Central banks'' asset purchase programmes introduced in the wake of the financial crisis seem to have been effective in lowering government bond yields and longer-term interest rates. What''s more, according to Professor David Miles and colleagues, writing in the November 2012 issue of the Economic Journal, these lower yields have in turn had a positive effect on the wider economy.


But although the evidence suggests that unconventional monetary policy works, these authors point out that its effects have not been enough to offset fully the negative forces of a banking crisis and a downturn led by deleveraging.


The implication, they conclude, is that central bankers and financial regulators need to work on improving their macro- and micro-prudential frameworks to reduce the probability – and limit the severity – of financial crises. This would mean that the limited though significant potency of unconventional monetary policy would not need to be relied on so heavily in the future.


The authors begin by noting that on the eve of the financial crisis of 2007-08, the intellectual and empirical foundations of monetary policy appeared secure and its implementation robust.


The aim of monetary policy was to achieve low and stable inflation; the policy framework was inflation targeting; the instrument was a short-term interest rate at which the central bank provided funds to banks; and the impact of this official rate on market rates and the wider economy was reliably quantified.


Within this framework, the setting of interest rates was done judgementally using a wide variety of macroeconomic signals but in a manner that could be approximated with reference to so-called Taylor rules.


All this changed after the financial crisis. The depth of the recession that followed in many countries meant that Taylor rules would recommend negative nominal interest rates. But market interest rates are effectively bounded by zero (or close to zero). With the standard central bank interest rates at or close to zero and the usually reliable relationship between changes in official interest rates and market interest rates also broken, other forms of monetary policy needed to be considered.


Central banks embarked on unconventional monetary policies – using their power to expand their balance sheets, massively increasing the amount of money by buying (either outright or as part of collateralised loans) large quantities of assets. Many of those assets were government bonds (and the purchases called ''quantitative easing'' or QE); some assets were issued by the private sector (in which case there is also an element of ''credit easing'').


There are conditions under which asset purchases by the central bank – irrespective of whether they are of private sector or government securities – are completely neutral and so both credit easing and QE would be ineffective. But those conditions require smoothly operating markets, rational and forward-looking behaviour by all people and no credit restrictions. It is debatable whether any of these assumptions hold even in unstressed financial markets; it is wildly implausible that they do so in the wake of a financial crisis.


Many view the most natural channel through which QE can work as being what is usually called the ''portfolio balancing'' channel. The evidence from the UK and the United States is that this mechanism worked.


In the UK, the Bank of England bought a large quantity of gilts (about £375 billion by November 2012). Many investors in gilts – for example, pension funds and insurance companies – have long-dated liabilities and prefer to match these liabilities with equally long-dated assets. These investors are likely to use some of the proceeds of gilt sales to purchase other long-dated assets, such as corporate bonds, equities or even property.


The resulting rise in asset prices – and decline in yields – on these other assets may make it easier for many companies to raise funds, easing credit conditions. They will generate capital gains for households who are the ultimate owners of those risky assets, boosting their wealth. If households consume part of that increased wealth or companies invest some of the extra funding raised on capital markets, demand (and GDP) will be higher. This is the portfolio rebalancing channel of asset purchases.


The evidence suggests that central banks'' asset market purchases do lower yields and longer-term interest rates and that these lower yields in turn have a positive effect on the economy. Purchases since 2009 by the Bank and the Federal Reserve may have reduced longer-term government bond yields by between 100 and 200 basis points.


''Quantitative Easing and Unconventional Monetary Policy'' by Michael Joyce, David Miles, Andrew Scott and Dimitri Vayanos is published in the November 2012 issue of the Economic Journal.  Michael Joyce is at the Bank of England. David Miles is a member of the Bank of England''s Monetary Policy Committee. Andrew Scott is at London Business School. Dimitri Vayanos is at the London School of Economics.

Media Coverage

Today Programme 1st November Business News with Simon Jack.

Vox Quantitative easing and unconventional monetary policy (audio)

Nasdaq Bond Buying Helps But Not Enough to Overcome Crises

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