liquidity to promote private lending, leaving them with large stocks of
excess reserves and therefore little risk of a liquidity shortage
• The BOJ accomplished this by buying more government bonds than would
be required to set the interest rate to zero. It later also bought
asset-backed securities and equities
• The BOJ increased the commercial bank current account balance from
¥5 trillion to ¥35 trillion (approximately US$300 billion) over a four-year
period starting in March 2001.
• The BOJ also tripled the quantity of long-term Japan government bonds it
could purchase on a monthly basis.
B- How does QE work ?
• Asset purchases by central banks can either be
• of government bonds (or bills)
• of assets issued by the private sector.

• Asset purchases – unlike decisions about a target for a policy rate –

are explicitly about quantities. They are the use by the central bank
of its ability to create acceptable means of payment in unlimited
quantity to acquire assets.
• In doing so, the central bank
• expands its balance sheet
• shifts the portfolio mix of assets held by the private sector

• who come to hold

• more claims on the central bank (‘money’ – the liability side of the central
bank’s balance sheet)
• fewer of the claims that the central bank has acquired (which now form the
asset side of its balance sheet).
Transmission channels (example of BoE)
• (Vocabulary : a gilt is the british name for a treasury bond)

• The mechanism by which QE works can also be understood in the

context of portfolio balance models and models of credit
imperfections.

• Two main channels through which asset purchases by the Bank of

England can affect the economy and a stylized representation of these
channels is shown in Figure 2.
• portfolio substitution channel
• Bank funding channel
The portfolio substitution channel
The portfolio substitution channel

• The central Bank purchases of bonds reduce the quantity of gilts

while increasing central bank reserves held by commercial banks.

• Most of the proceeds from the sale of gilts show up in bank deposits.

• The transmission channel exploits the fact that treasury bonds and
bank deposits are not perfect substitutes
• There are at least two (related) reasons for this,
• one related to preferred habitats and
• the other to the pricing of duration risk.

• When investors sell gilts to the Bank of England, they initially exchange a
long-dated asset – the gilts – for a short-dated asset: bank deposits.

• Some investors may not care much about the resulting change in duration
in their portfolio. But, they may be in a minority.

• Many investors in gilts – primarily pension funds and insurance companies

– have long-dated liabilities and prefer to match these liabilities with
equally long-dated assets. (Pension funds and insurance companies own
about 30% of gilts.)
• These investors are likely to use some of the proceeds of gilt sales to
purchase other long dated assets, such as corporate bonds, to restore
the duration of their portfolio.

• By purchasing gilts, the Bank of England reduces the stock of privately

held, relatively long-dated assets.

• With less duration risk to hold in the aggregate, those in the market
that needed to be induced to take it should require a lower premium.

• This tends to reduce the term premium for all long-dated assets; the
prices of long-dated risky assets – corporate bonds and equities – are
likely to rise.
• The rise in asset prices and decline in yields on these other assets may
make it easier for many companies to raise funds, easing credit
conditions.

• They will generate capital gains for households who are the ultimate
owners of those risky assets, boosting their wealth.

• If households consume part of that increased wealth, or companies

invest some of the extra funding raised on capital markets, demand
(and GDP) will be higher.

• This is the portfolio rebalancing channel of asset purchases.

The bank funding channel
• This channel might help to improve the availability of bank credit (or
prevent it becoming less available under conditions of stress in the
availability of funds to individual banks.

• The more concerned banks are about their ability to refinance

themselves, the less likely they are to grant loans.

• When the central Bank purchases gilts owned by non-banks, all else
equal, banks’ deposits rise as do reserve balances at the central bank.

• To the extent that a bank’s reserve holdings would then come to exceed
its demand for liquidity, it is likely to be more willing to expand lending.
• Pb: The bank funding channel might be weak.

• It would be weak when

• the funds generated by the central bank asset purchases come to banks as
very short-term wholesale deposits
• and if banks feel the need to increase their liquid asset holdings (in the form
of reserve balances at the central bank) to insure against the risk that these
deposits might be withdrawn at short notice.

- Should the money inflow to a bank – generated by asset purchases –

be in the form of longer term funds (term deposits, bonds or even
purchases of bank equity), then it is more likely that the additional
funds could help banks to expand, or at least to avoid contracting, their
lending.
C- National experiences since 2007
• The US
• The ECB

• A main result : huge increase of these bank balance sheet

A graphical presentation of the consq. of QE
• The US: three operations QE1, QE2, and QE3

• Before the three ounds of QE, the U.S. Federal Reserve System held
between $700 billion and $800 billion of Treasury notes on its balance
sheet before the recession.
QE1

• In late November 2008, the Federal Reserve started buying $600

billion in mortgage-backed securities
• By March 2009, it held $1.75 trillion of bank debt, mortgage-backed
securities, and Treasury notes; this amount reached a peak of $2.1
trillion in June 2010.
• After the halt in June, holdings started falling naturally as debt
matured and were projected to fall to $1.7 trillion by 2012.
• The Fed's revised goal became to keep holdings at $2.054 trillion. To
maintain that level, the Fed bought $30 billion in two- to ten-year
Treasury notes every month.
QE2
• In November 2010, the Fed announced a second round of
quantitative easing, buying $600 billion of Treasury securities by the
end of the second quarter of 2011.
QE3
• A third round of quantitative easing, "QE3", was announced on 13
September 2012.
• the Federal Reserve decided to launch a new $40 billion per month, open-
ended bond purchasing program of agency mortgage-backed securities.
• Additionally, the Federal Open Market Committee (FOMC) announced that
it would likely maintain the federal funds rate near zero "at least through
2015.“
• Because of its open-ended nature, QE3 has earned the popular nickname
of "QE-Infinity."[
• On 12 December 2012, the FOMC announced an increase in the amount of
open-ended purchases from $40 billion to $85 billion per month.[58]
• On 19 June 2013, Ben Bernanke announced a "tapering" of some of the
Fed's QE policies contingent upon continued positive economic data.
• Specifically, he said that the Fed could scale back its bond purchases
from $85 billion to $65 billion a month during the upcoming September
2013 policy meeting
• He suggested that
• the bond-buying program could wrap up by mid-2014
• if inflation followed a 2% target rate and unemployment decreased to 6.5%, the
Fed would likely start raising rates.
• On 18 September 2013, the Fed decided to hold off on scaling back its
bond-buying program, and announced in December 2013 that it would
begin to taper its purchases in January 2014.
• Purchases were halted on 29 October 2014 after accumulating $4.5
trillion in assets.
The ECB

• The European Central Bank said that it would focus on buying covered bonds, a form of corporate
debt.
• It signalled that its initial purchases would be worth about €60 billion in May 2009

• In a dramatic change of policy, following the new Jackson Hole Consensus, on 22 January 2015
Mario Draghi, President of the European Central Bank, announced an 'expanded asset purchase
programme‘.
• €60 billion per month of euro-area bonds from central governments, agencies and European institutions would be
bought.

• Beginning in March 2015, the stimulus was planned to last until September 2016 at the earliest with a
total QE of at least €1.1 trillion.

• Mario Draghi announced the programme would continue: 'until we see a continued adjustment in the
path of inflation', referring to the ECB's need to combat the growing threat of deflation across the
eurozone in early 2015.

• On 10 March 2016, ECB increased its monthly bond purchases to €80 billion from €60 billion and
started to include corporate bonds under the asset purchasing programme and announced new ultra-
cheap four-year loans to banks.
D – Economic Impact
• Two aspects have to be accounted for
• Effectiveness
• Risks and secondary effects
Effectiveness

• According to the IMF, the QE policies undertaken by the central banks

of the major developed countries since the beginning of the
late-2000s financial crisis have contributed to the reduction in
systemic risks following the bankruptcy of Lehman Brothers.

• Several studies published in the aftermath of the crisis found Large

Scale Asset Purchases to have lowered long term interest rates on a
variety of securities as well as lower credit risk.
• quantitative easing by the US Federal Reserve likely contributed to:
• i) Lower interest rates for corporate bonds and mortgage rates, helping
support housing prices;
• ii) Higher stock market valuation, in terms of a higher price-earnings ratio for
the S&P 500 index;
• iii) Increased inflation rate and investor's expectations for future inflation; iv)
Higher rate of job creation; and v) Higher rate of GDP growth.
Main risks
• Inflation

• Economists such as John Taylor believe that quantitative easing creates

unpredictability.

• Since the increase in bank reserves may not immediately increase the money
supply if held as excess reserves, the increased reserves create the danger
that inflation may eventually result when the reserves are loaned out.

• Savings

• artificially low government bond interest rates induced by QE will have an

adverse impact on the underfunding condition of pension funds
• Capital flight

• The new money from quantitative easing could be used by the banks to invest
in emerging markets, rather than to lend to local businesses that are having
difficulty getting loans.

• Criticism by emerging countries

• BRIC countries have criticized the QE carried out by the central banks of
developed nations.
• such actions amount to competitive devaluation.
• As net exporters whose currencies are partially pegged to the dollar, they
protest that QE causes inflation to rise in their countries and penalizes their
industries.
E – Exit strategy
• Unconventional policy is considered as a temporary situation

• Pb: how to unwind these policies ?

• Currently one experience: the fed,

• In his June 19, 2013, press conference, Ben Bernanke discussed the process of
“normalizing policy for the long run.”
• This process was initially outlined in a set of principles published in the June
2011 FOMC minutes.
multistep process of the Fed

• First, the FOMC would cease reinvesting some or all of the proceeds from
maturing MBS and Treasury securities that it holds on its balance sheet.
• Currently, when the security matures, the proceeds are used to purchase more
Treasury securities or MBS.
• Second, the FOMC would modify its forward guidance on the future path
of the federal funds target rate.
• Third, the FOMC would then begin to raise its federal funds target rate.
• Fourth, “sometime after” the first increase in the federal funds target rate,
the FOMC would begin to sell assets.
• Finally, the process of returning to a normalized balance sheet, entailing
sales of housing-related securities, would occur over a two- to three-year
period.
More generally
• when do central banks need to unwind the extra monetary stimulus?

• simple answer to this question: when the economy rebounds and inflationary
prospects are back in line with the central bank’s price stability objective.

• Unfortunately, for a number of reasons, formulating an adequate exit

strategy is not such an easy task.

• In the case of quantitative easing and credit easing policies, it normally

implies selling assets outright, and in significant amounts.
• Main problems to solve:

• First raising interest rates would risk undermining a sustained recovery by

money markets.

• Second, supplying extra liquidity to the markets through non-standard

measures while, at the same time, tightening monetary policy would send
mixed signals on the effective monetary policy stance.

• Third, with markets still in need of additional non-standard measures, the

pass-through of an increase in policy rates would probably be hampered.
• the key question concerns the reaction that financial markets might
have to the start of the unwinding of the direct easing measures.

• How would markets react to the central bank starting to sell the
government bonds it purchased under the direct quantitative easing
policy?

• Such a start would signal presumably that the tightening cycle is close
and could affect yields. Furthermore, if the amount of assets to be
sold is significant, this can have an impact on the market conditions of
the underlying assets, possibly further depressing its price.
• how quickly should policy-makers reverse their policies?

• On the one hand, withdrawing liquidity in such large quantities will trigger a
substantial contractionary monetary policy shock.
• The large size of many easing programmes will make it difficult to sell assets
without a significant market impact.
• if it happens too quickly or abruptly, policy-makers risk choking off the economic
recovery or imposing heavy capital losses on lenders.

• On the other hand, taking more time may increase inflation

• with policy rates at record low levels and additional liquidity-providing measures
adopted in so many countries, the possibility of inflation risks emerging sometime
later is not something that can be excluded.

• Getting the timing right in withdrawing additional liquidity is likely to be

decisive in order to ensure a non-inflationary recovery.
• However, to a large extent the speed of unwinding of unconventional
measures would depend on their degree of reversibility.
• some of the unwinding would happen automatically as central bank
programmes become increasingly unattractive as financial conditions
normalise.
• The speed of tightening would also depend on the maturity of the
assets bought by central banks within the framework of their easing
programmes.
• Differences in the maturity of assets will ensure that a tightening of the
accommodative stance would come in gradual tranches.
• This is important to avoid any abrupt tightening of credit conditions in the
middle of the recovery.
• At the same time, measures centered on assets that are longer-term in
nature and less liquid could pose challenges to the future unwinding of
these measures.
• An important final element related to the exit strategy, is that when
the central bank sells the assets their value is likely to have declined
considerably, given the higher rate of interest.

• This implies a financial loss for the central bank.

• The consequences for the financial – and overall – independence of

the central bank should not be downplayed.
III - Forward guidance
• Since 2008, forward guidance has become a key element of monetary
policy.
• The Federal Reserve, the Bank of Japan, the ECB and the Bank of
England have all provided forward guidance about future policy rates in
various forms,
• some qualitative,
• others quantitative, I
• In some cases conditional on specific economic developments (real variables
such as the unemployment rate.
• This has been helpful in clarifying policy intentions in highly unusual
economic circumstances.
• Roadmap
• A – FG in general
• B – FG in practice
• C – empirical assessment
• D - Risks
A – FG in general
• Forward guidance is not new.

• Starting in the 1990s, central banks relied on qualitative descriptions

of the main thrust of their interest rate policies to inform the public.

• Since the late 1990s, a number of small inflation targeting economies

have adopted quantitative forward guidance by regularly publishing
their own quantitative forecast of the future path of policy interest
rates.
Some historical perspective…
• Forward guidance at the zero lower bound was first adopted by the
Bank of Japan in the context of its zero interest rate policy in 1999.

• The Federal Reserve also adopted forward guidance on policy rates in

2003 when it stated that policy accommodation would be maintained
for a considerable period.

• In the wake of the global financial crisis, the Federal Reserve, the Bank
of England, the Bank of Japan and the ECB all adopted forward
guidance on policy rates, albeit at different times and in different forms.
purpose of forward guidance?

• Forward guidance aims to ensure that market expectations on future

monetary policy are indeed consistent with the policy intentions of
the respective central bank.

• The objective of forward guidance at the zero lower bound has been
to clarify the central banks' intended policy rate path.

• This can provide additional stimulus at the zero lower bound when
central banks communicate that policy rates will remain lower for
longer than is priced into markets.
conditions for effectiveness
• For forward guidance to be effective, the public must believe that the
central bank will deliver on its guidance.

• Only then can the guidance have an impact on the public's

expectations of the future path of policy rates.

• There are 3 pbs with Forward Guidance

• The potential usefulness of forward guidance depends on it being
• (i) seen as a commitment;
• (ii) clearly communicated;
• (iii) interpreted in the way intended by the central bank.
• Pb 1: it can be time inconsistent

• Woodford (2012), has suggested that central banks should use

forward guidance to commit to a very low policy rate beyond the
point in time when economic developments would normally
indicate a tighter policy.

• In principle, this strategy would yield greater monetary stimulus.

• However, this approach would require the central bank to pre-commit

to a policy course that it would have an incentive to eventually renege
on when conditions normalise (a "time inconsistent" policy).5
• This highlights the trade-off that central bankers face when designing
forward guidance aimed at stimulating the economy at the zero lower
bound, ie the trade-off
• between the strength of the commitment
• and future policy flexibility.

• The stronger the perceived commitment is in the eyes of the public,

the bigger the likely impact on financial market expectations and
economic decisions,

• but the greater also the risk of a retrospectively undesirable tying of

the central bank's hands or of taking actions that are at odds with the
original guidance.
Pb 2: misinterpretation of FG by the public
• Even if forward guidance is quite explicit, it may not have the desired
stimulative effects if it is not interpreted by the public in the intended way.

• In general, forward guidance conveys two types of information:

• the central bank's assessment of the economic outlook
• the degree of policy accommodation given

• Communicating the intention to keep policy rates at the zero lower bound
for longer may be misinterpreted rather as signaling a more pessimistic
economic outlook by the central bank.

• In this case, negative confidence effects would counteract the intended

stimulus.
Pb 3: Clarity in communication
• Forward guidance effectiveness also requires that it is clearly
communicated to the public.
• In principle, clarity can be enhanced by spelling out more explicitly
what the central bank aims to achieve and how it will respond to
economic developments. (conditionality of FG)
• However, if too complex, conditionality may end up confusing the
public and leading to conflicting interpretations of policy intentions.
• Central banks then face the risk of getting involved in continuous
discussions with the media and other observers about nuanced
wording and technical details.
B- FG in practice
• Three different broad forms of policy rate forward guidance can be
distinguished:
• (i) qualitative, where the guidance does not provide detailed quantitative
information about the path of the policy rate or the envisaged time
frame (eg "the policy rate will be maintained for an extended period");
• (ii) calendar-based, where the guidance applies to a clearly specified
time horizon (eg "the policy rate will be kept at the current level for x
years");7 and
• (iii) threshold-based, where the guidance is linked to specific quantitative
economic thresholds (eg "the policy rate will not be raised at least until
the unemployment rate has fallen below y%").
• The Federal Reserve adopted qualitative forward guidance on policy
rates when it cut the federal funds rate to its effective lower bound in
December 2008.
• Subsequently, in 2011, the Fed shifted to calendar-based guidance by
communicating that economic conditions would warrant policy rates at
their lower bound for at least two years.

• Since December 2012, the Federal Reserve has been pursuing threshold-
based forward guidance, clarifying the key factors that would influence
the timing of future changes in the policy stance.
• Specifically, the Fed stated its intention to maintain the federal funds rate
at its prevailing level conditional on explicit quantitative thresholds for
both the unemployment rate (>6.5%) and inflation projections (<2.5%) as
well as on evidence of well anchored long-term inflation expectations.
• The Bank of Japan implemented threshold-based forward guidance
linked to the inflation rate in the context of its Comprehensive
Monetary Easing (CME) program in October 2010.

• It announced that the zero interest rate policy would remain in place
until the Bank of Japan's price stability goal was achieved and
conditional on the absence of significant risks, including the
accumulation of financial imbalances.
• The Bank of England and the ECB introduced new forward guidance
policies in mid-2013.

• The Bank of England initially laid out its threshold-based forward

guidance, linking the maintenance of prevailing low policy rate levels
• to a quantitative threshold for the unemployment rate (>7%)
• with three so-called "knockout" criteria including
• a quantitative threshold for inflation projections 18-24 months ahead (<2.5%)
• the absence of financial instability risks.
• The ECB adopted open-ended qualitative forward guidance on policy
interest rates in July 2013, stating its intention to keep interest rates
at prevailing or lower levels "for an extended period of time".

• This represented a break with the long-standing practice of not

commenting on policy rates beyond the following policy meeting.

• This decision was partly motivated at the time by a rise in the

expected path of euro area policy rates that was seen to be
inconsistent with the subdued outlook for inflation and broad-based
economic weakness.
• The different approaches taken by central banks and their changes
over time reflect the evolution
• of the challenges,
• the public and academic debate,
• lessons from experience at home and abroad.
• The different approaches a priori offer different pros and cons.
• Qualitative forward guidance, for instance, is a relatively vague form
of forward guidance, but at the same time it minimizes the risk of
excessively tying one's hand and the complications of forging a
consensus on the guidance in monetary policy committees.
• Calendar-based forward guidance is more explicit than qualitative
forward guidance, but could be seen as strongly tying the central
bank's hand.
• At the same time, subsequent revisions to calendar-based forward
guidance could be interpreted as indicating
• either a change in the outlook
• or a change in the degree of monetary accommodation deemed appropriate
given the outlook.
• If the revision is misinterpreted as a change in the outlook, the
guidance may prove to be counterproductive.
• Threshold-based forward guidance is less affected by time
inconsistency since it spells out more clearly the conditionality, but at
the risk of high complexity.

• The shift to threshold-based forward guidance has generally been

associated with an increased length of forward guidance statements.
• For instance, in the case of the Federal Reserve, statements at the
time of policy meetings increased from around 20 words under
qualitative forward guidance to an average of about 100 words under
the recent threshold-based forward guidance;

• the word count for the Bank of England's threshold-based forward

guidance in August 2013 and February 2014 was roughly 200 words.
C- Empirical appraisal of FG
• Forward guidance on policy rates can impact financial markets and the
economy in three main ways.
• First, to the extent that the guidance implies an easier future monetary policy
stance than expected by market participants, it should affect the level of
future expected short-term rates as well as long-term bond yields.
• Second, to the extent that central banks provide greater clarity about the
future path of policy interest rates, the volatility of market expectations of
future policy rates should fall, possibly also compressing risk premia.
• Third, to the extent that the conditional nature of forward guidance highlights
specific indicators, the guidance should make markets more sensitive to data
releases related to these indicators and less sensitive to other information.
Lowering the path of expected future interest rates
• The evidence from the reactions of three-month futures rates and 10-
year benchmark bond yields to forward guidance announcements
suggests, however, that the effects have varied across jurisdictions
and over time.
• For the United States, futures rates and
long-term bond yields tended to decline on
most announcement days
• The market reaction to calendar-based
forward guidance shows a decline over
time.
• For instance, the August 2011
announcement was associated with a drop
in the two-year-ahead futures rate of more
than 20 basis points, compared with a 5
basis point drop after the January and
September 2012 statements.
• The threshold-based forward guidance of
December 2012 and December 2013 had
essentially no measurable impact on
futures rates and long-term bond yields
• In the case of the Bank of England,
futures rates did not drop
following the formal introduction
of forward guidance in August
2013.
• However, two-year futures rates
did drop by more than 10 basis
points in July 2013 .

• The ECB's forward guidance in July

also had a negative impact on
futures rates at the one- and two-
year horizons (7 and 8 basis points,
respectively).
• In general there has been an immediate impact of policy rate forward
guidance on the level of expected future interest rates, but it has varied
over time with some indication of a diminishing effect.
• However, caution is called for when interpreting results from event studies of
this type.
• In particular, they do not take into account prior market expectations or
possible delayed reactions.
• For instance, the declining impact may reflect an improved ability of markets to
anticipate the actions of the central bank over time.
• Moreover, they do not control for the influence of other relevant news;
• many forward guidance announcements have coincided with asset purchase
announcements, making it harder to isolate their market impact.

• it is not possible to draw strong conclusions about the relative effectiveness

of the different types of forward guidance from the announcement effect
evidence alone.
Reducing the volatility of expected future
rates
• Graph 2 presents evidence that policy rate forward guidance at the
zero lower bound has reduced the volatility of expected interest
rates at short horizons, but less so at longer horizons.
• The graph plots 10-day realised futures volatilities during periods of
forward guidance (vertical axis) against those in periods without
forward guidance (horizontal axis).
• For the United States, the scatter plot distinguishes between the
period of calendar-based (US1) and threshold-based (US2) forward
guidance.
• Xx
• The clustering of the points below the 45-degree line indicates that the
interest rate volatility in the forward guidance period tends to be
lower than in the non-forward guidance period.
• This pattern is evident in the case of the one-year horizon. Not
surprisingly, the volatility relationship between forward guidance and
non-forward guidance periods appears weaker at longer horizons.
• At the two- and five-year horizons, the clustering of the dots is much
closer to the 45-degree line. This presumably reflects market views that
the policy rate forward guidance from the respective central banks is a
commitment of limited duration and fades with the horizon.
• Xx
Changing sensitivity to economic news

• Policy rate forward guidance appears to have influenced the

sensitivity of financial variables to economic news.
• Some studies have documented a reduction in the sensitivity of
interest rate futures to news at the zero lower bound for short policy
horizons under calendar-based forward guidance (Swanson and
Williams (2013)).
• Bank of England's and the ECB's forward guidance experience in mid-2013.

• Graph 3, which shows the volatility of three-month futures rates at the one- and two-year
horizon between May and October 2013, supports the view that the guidance helped to
insulate their respective economies from the news about Federal Reserve tapering.
• The first spike in US interest rate volatility occurred in mid-year and was
associated with prospects of early Federal Reserve tapering of large-scale asset
purchases.
• The graph documents the outsize volatility reaction at the time for the euro area
and the United Kingdom. By contrast, in late summer, the second spike in US
rate volatility had a more muted impact on Europe, for both the one- and two-
year horizons, after the ECB and the Bank of England had adopted forward
guidance.
D - Challenges ahead

• Policy rate forward guidance raises a number of challenges.

• These include in particular
• the risks to central banks' reputations
• The risks to financial stability.
Central bank reputation

• Forward guidance exposes central banks to various reputation risks.

• If the public fails to fully understand the conditionality of the

guidance and the uncertainty surrounding it, the reputation and
credibility of the central bank may be at risk if the guidance is
revised frequently and substantially.

• This is particularly relevant in the case of calendar-based forward

guidance, in which deviations in the preannounced timetable may be
perceived as reneging on a commitment even if conditions change
unexpectedly.
• The announcement of unemployment-based thresholds could be
seen as signalling a fundamental shift in monetary strategies and
goals.

• As history has shown, the perception that central banks have elevated
the role of real variables in monetary policy frameworks can
adversely affect a central bank's credibility for price stability.

• A widespread perception of this could also create policy uncertainty

about what central banks are truly aiming at, which would be
counterproductive in the current post-crisis environment.
Financial stability risks

• Forward guidance can give rise to financial stability risks in two ways.
• First, if financial markets become narrowly focused on certain aspects
of a central bank's forward guidance, a broader interpretation or
recalibration of the guidance could lead to disruptive market reactions.
• The global financial market developments in May and June 2013 in
response to the Federal Reserve's tapering communication highlight
such a risk. In that episode, financial markets fundamentally
reassessed the path of future interest rates in the United States, and a
global bond market sell-off ensued, along with a break in equity
markets and a sharp depreciation of some emerging market exchange
rates .
• Second, forward guidance can indirectly create financial stability risks
if monetary policy becomes increasingly concerned about adverse
financial market reactions (also referred to as the risk of financial
dominance).

• This could translate into an undue delay in the speed of monetary

policy normalisation and raise the risk of an unhealthy accumulation
of financial imbalances.

• Moreover, the mere perception of this possibility, over time, could

encourage excessive risk-taking and thereby foster a build-up of
financial vulnerabilities.
• Conclusion on FG
• The empirical evidence on the effectiveness of policy rate forward
guidance at the zero lower bound provides some support for the view
that it has helped to shape market expectations.
• We find that recent forward guidance by four major central banks has
so far reduced the volatility of near-term expectations about the
future path of policy interest rates, suggesting that near-term policy
intentions have been clarified.
• Beyond this result, the evidence is more mixed.
• In particular, the impact of the new forward guidance practices on
expected interest rates has varied across episodes and economies and
has not been very systematic in one direction or another.
• How long the new forward guidance practices will remain in place in
the post-exit period is an open question, especially when it comes to
the more explicit, state-contingent measures.