Do “Unconventional” Monetary Policies Work?

Philip Arestis and Malcolm Sawyer

The “unorthodox” Quantitative Easing (QE) monetary measures, along with another “unorthodox” monetary policy, namely negative interest rates, have been implemented by a number of countries in the years following the global financial crisis. This is as a result of the normal policy monetary instrument, the rate of interest, being reduced to nearly zero by a number of central banks. We discuss these measures but most importantly we discuss the extent to which they have been successful in terms of their targets.

QE includes two types of measures: (i) one is “conventional unconventional” measures, whereby central banks purchase financial assets, such as government securities or gilts, which boost the money supply; (ii) another is “unconventional unconventional” measures; in this way central banks buy high-quality, but illiquid corporate bonds and commercial paper. The purpose under both measures is not merely to increase the money supply but also, and more importantly, to increase liquidity and enhance trading activity in these markets.

A number of QE possible channels can be identified. There is the liquidity channel, whereby the extra cash can be used to fund new issues of equity and credit; thereby bank lending is influenced positively, which potentially can affect spending. The purchase of high-quality private sector assets, which aims at improving the liquidity in, and increase the flow of, corporate credit. There is also the portfolio channel, which changes the composition of portfolios, thereby affecting the prices and yields of assets (and thus asset holders’ wealth); the cost of borrowing for households and firms is also affected, which influences consumption (also affected by the change in wealth) and investment. Additionally, there is the expectations-management channel: asset purchases imply that, although the Bank Rate is near zero, the central bank is prepared to do whatever is needed to keep inflation at the set target; in doing so the central bank keeps expectations of future inflation anchored to the target.

The success of QE depends on four aspects: (i) what the sellers of the assets do with the money they receive in exchange from the central banks; (ii) the response of banks to the additional liquidity they receive when selling assets to the central banks; (iii) the response of capital markets to purchases of corporate debt; and (iv) the wider response of households and companies, especially so in terms of influencing inflation expectations.

There are doubts in terms of its effectiveness in view of the combination of QE and very low interest rates, which are close to zero. The ex-Governor of the Bank of England, Mervyn King (2016), has recently argued that when interest rates of all debt maturities are zero, “then money and long-term government bonds become perfect substitutes (they are both government promises to pay which offer zero interest), and the creation of one by buying the other makes no difference” (p. 183). However, there is a clear advantage in such a situation. This is that QE has made it easier for governments in terms of their fiscal policies because it provides a ready buyer for government debt. Without this facility, there would be serious difficulties in that governments may be seriously constrained in terms of the degree of their fiscal initiatives.

Another unconventional monetary policy, recently introduced by a number of central banks, is that of negative interest rates. As central banks have pursued QE, they have had to broaden the definition of assets that are included in their QE activities; this is as sovereign debt alone cannot satisfy central banks’ QE operations. It is the case that as options for further QE diminish, negative interest rates have become a new toolkit of monetary policy. A number of central banks have pushed their interest rates into negative territory, in an attempt to increase inflation expectations and raise inflation rates to their targets, as well as enhance growth rates. Negative interest rates are viewed by policymakers as part of their strategy to raise worryingly low inflation rates and offset downward pressures on inflation expectations. Negative interest rates are expected to drive down borrowing costs for business and consumers, and thereby redirect capital into higher-return investments; also to persuade savers to spend. Furthermore, lower interest rates are expected to weaken the country’s currency, thereby stimulating growth through more competitive exports. Such results would also increase inflation rates towards the central banks’ target inflation rates, usually 2 percent. However, this monetary policy experiment would only be successful if banks are willing to lend more; and its introduction has been accompanied by doubts as to whether this can be achieved in view of widespread volatility in financial markets, stagnant economies and poor economic growth; and most importantly poor expectations for future growth.

A further problem with the negative interest rates ‘unconventional’ monetary policy type is that it could produce reductions in the velocity of circulation of money. As such this type of “unconventional” monetary policy would not produce the expected results as envisaged by the proponents. So long as money (whether in the form of bank deposits or cash) maintains a zero rate of interest, it becomes a relative attractive financial asset when bonds offer a negative nominal rate of interest.

Low rates of interest on bank loans are argued to encourage investment thereby stimulating the economy. Apart from doubts on the size of such an effect, the other side of the coin is that those with accumulated savings face lower income (from interest rate payments). The retired who directly or indirectly rely for their income on interest payments have lower income, and have to lower their consumer demand.

It is also the case that negative interest rates can cause disruption by jeopardising the insurance companies and pension funds sectors through lowering their incomes. Under such circumstances both insurance companies and pension funds may shift the composition of their portfolios to risky assets, thereby adding to asset price bubble pressures, and could potentially create another type of the 2007/2008 international financial crisis. A further serious concern is the impact of negative interest rates on the rather fragile banking sectors. Those institutions, which are unable to increase lending, or pass the costs of negative interest rates on to their depositors, face a serious squeeze on their profits with serious implications on their ability to provide credit. Indeed, a prolonged period of low and negative interest rates may discourage lending as the net interest rate merging becomes smaller.

We may, therefore, conclude that “unconventional” monetary policies may be very unproductive and could potentially create further problems and crises.


King, M. (2016), The End of Alchemy: Money, Banking and the Future of the Global Economy, Little, Brown: London.

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