Unconventional Monetary Policy

Unconventional Monetary Policy refers to actions taken by the Federal Reserve that are outside of its standard toolkit. This section outlines the many different policy responses by the Federal Reserve since March 2020. Many of these policies were used during the Great Recession. When they were, we briefly compare today's response with the response then.

Before digging in, we remind the reader that while the Fed has offered a large amount of funds to various financial institutions distressed by the coronavirus crisis, in reality, only a fraction of the funds have been used. Moreover, while each of the following policies targets a specific market or financial actor in the financial sector, the Fed oftentimes has as its ultimate goal the support of non-financial firms and/or households.

What is the Policy Response to the Coronavirus Crisis?

Quantitative easing refers to the central bank expanding the money supply by buying assets, typically longer-dated government securities. It is the most common form of unconventional monetary policy, and is typically only resorted to once interest rates have reached the zero lower bound. By purchasing long-dated assets, the Fed is in a sense increasing demand for such securities and, in turn, driving up their price.

This process has two effects. First, through a credit channel, there is more liquidity in the financial system. Increased liquidity makes it easier for banks and other financial intermediaries to make loans. Second, there is a portfolio rebalancing channel. By lowering the yield on safe, long-dated securities, investors may tilt their portfolio towards riskier assets, such as corporate securities, which would tend to ease financial constraints faced by the corporate sector. For more details on these two channels, see Krishnamurthy and Vissing-Jorgensen (2011).

Federal Reserve Balance Sheet - Assets

By the end of October 2014, the Fed was no longer buying new assets and was trying to shrink its balance sheet. The size of the balance sheet began falling in late-2017 as assets began to "roll off" its balance sheet. In other words, the Fed was letting them mature without reinvesting the proceeds. In September 2019, following disruptions in the repo market, the Fed began investing a portion of the principal repayments into treasury securities and agency debt.

On March 15, 2020, in the FOMC statement the Fed announced purchases of at least $500 billion in treasury securities and $200 billion in agency mortgage-backed securities over the next few months. On March 23, 2020, they included agency commercial mortgage-backed securities in its expected purchases.

What is the Historical Precedent?

Quantitative easing was first used in Japan in 2001. It was mostly a Japanese phenomenon until the Great Recession, when policy rates for central banks around the world hit zero. In the United States, there were many rounds of Quantitative Easing, or Large Scale Asset Purchases, during the Great Recession. All told, the Fed's balance sheet increased from around $800 billion to over $4 trillion. This increase was due to purchases of agency MBS (mostly held by Fannie Mae, Freddie Mac, and Ginnie Mae) and long-term treasury securities

What is the Academic Evidence?

The academic evidence on the effectiveness of QE grew substantially following the Great Recession. Krishnamurthy and Vissing-Jorgensen (2011) find that yields fell in response to QE announcements. They highlight that QE works thorugh narrow channels that depend crucially on the types of assets purchased and the prevailing economic conditions. Di Maggio, Kermani, and Palmer (2019) find evidence of a refinancing channel, whereby households refinanced their mortgages and thus faced lower interest rates. Rodnyansky and Darmouni (2017) find evidence of banks increasing lending following announcements of QE during the Great Recession.

What Market is Under Stress?

A repurchase agreement (repo) is a short-term, secured loan where one party sells a security to another party with the intention of buying it back shortly thereafter (i.e., a simultaneous sale of a security and purchase of a forward contract). The traded security is therefore the collateral for the loan, in much the same way a home is collateral for a mortgage loan. The majority of repos are overnight loans but longer term agreements also occur, as can clearly be seen in the figure below (see next paragraph and figure following).

The largest repo market is the US Treasury repo market, with between $2-4 trillion worth of repo's traded daily. A reverse repurchase agreement is simply the opposite transaction, whereby one party buys a security from another party with the intention of selling it back shortely thereafter. The Federal Reserve uses the US Treasury repo market to conduct monetary policy. They buy and sell government securities in the repo market using reserves.

Treasury Repo Market - Primary Dealers

What is the Policy Response to the Coronavirus Crisis?

Before the Coronavirus epidemic, the Fed was offering $100 billion and $20 billion in overnight and two-week repo operations, respectively. Overnight operations were conducted daily, and two-week repo operations were conducted multiple times per week. These repo operations were announced approximately one month in advance on the New York Fed's repo calendar.

On March 12, 2020, the New York Fed announced that they would immediately conduct a $500 billion three-month repo operation. They also announced a $500 billion operation for both three-month and one-month repos on March 13, 2020. This $1.5 trillion repo operation announcement garnered a lot of press, both for its immediacy and its scale (for comparison, the estimated size of the CARES Act is estimated to be approximately $2 trillion). While the scale of these offerings is quite large, it is worth reminding the reader that repo operations are loans that, absent default of the counterparty, will be paid back; moreover, these repo agreements are collateralized by safe securities, which the Fed retains on its balance sheet in the case of default.

These $500 billion three-month and one-month operations are planned to be offered weekly for the foreseeable future. These additional repo operations were added to the pre-existing $175 billion and $45 billion in overnight and two-week repo operations. On March 17, 2020, the Fed increased the amount for daily overnight repo operations to $500 billion, at least through April 13, 2020.

The interest rate on these repo operations is determined by an auction mechanism. First, the Federal Reserve sets a minimum interest rate (i.e., a reserve price), typically equal to the federal funds rate, with additional basis points added depending on the maturity of the repo operation. If the minimum bid for a repo operation is above this level, then the interest rate will rise to reflect this minimum bid.

What have been the Results?

The total results of each repo operation is available daily. While the Fed has offered half a trillion dollars in three-month and one-month repo operations, the actual takeup of these amounts has been small. The daily amounts submitted and accepted for any individual one-month or three-month operation have never gone over $80 billion. In total, the largest day for repo operations in March has been March 12th, when total accepted repos went over $250 billion.

Federal Reserve Repo Operations