Previously, I discussed the Federal Reserve’s conventional monetary policy tools. Of these, open market operations was the primary method, with the discount window and reserve requirements playing a less prominent role. However, these are not the only tools the Fed can use. This is where unconventional policy comes into play. The Fed utilizes unconventional monetary policy in various circumstances, but primarily when the conventional tools are not sufficient in remedying economic downturns. These tools range from quantitative easing, which has received substantial press in recent years, to more simple strategies such as interest on excess reserves, or communication strategies.
In normal times of economic distress, financial institutions decrease loans and turn to safer investments such as treasury bonds. This lowers the money supply and decreases economic activity. A central bank implements quantitative easing in order to stimulate investment and consumer spending.
Under Quantitative Easing, the central bank purchases bonds or other financial assets from commercial banks in order to increase the supply of money in the open market. For example, in the sub-prime mortgage crisis in 2008/2009, the Fed responded by purchasing mortgage backed securities from financial institutions.
A “twist” on quantitative easing can also occur when the central bank purchases long-term bonds while selling short-term debt in order to flatten the yield curve. Flattening the yield curve functions to encourage investment and consumer spending that relies on long-term borrowing (such as purchasing a house). This took form during the second round of quantitative easing when the Fed performed “operation twist”.
The second form of unconventional policy is changing interest on excess reserves. This means that the Fed pays financial institutions to hold reserves. This interest prevents financial institutions from flooding the market with money, or promotes financial institutions to invest their reserves in the open market with the intention of gaining higher returns. An example of increased interest on excess reserves can be seen in recent years. The Fed fears that money from financial institutions resulting from quantitative easing could flood the markets and potentially lead to inflation. Therefore, they increased interest, incentivizing these institutions to hold their cash.
The final form of unconventional monetary policy is the Fed’s communication strategy. The Fed’s rhetoric has enormous influence on the economy. After every meeting, they convey their economic outlook and strategies moving forward. If the Fed believes the economy is too weak to raise interest rates, asset markets and financial institutions usually respond with policies to accommodate these weak conditions. These responses often further stagnate the economy or slow its growth. Conversely, if the Fed believes the economy is strong, the markets will continue investing, further growing the economy. This has been seen in recent months as the Fed began raising interest rates for the first time since the Great Recession, thus signaling a positive economic outlook. Asset markets have progressed substantially in response to the Fed’s optimism. Though the Fed can use this to its advantage, unclear communications often negatively impact economic growth.
When the Fed conveys its strategies, they can also impact future economic growth. An example can be seen when they discuss plans to continue raising rates over time. This signals that the most recent interest rate hike is not the only one and will be followed by further rate hikes. Though this positive outlook can often be good for the economy, it also conveys that lending will be more expensive and the Fed is intentionally slowing down growth.
Whether communication is positive or negative, the Fed must ensure that they stick to their conveyed strategies. If they fail to do this, the public can lose faith in the Fed’s policies and the Fed will lose influence. One of the Fed’s key phrases in press releases is that they will “remain data dependent,” allowing for future flexibility in case of unexpected activity.
These three strategies constitute the majority of unconventional monetary policy. Quantitative easing is the youngest of these strategies, as it was first utilized in the U.S. during the Great Recession. Though these are the main three, recent implementation of alternative strategies shows that the Fed is willing to experiment with various forms of unconventional policy in response to unprecedented economic downturns.