Monetary policy in exceptional times and the economic implications of phasing out in the Eurozone

Michele Lenza, Lucrezia Reichlin 16 February 2010



In response to the global financial crisis, central banks have reacted in a number of novel and innovative ways. Recently, some economists have started to assess the effects of these measures (e.g. Taylor and Williams 2008 for the effects of Fed policies on money market spreads) while others have suggested a framework to analyze the non standard policies in the new Keynesian monetary model (see Cardia and Woodford, 2010).

Following the emergence of money market tensions in August 2007, central banks offered support to the financial system by changing the composition of their balance sheets, including lengthening the maturity of outstanding monetary operations and holding securities issued by the private sector. After the collapse of Lehman Brothers, such changes in composition were accompanied by significant expansion of the central banks’ balance sheets, with monetary liabilities rising as a result. Despite their differences in rhetoric, the non-standard measures of the ECB, the Federal Reserve and the Bank of England involved a combination of both quantitative easing (i.e. expanding the monetary base) and qualitative easing (i.e. changes in the asset composition of central bank balance sheets).

What effect have these policies had on loans and unemployment, and what are the possible effects of phasing them out? In recent research (Lenza et al. 2010), we describe the non-standard policy measures introduced since August 2007 by three major central banks – the European Central Bank, the Federal Reserve and the Bank of England and quantify their effect on the macroeconomy in the case for the eurozone. We argue that non-standard measures should be seen as affecting the economy through their impact on interest rate spreads, rather than their impact on the monetary base (i.e. via prices rather than via quantities) (on this point see also Cardia and Woodford, 2010). For the euro area, this view is supported by an analysis of the fixed rate / full allotment (FRFA) procedure the ECB introduced in its monetary policy operations as from October 2009. As a result of this procedure, the ECB provides unlimited liquidity (against a wide definition of eligible collateral) to banks at a fixed interest rate. In the absence of liquidity-draining operations, the ECB therefore foregoes control of the quantity of liquidity provided to the market by deferring volume decisions to its counterparties. This approach allowed inter-bank transactions – which had been severely disrupted by the dislocation to the money market – to be intermediated across the central bank balance sheet. Such measures served to contain and then reduce the significant money market spreads that had resulted from the crisis (see Figure 1), thereby supporting economic activity. (Non-standard measures (e.g. the conduct of 12-month maturity operations by the ECB using FRFA in June, September and December 2009) may (other things equal) also have led to some flattening of the money market yield curve.)

Since in aggregate the demand for central bank liquidity has exceeded the banking system’s liquidity needs, one implication of the adoption of the FRFA tender procedure by the ECB has been a fall in the euro overnight market interest rate to the lower bound of the interest corridor determined by the ECB’s standing facilities. In other words, the intermediation offered by the ECB has involved providing liquidity to the market at the FRFA operations and then reabsorbing the excess liquidity provided at the deposit facility. For an unchanged level of the policy rate (i.e. the rate at the ECB’s main refinancing operation), the FRFA procedure has thus resulted in a lower market overnight rate than under normal conditions, implying a further stimulus to the economy.

Figure 2 illustrates this point. The spread between the euro overnight market interest rate (EONIA) and the ECB’s main refinancing operation rate (MRO) – which is small and positive (average around 5 basis points) in normal times – both widened and turned negative following the adoption of the FRFA procedure in October 2008, decreasing to average approximately -65 basis points since May 2009.

Figure 2. MRO / EONIA spread (percent per annum; percentage points)

The stimulative effect coming from the behaviour of these spreads can be quantified with standard macroeconomic tools. We provide such quantitative analysis for the Eurozone on the basis of the model developed by Giannone, et al. (2009). The model is a Bayesian vector autoregression (B-VAR) including thirty-two monthly variables on real, nominal, credit variables and various interest rates. The analysis compares two counterfactual scenarios. The counterfactual scenarios are forecasts of some selected policy-relevant variables exclusively conditional on specific paths of money market interest rates between November 2008 and August 2009.

In the scenario without non-standard measures (labelled NP), we assume that spreads between money market rates and the ECB’s main refinancing operation rate remained at the levels observed in October 2008 (i.e. in the immediate aftermath of the Lehman Brothers failure). We assume that the difference between the observed path of money market rates and their value in the non-standard scenario reflects solely the impact of non-standard monetary measures (this is the key identifying assumption). By implication, the scenario with the non-standard measures (labelled P) is a forecast of all variables of interest from October 2008 conditional exclusively on the actual path of money market rates observed between November 2008 and August 2009. The impact of non-standard measures is then defined as the difference between the NP and P scenario conditional expectations derived using the methods outlined above. Figures 3a and 3b illustrate the results of this exercise, showing estimates of the impact of non-standard measures on unemployment and sectoral bank loans.

Figure 3a. Unemployment rate (percentage points)


Figure 3b. Loans to private sector (difference in annual growth, percentage points)

These estimates indicate that non-standard measures have supported bank loans for house purchase since their introduction, whereas the stimulative impact on loans to non-financial corporations is delayed. That loans to non-financial corporations lag the business cycle is a well-documented fact for both the Eurozone (Giannone et al., 2009) and the US (den Haan et al. 2007), and is consistent with the observed Eurozone bank loan data over the past year. The modelling exercise also suggests that non-standard measures will reduce unemployment, but again only after a considerable lag.

The analytical machinery described above is symmetric. It can also be used to assess the macroeconomic impact of the phasing out of non-standard measures, at least insofar as this affects money market spreads. To illustrate this possibility, we present another set of scenarios based on different assumptions for the behaviour of the euro overnight market interest rate.

In one scenario (labelled no phasing out or NPO), we simply assume that the overnight rate remains constant at the level observed in January 2010 until the end of the year. In the other scenario (labelled phasing out or PO), the overnight rate is assumed to follow the path embedded in market expectations (as observed at the end of January 2010) until the end of the year. Implicit in the construction of these scenarios is the assumption that the phasing out of non-standard measures will result in the normalisation of the spread between the overnight rate and the refinancing rate. From January 2011 onwards, in both scenarios the overnight rate is assumed to follow the path endogenously determined within the model. Moreover, other money market rates are assumed to follow their usual (and high) correlations with the overnight rate, as captured by the B-VAR model. The implied paths of the ONIA during 2010 are shown in Figure 4.

Figure 4. Assumed EONIA path in the PO and NPO scenarios (percent per annum)

The counterfactual analysis discussed above can then be repeated for the PO and NPO scenarios, with the impact of phasing out on macroeconomic variables characterised as the difference between the conditional forecasts of that variable embedded in these scenarios. The results are shown in Figure 5a and 5b.

Figure 5a. Unemployment rate (percent)

Figure 5b. Loans to private sector difference in annual growth, percentage points

The effects of a normalisation of the spread between the euro overnight market interest rate and main refinancing operation rate on unemployment are moderate. Unemployment increases by only 0.2 percentage points over five years. Moreover, the reaction of unemployment is quite sluggish, peaking only in 2014.

Turning to bank loans to non-financial corporations, the reduced spread is estimated to boost borrowing by firms in the short-run, even if such borrowing weakens after a lag. As discussed above, this positive reaction of credit to non-financial corporations in response to shocks that affect negatively the business cycle (like exogenous monetary policy tightening or negative business cycle shocks) is a well-established stylised fact, which could be explained by an increased demand for corporate borrowing owing to reduced availability of internal financing (Bernanke and Gertler. 1995). By contrast, loans for house purchase are negatively affected by the normalisation of the spread even on impact, although the overall impact is modest. Overall, we find that aggregate loan dynamics are barely affected by the normalisation of the spread, as the different sectoral responses tend to cancel one another out.

Disclaimer: The views expressed in this article do not necessarily reflect those of the European Central Bank and the Eurosystem.


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Topics:  Monetary policy

Tags:  ECB, monetary policy, market spreads

Head of Section, D-G Research, Monetary Policy Division, Macroeconomics Section, European Central Bank

Professor of Economics, London Business School; CEPR Research Fellow and trustee; IFRS Foundation trustee (chair steering committee sustainability reporting); Fellow of the British Academy; Fellow of the Econometric Society


CEPR Policy Research