Unconventional monetary policy
When interest rates hit zero, central banks turned to new tools. Recent years have tested monetary policy in new ways.
The zero lower bound
Central banks cannot easily cut rates far below zero, because people could hold cash instead of deposits paying negative interest. When rates are near zero and the economy is still weak, as after 2008 and in 2020, conventional policy runs out of room.
Quantitative easing
Quantitative easing (QE) is large-scale buying of government bonds and other assets by the central bank, paid for with newly created reserves. It lowers long-term interest rates, raises asset prices, and signals that policy will stay loose. The Fed, ECB, Bank of England, and Bank of Japan all used QE extensively.
Quantitative tightening
Quantitative tightening (QT) is the reverse: shrinking the central bank's balance sheet by letting bonds mature without replacing them or selling them. Several central banks began QT in 2022 alongside interest rate rises.
Negative interest rates
Some central banks, including the ECB, the Swiss National Bank, and the Bank of Japan, set slightly negative rates on bank reserves in the 2010s to encourage lending. Effects were modest, and concerns about bank profitability limited how far rates could go. The Bank of Japan ended its negative rate policy in 2024.
Lender of last resort in action
In financial panics, central banks lend freely to solvent banks against good collateral to stop runs, following the principle set out by Walter Bagehot in 1873. In 2008, 2020, and the 2023 regional bank stresses in the US, central banks created emergency lending facilities to calm markets.
The 2021-2023 tightening
As inflation surged in 2021-2022, central banks raised rates at the fastest pace in decades. The Fed raised its target range from near zero in early 2022 to 5.25-5.50% by July 2023. Inflation fell substantially, and the US avoided a recession over that period, though higher rates strained some banks and borrowers.
Debates about monetary policy
Critics argue that long periods of low rates and QE inflated asset prices and widened wealth inequality; supporters argue they prevented deeper recessions and higher unemployment, which would have hurt lower-income people more. Others debate whether central banks should target inflation alone or broader goals like financial stability or climate risk.
Worked example
In 2020, the Fed cut rates to near zero and bought trillions of dollars of bonds. Mortgage rates fell to record lows, around 3% for a 30-year loan, boosting housing demand and refinancing. In 2022-2023, as rates rose, mortgage rates passed 7%, and home sales fell sharply.
Key takeaways
Rates cannot go far below zero, limiting conventional policy. QE buys assets to lower long-term rates; QT reverses it. Negative rates had modest effects. Central banks act as lenders of last resort, following Bagehot. The rapid tightening of 2022-2023 cut inflation. Debates continue about distributional effects and central bank goals.
Flashcard
Rates cannot go far below zero
Check your understanding
Why did central banks turn to quantitative easing after 2008?