Volume 2(2013)

PAGE 1/11
Negative Implications of the Unconventional
Monetary Policies in the Advanced
Economies:Time for an Orderly Exit
Shalendra D. Sharma, Ph.D

Professor of Political Science University of San Francisco

Negative Implications of the Unconventional Monetary Policies in the
Advanced Economies:Time for an Orderly Exit

Central banks in the United States, Japan, Great Britain and in the Eurozone have deployed new policy tools labeled “unconventional monetary policies” both during and after the global financial crisis of 2008.These policies were designed to (a) prevent a collapse of the financial system by stabilizing financial markets via massive injection of cash into the system through direct liquidity provision and purchases of private assets, and (b) to provide monetary policy assistance through bond purchases to keep interest rates at zero or near zero. Clearly, these policies have helped support economic recovery. Nevertheless, these unconventional measures also carry potentially unintended risks. Therefore, a timely and orderly exit from these easy monetary conditions is essential.

JEL classification: C32, E30, E44, E51, E52

Keywords: unconventional monetary policy, zero lower bound, sovereign debt, central bank, Japan

Both during and in the aftermath of the global financial crisis of 2008 central banks in advanced economies were forced to adopt unconventional monetary policies to counter the risks to their financial systems and reboot economic growth. This is because with policy rates already near zero, advanced country central banks had little choice but to turn to these unconventional monetary policies to stimulate growth. These measures included direct lending to distressed short-term credit markets, expanding bank reserves and via the purchase of long-term assets to reduce long-term interest rates.

In the United States, with the Federal Reserve's (for the Fed) main policy tool, the federal funds rate at “zero lower bound” on nominal interest rates since December 2008, the Fed could no longer lower interest rates to boost investment and consumption. Hence the use of “Quantitative Easing” (QE) which allowed the central bank to literally flood the banking system with excess reserves in the hopes that the banks would begin to lend, and, in the process jump-start economic growth. This policy option also allowed the Federal Reserve to engage indirectly in real exchange rate depreciation through “large-scale asset purchases” (LSAPs) or Quantitative Easing. To this effect, the U.S. Federal Reserve has literally created large volumes of money to purchase equally large quantities of bonds from the financial markets to boost economic activity. Again there are costs: From November 2008 through March 2010, Quantitative Easing 1 (QE1) bought $1.75 trillion in long-term Treasuries as well as debtissued by Fannie Mae and Freddie Mac and fixed-rate mortgage-backed securities (MBS) guaranteed by those agencies. In other words, it purchased mostly bad mortgage debt. From November 2010 through June 2011, Quantitative Easing 2 (QE2) bought $600 billion of U.S. government debt in the form of long-term Treasuries. In June 2012 the Federal Reserve's “Open Market Committee” voted to extend “Operation Twist” or its program of selling short-term Treasury securities and purchasing long-term Treasuries through the end of 2012. Altogether, the Fed plans to sell some $667 billion in short-term bonds and purchase roughly the same amount of Treasuries with maturities ranging from six to thirty years. In September 2012 the Open Market Committee announced QE3 to begin purchasing $40 billion in agency-backed MBS per month until economic condition improved, including maintaining its previous program of exchanging about $45 billion monthly in short-for long-term securities. Overall, between August 2008 to end-2012, the Federal Reserve has tripled the monetary base from roughly $0.8 trillion to $2.9 trillion.