Non-Standard Monetary Policy

What Is Non-Standard Monetary Policy?

A non-standard monetary policy — or unconventional monetary policy — is a tool used by a central bank or other monetary authority that falls out of line with traditional measures. Non-standard monetary policies came to prominence during the 2008 financial crisis when the primary means of traditional monetary policy, which is the adjustment of interest rates, was not enough. Non-standard monetary policies include quantitative easing, forward guidance, and collateral adjustments.

Understanding Non-Standard Monetary Policy

Monetary policy is used in either a contractionary form or an expansionary form. When an economy is in trouble, such as a recession, a country's central bank will implement an expansionary monetary policy. This includes the lowering of interest rates to make money cheaper to encourage spending in the economy.

An expansionary monetary policy also reduces the reserve requirements of banks, which increases the money supply in the economy. Lastly, central banks purchase Treasury bonds on the open market, increasing the cash reserves of banks. A contractionary monetary policy would entail the same actions but in the opposite direction.

During the 2008 financial crisis, global economies were looking to pull their countries out of recessions by implementing expansionary monetary policies. However, because the recession was so bad, standard expansionary monetary policies were not enough. For example, interest rates were dropped to zero or near zero to fight the crisis. This, however, was not enough to improve the economy.

To complement the traditional monetary policies, central banks implemented non-standard measures to pull their economies out of financial distress.

The Fed put into place various aggressive policies to prevent even more damage from the economic crisis. Similarly, the European Central Bank (ECB) implemented negative interest rates and conducted major asset purchases in order to help stave off the effects of the global economic downturn. 

Types of Non-Standard Monetary Policies

Quantitative Easing

During a recession, a central bank can buy other securities in the open market outside of government bonds. This process is known as quantitative easing (QE), and it is considered when short-term interest rates are at or near zero, just as they were during the Great Recession. QE lowers interest rates while increasing the money supply. Financial institutions are then flooded with capital to promote lending and liquidity. No new money is printed during this time. 

During the recession, the U.S. Federal Reserve began buying mortgage-backed securities (MBSs) as part of its quantitative easing program. During its first round of QE, the central bank purchased $1.25 trillion in MBS. As a result of its QE program, the Fed's balance sheet swelled from about $885 billion before the recession to $2.2 trillion in 2008 where it leveled out to about $4.5 trillion in 2015.

Forward Guidance

Forward guidance is the process by which a central bank communicates to the public its intentions for future monetary policy. This notice allows both individuals and businesses to make spending and investment decisions for the long-term, thereby bringing stability and confidence to the markets. As a result, forward guidance impacts the current economic conditions.

The Fed first used forward guidance in the early 2000s and then during the Great Recession to indicate that interest rates would remain at low levels for the foreseeable future.

Negative Interest Rates

Many countries adopted negative interest rates during the financial crisis. In this policy, central banks charge commercial banks an interest rate on their deposits. The goal is to entice commercial banks to spend and lend their cash reserves rather than storing them. The storing of cash reserves will lose value due to the negative interest rate.

Collateral Adjustments

Criticism of Non-Standard Monetary Policy

Non-standard monetary policies can have negative impacts on the economy. If central banks implement QE and increase the money supply too quickly, it can lead to inflation. This can happen if there is too much money in the system but only a certain amount of goods available.

Negative interest rates can also have consequences by encouraging people not to save and rather to spend their money. Furthermore, QE increases the balance sheet of a central bank, which can be a risk to manage, and also inadvertently determines the types of assets available to the private sector, possibly leading it to purchase more risky assets if the Fed is buying up tremendous amounts of Treasuries and MBSs.