Risks of Unconventional Monetary Policy at the Zero Lower Bound

The role and risk of unconventional monetary are widely debated by central banks and government policymakers.  Ben Bernanke is a leading proponent of the policy since most central banks have limited policy options at zero rates.

There are a number of critics such as Michael Woodford, who delivered a critique at Jackson Hole of how the Federal Reserve has gone about monetary easing.  He remains skeptical of the efficacy of quantitative easing and prefers a central bank target path for nominal GDP.

A recent BIS study by Leonardo Gambacorta, Boris Hofmann & Gert Peersman examines the role of unconventional monetary policy during the financial crisis (The Effectiveness of Unconventional Monetary Policy at the Zero Lower Bound: A Cross-Country Analysis BIS WP, August 2012) This study examines the macroeconomic effectiveness of unconventional monetary policies adopted during the financial crisis by exploring the shock effects to the central bank balance sheet on output and the price level. 

The author’s use a panel vector autoregressive approach (VAR-a statistical technique measuring the casual linkages between variables) estimated from eight advanced economies.  The authors found an exogenous increase in central bank balance sheets leads to a temporary rise in economic activity and the price level. The qualitative response pattern of output is very similar to previous studies on interest rate shocks, while the price level reaction is weaker.  The estimations suggest that the panel results do not obscure considerable cross-country heterogeneity in the macroeconomic consequences, despite differences, possibly reflecting the fact that central banks implemented these policies according to specific needs.

These results suggest that the unconventional monetary policy measures adopted by central banks in the wake of the global financial crisis provided temporary support to their economies. However, this does not imply that an expansion of central bank balance sheets will in general have positive macroeconomic effects. The set-up of the analysis is specifically tailored to the crisis period, when unconventional monetary policy measures were actively used to counter financial and economic tail risk. The results therefore do not in general pertain to the possible effects of central bank balance sheet policy in non-crisis periods.

Finally, there are a couple of caveats for consideration. Firstly, the analysis does not explicitly assess the effectiveness of different types of unconventional monetary policies. The individual country results do not indicate that such composition effects are a major distorting factor, but a more careful analysis could be done in future research. Secondly, the analysis does not capture the announcement effects of unconventional monetary policies.  The approach taken by the authors focuses on identifying the effects of central banks unconventional monetary policy actions, which could be seen as an assessment of the overall "stock effect" of central bank balance sheet policy on the macroeconomy.

The study only answers the basic question that unconventional policy does work when limited policy options are available.  However, the concerns about how it works and the risks it may create remain unanswered.

www.bis.org/publ/work384.htm