Unconventional Monetary Policy

Discuss “unconventional” monetary policy: how it is conducted and rationale for using it. Then explain the difference between the approaches used by the two central banks.

Unconventional monetary policy is used by central banks in an economy that is in deep distress, when conventional ways are no longer effective. This tool can be conducted in various ways, such as qualitative easing, forward guidance, negative interest rate policy, purchase of foreign exchange, etc. QE takes place when the central bank decided to purchase other securities in place of government bonds. This is beneficial when interest rates are at or near zero, as QE results in increased money supply and decreased interest rates. There are possible consequences to QE, as if money supply grows rapidly and good available are scarce, inflation occurs(CITE). Another method is buying long term government bonds, as it can impact the yield curve and reduce long term interest rates(CITE). The commitment effect signifies forward guidance, as it takes place when the central bank promises to keep interest rates low for a longer period, which increases consumer confidence, leading to more financial stability. The negative interest rate policy is when depositors must pay institutions to hold their money, the negative consequence to this tool is it punishes individuals that save. Purchase of foreign exchange as a practice by the central bank, influences the exchange rate and impact value of local currency. There are different types of unconventional monetary policies that can be conducted, and they can be beneficial specifically when the economy needs a jump start.

Both Israel and Switzerland are small open economies which had to partake in unconventional monetary policy since the global financial crisis (GFC). A key factor for the differences in monetary policies is due to Israel’s consistently higher inflation and real growth rate compared to Swiss. Due to this, the SNB began setting lower policy rates, specifically earlier then BOI. In Israel, during the global crisis, various tactics such as purchase of foreign currency, and secondary market government bonds were conducted, with a goal of appreciation of local currency and increase of forex reserves. Swiss National Bank also used FX intervention, followed by a large QE program, which led to a large increase in their forex reserves(CITE). As the volatility of the currency eroded swiss export competitiveness, SNB’s reliance on forex interventions increase(CITE). As both central banks used forex intervention, Swiss and Israel began with sterilized interventions but at some point, Swiss interventions became unsterilized as once the ZLB is reached, the need for sterilization is not there. As negative policy rate hit after reaching ZLB, the non-sterilized forex interventions were the better option as sterilized FX intervention required at least a small positive rate.

The policies used by both central banks varied as the objectives of each country was different, the purpose of interventions for Israel was influenced more by controlling volatile rates as it has higher inflation and real growth rates, rather than seeing it as a monetary tool, whereas SNB saw it as a measure to increase forex reserves.

Discuss the mechanism and the purpose of FX intervention. Use an example to show how intervention affects monetary base (MB).

FX intervention takes place when the central bank purchases or sells domestic currency in exchange for foreign currency. The purpose of FX intervention is mainly to maintain the exchange rate and control short term high volatility as it can erode market confidence. Reasons such as maintenance of financial stability, competitiveness and inflation control, forex reserve accumulation motivate FX interventions. The mechanism with their tool can be split in two segments, direct and indirect. Direct intervention includes both sterilized and unsterilized. The key difference between the two is that sterilized impacts the exchange rate but does not change the monetary base whereas unsterilized does. Sterilized intervention was used by BOI and SNB during the GFC, is involves buying foreign currency bonds with local currency and then selling an equal amount of domestic bonds, which results in an increase of domestic currency. Due to this exchange, the net money supply stays the same ad every purchase is corresponded with an equal sale, or vice-versa. On the other hand, unsterilized is a technique used through buying or selling foreign bongs or currency using local money, this impact and alters not only the exchange rate but also the monetary base. An example of how intervention affects monetary base can be seen through SNB as even though the bank started with sterilized policy, it switched to unsterilized as its objective of local currency appreciation. As the bank sold foreign currency bonds, which decreased local currency, increasing currency price and the increase supply of foreign currency will decrease foreign currency price, resulting in a higher exchange rate which will in the end impact the net monetary base.