How Monetary Policy Strategies Changed After the Global Financial Crises?

Unconventional Policies

The post-crisis situation drove central banks to implement unconventional monetary policies to deal with the crisis and to minimize the damage to the economy. In this context, central banks have started to implement unconventional monetary policy measures and to practice quantitative easing and asset purchasing programs, where policy rates have been at or close to their zero effective lower bound, to provide more incentives to the economy and to contribute financial stability.

Quantitative Easing: Quantitative easing (QE) were used for the first time as a description of its policy by a central bank in the Bank of Japan's Japanese-language publications. In its announcement of 19 March 2001 – universally cited by commentators as the first time a policy called QE was implemented by central bank – the Bank of Japan announced a high target of bank reserves held with the central bank, which would (at least partly) be achieved by purchasing more government bonds (Bank of Japan, 2001; Lyonnet and Werner, 2012:96).

After the financial crises, major central banks pioneered by the FED started to carry out large-scale asset purchases of Treasury securities and other debt instruments in order to put further downward pressure on long-term interest rates, thereby stimulating consumer and business spending. In addition to this particular measure, known as QE, FED, lowering short-term interest rates essentially to the zero lower bound, has pioneered a new an unconventional measure by adding forward guidance to the policy mix.

Forward Guidance: Implementing unconventional monetary policies made it harder for the public to understand the future path of monetary policy, thus central banks have started to take new steps in communication policies that are very different from previous methods (Woodford, 2013, s.96).

Over time this has given way to the view that effective monetary policy is possible through transparency and effective communication and later to the idea that the management of expectations is fundamental to monetary policy. Effective communication is essential to expectation management. Now communication is accepted both in academic literature and in real-world practice as central to the effectiveness of monetary policy (Kahveci and Odabaş, 2016). In this regard, central banks’ communication policies and tools have become as important as unconventional policies, measures and tools. Forward guidance, which emerged as a discrete unconventional policy tool, started to play a key role in terms of central banking communication, come to the fore with the crisis and increasingly adopted and used by central banks related to their long term expectations and to their transparency (Vayid, 2013, s. 25). The post-crisis transition in Central Bank policy from mystery and inscrutability to the era of transparency and the importance of “forward guidance” is a demonstration of how rapidly and radically communication strategy has changed (Kahveci and Odabaş, 2016). Importantly, forward guidance is designed to contribute to monetary easing and to halt the decline in economic activity. With the policy rate practically at zero, and with some central banks using QE as an additional monetary stimulus, it became more difficult for markets and the public to anticipate how monetary policy would affect and respond to economic conditions (Vayid, 2013, s. 25).

Forward guidance is a communication tool which is conditional on the assessment of the economic outlook and gives direction to the future of monetary policy. Praet (2013) defines forward guidance as an advanced form of communication which is related to the future course of monetary policy. This type of orientation of central banks emerges as a form of tool especially when the monetary policy challenges arise in exceptional circumstances. Forward guidance is not necessarily a dimension of policy that becomes relevant only at the lower bound of policy rate, the experience of reaching the lower bound has undoubtedly increased the willingness of central banks to experiment forward guidance (Woodford, 2012, s.2).

As in every step of central banks communication, forward guidance is a monetary policy tool that would also be thought deeply and would be formatted and built carefully. The message that would like to be given should be supported by policy text and more importantly it should be dealt with holistic approach along with all other monetary policy tools instead of a single policy tool (Yilmaz & Kahveci, 2014).

In this regard, explicit conditional statements about the future path of the policy rate and of QE stimulus started to be used to guide markets that the central bank will keep rates at this level for longer (allowing inflation to be higher in the recovery) than consistent with its normal policy rule.

Negative Interest Rate:Aftermath of the global financial crisis, several central banks around the world have introduced negative interest rate policy as an unconventional policy to provide additional monetary stimulus. Danmarks Nationalbank (DN), the European Central Bank (ECB), Sveriges Riksbank and the Swiss National Bank (SNB) and most recently the Bank of Japan (BoJ) all cut their key policy rates to below zero over the period from mid-2014 to early 2015. The motivations behind the decisions either to counter a subdued inflation outlook or to focus on currency appreciation pressures in the context of bilateral pegs or floors on exchange rates.

Negative interest rates so far suggest that modestly negative policy rates are transmitted to money market rates in very much the same way as positive rates (Bech, and Malkhozov, 2016) are and have had a positive effect on the economy, helping to lower bank funding costs and boost asset prices. In addition, Jobst and Lin (2016) says, negative rates have significantly enhanced the signalling effect of the ECB’s monetary stance strengthening its forward guidance. However, questions remain as to whether negative policy rates are transmitted to the wider economy through lower lending rates for firms and households, especially in rates associated with bank intermediation (Bech, and Malkhozov, 2016).

Macro-prudential Regulations: Regulation of financial services has traditionally concentrated on so-called micro-prudential regulation, which is geared towards controlling excessive risk-taking in individual banks. However, micro-prudential regulation does not always secure the robustness of the financial system as a whole. The recent crisis is a reminder in that regard. In the aftermath of the financial crisis of 2007-2009, a macro-prudential approach to financial regulation has emerged. Macro-prudential regulation is concerned with the risks at the level of the financial system (systemic risk ) and recognizes the importance of general equilibrium effects, that is how the financial sector interacts with he real economy (Borchgrevink et al. 2014).

Da Silva et al. (2012) define macro-prudential measures as to calibrate existing micro-prudential rules and/or to extend them to cover exhaustively all dimensions of vulnerabilities in a financial system in order to put systemic risk below an agreed upon threshold (Da Silva et al., 2012).

IMF (2011) survey suggests that it may be appropriate for several countries, based on their current circumstances, to consider prudential measures or capital controls in response to capital inflows (IMF, 2011).

Mishra, et al. (2014) said that macro-prudential policy is important in minimizing the spillover effect of US monetary policy. Their results suggest that countries with deeper financial markets, better macroeconomic fundamentals, and better macro-prudential policy experienced less exchange rate depreciations and less increase in government bond yields (Mishra, et al. 2014).

Developed Countries’ Central Bank Policy Implementations

Prior to the crisis, the monetary policy conducted by central banks in advanced economies was predictable and the key policy tool was a short-term interest rate. Its transmission mechanism was reasonably well understood. However, due to the severity of the crises and the challenge of slow recovery, the central banks of major advanced economies (United States, United Kingdom, Japan, and euro area) have implemented a variety of unconventional policies since the beginning of the financial crises to restore the functioning of financial markets and intermediation.

The U.S. Federal Reserve (Fed) has been the leader in these efforts. Fed, having two legislated goals—price stability and full employment in the United States, widened its liquidity facilities significantly and reduced its policy interest rate to near zero. It has also provided forward guidance on the federal funds rate. This policy seeks to influence market expectations for the future path of short-term rates and so reduce long-term real interest rates. Fed also began purchasing financial assets (Treasury bonds and mortgage-backed securities) from the market, in successive programs referred to as QE.

The Bank of England (BoE) has also engaged in implementing unconventional monetary policies to loosen monetary conditions. These measures include increased liquidity support, actions to deal with dysfunctional financial markets and large-scale asset purchases. BoE has also recently introduced explicit forward guidance for its policy rate.

The European Central Bank (ECB) has adopted similar policies to promote recovery and price stability. The ECB has significantly extended the liquidity facility by offering longer term refinancing operations and purchased securities in troubled markets. The ECB recently adopted open-ended qualitative forward guidance on policy interest rates and stated its intention to keep interest rates at prevailing or lower levels “for an extended period of time”.

Following the financial crises The Bank of Japan (BoJ) adopted a number of unconventional measures to promote financial stability. BoJ increased the pace of its Japanese Government bonds purchases. In order to response to the deflation and slowing recovery, BoJ introduced Comprehensive Monetary Easing Policy. Unlike the Federal Reserve, the BOJ has had no forward guidance related to a policy interest rate. The BOJ applies forward guidance to indicate its future stance over the continuation of quantitative and qualitative monetary easing (QQE).

Due to the severity of the crises and the challenge of slow recovery, to cope with the weak demand and the low inflation, six developed economies’ central banks, except from Australia, New Zeland and Norway, has carried out a QE program and Swiss National Bank, Bank of Japan and ECB have announced the introduction of negative interest policy (Table 3 ).

FED was the first with its November 2008 announcement and Bank of England was second in 2009 which started to carry out QE program. Then ECB started to give liquidity to the market with its credit easing and asset purchase program. In a dramatic change of policy, on 22 January 2015 ECB announced an expanded asset purchase programme after FED’s purchases were halted on 29 October 2014 after accumulating $4,5 trillion in assets. Asset purchase programs implemented by FED and ECB are the most affecting the market and shaping capital flows to developing countries. Although Bank of England’s and other central banks’ programs have been effective, their impact on global markets and on developing countries have been more limited (Figure 2 ).

A large amount of capital flows to developing countries by the announcements of QE programs after the global crises continued until the announcement of ending QE program by the FED in 2014. Then, significant capital outflows have been observed until ECB's asset purchase announcement. Then, it has been volatile with normalisation talks (Figure 2 - 3 ).

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After analyzing the measures taken in detail after the crises, it is very remarkable that it is neither the start of the implementation nor the end of the asset purchase program that has impact on the markets, rather its communication to the market which means forward guidance measures which was implemented (Figure 2 ). When we carefully look at Figure 2 , the most remarkable date, other than the after crises period, is May 2013, FED’s announcement about tapering of some of the Fed's QE policies contingent upon continued positive economic data and  likely start raising policy rate. After this announcement huge capital outflows from developing countries started.

The Bank of Canada (BoC) was the first major central bank to use forward guidance in April 2009, indicating that the Bank intended to keep the policy rate at the effective lower bound until the end of the second quarter of 2010, explicitly conditional on the outlook for inflation. Vayid (2013) says the BoC’s conditional commitment succeeded in changing market expectations of the path of the policy rate, lowering longer-term interest rates, and thus underpinning a rebound in growth and inflation which, in turn, obviated the need to use other unconventional policies, notably QE. Carney (2013) reasons that the commitment worked because it was exceptional, explicit and anchored in a highly credible inflation-targeting framework. It was also backed by the availability of exceptional liquidity; and it reached beyond central bank watchers to make a clear, simple statement directly to Canadians (Vayid, 2013, s. 28).

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Developed economies’ Central banks (except for Australia, Switzerland and Japan), analyzed in this research, put forward guidance into practice (Table 4 ).

Developing Countries’ Central Bank Policy Implementations

During the period after the global crises, starting from developed economies and had impact on all over the world, the main shared point among the developing economies’ central banks, except for South African Reserve Bank, is to deal with the negative effects of the unconventional monetary policies in developed economies; such as increasing volatility of funds (Figure 2 -3), due to quantitative easing, forward guidance and negative interest rate policies of developed countries, and increasing risks to the financial stability. Developing countries mostly started to implement macro-prudential measures, to be able to eliminate increasing volatility of funds and systemic risks and to avert the negative impacts of financial system on the real economy. Most of the macro-prudential measures taken are with regard to financial stability, banking sector and credit market.

There is very interesting point to mention which none of the developing economies’ central banks deployed neither QE, nor forward guidance nor negative interest rate policy as the case for developed economies (Table 5 ). Put in another words, while developing economies putting into practices some new unconventional policies such as quantitative easing, forward guidance and negative interest rate policy to tackle with the global crises, on the other hand, central banks in developing countries had to deal with both global crises and the negative effects of the unconventional monetary policies put into practice by developed economies. They did not have a chance to put into practice such new unconventional policy mix as developed economies. Most of them used various types of reserve requirement measures to tackle the increased volatility of funds causing financial stability risks.

One of these examples, in 2008 PBoC started to use differentiated required reserves. First it started as increased required reserves for the bigger banks in size, changed into case-by-case differentiation in order to control the money, credit and liquidity growth conditions in 2011. Thus the different reserves requirements ratios were applied to the banks in terms of their size. PBoC used macro-prudential measures both before and after the crises. Before and during the crises Windows guidance continued to use to guide the banks. In 2009, PBoC give some guidance about the increasing credit support to basic sectors and credit controls of companies with higher consumer of energy.

Turkey is another country put new framework into practice after the global crises. The CBRT has introduced a new monetary policy framework as of late 2010, through modifying the inflation targeting regime it has been implementing since 2006. Therefore, the CBRT diversified its instruments and started using the interest rate corridor, liquidity management and reserve options. Hence, the documents released after the MPC Meeting is tripled, covering decisions on three instruments. Unique macro-prudential policy called Reserve Option Mechanism (ROM) designed by CBRT is mainly an “automatic stabilizer” (in a way that banks can internally adjust the utilization rates of reserve option against external shocks). The ROM enables the banks to keep a certain ratio of TL reserve requirements in FX and gold. The coefficients showing the amount of FX or gold to be held per unit of TL reserve requirements are defined as the Reserve Option Coefficients (ROC). Since the changes in the facility provided by the ROM as well as those in the ROC influence the ratio of TL reserves held in FX, this policy directly affects the TL and FX liquidity management. As this concept enables each bank to make its own optimization given its own constraints, the ROM is considered to be more efficient in an economic sense compared to other instruments used in FX liquidity management. Moreover, parameters of the system can also be used as a cyclical instrument to adapt to permanent changes in domestic and external environment when necessary (CBRT, 2014). There is also another measure taken by CBRT in terms of leverage ratios. According to this measure, the banks that raise the leverage ratios to excessive levels compared to the current circumstances might be subjected to additional reserve requirement. In this context, a countercyclical and macro-prudential policy is based on leverage. The idea behind this is that operating of the financial system under a high leverage would cause economic damage in the medium and long term. By posing higher reserve requirements for those banks which have higher leverage should keep the banks using additional leverage. Another measure taken by CBRT is maturity based reserve requirement. The maturity based RR has been designed to reduce maturity mismatches between assets and liabilities of banking sector. Leverage ratios, which will be effective in 2018 as per the timetable of the Basel III, are projected to impose an additional RR on the banks with low leverage ratios to contribute to financial stability by preventing a sharp fall in leverage ratios prior to this period and by limiting bank indebtedness.

Both before and after the crisis / India’s experience with the conduct of macro-prudential policy has spanned initiatives to address both dimensions of systemic risks, pro-cyclicality and crosssectional risks. India, has been using macro-prudential measures for systemic risks for years, has continued its macro-prudential measures after the global crises. The measures taken for the sectors (e.g. real estate) growing disproportionately before the global crises have eased after the second half of 2008 and Reserve Bank of India has decreased the provision ratios and risk weigh for standard assets.