Summary
Focus
Central banks in many jurisdictions have large balance sheets. This complicates the formulation of monetary policy, as policymakers must account for both short-term interest rates and balance sheet policies. The lack of a unified measure of monetary policy that captures multiple policy instruments also presents challenges for empirical research.
Contribution
We introduce a new monetary policy conditions index (MCI) that integrates conventional and unconventional monetary policy tools into a single measure. The MCI is a weighted average of the short-term interest rate and the size of the central bank’s balance sheet. Unlike the shadow rate, it captures the effects of balance sheet policies even away from the effective lower bound. The MCI’s weight and dynamic interactions with output, inflation and financial conditions are estimated using a Bayesian vector autoregression framework.
Findings
Large-scale balance sheet expansions have had a significant accommodative impact, including in periods when the effective lower bound was no longer binding. Historical decomposition and counterfactual simulations using the MCI offer fresh insights into the effectiveness of balance sheet policies and their potential unintended consequences.
Abstract
This paper introduces a new Monetary Policy Condition Index (MCI) that integrates conventional and unconventional monetary policy tools into a unified measure. The MCI is a weighted average of short-term interest rate and central bank balance sheet size, improving upon the shadow rate by capturing balance sheet policy effects away from the effective lower bound. We estimate the MCI’s weight and its dynamic relationships with output, inflation and financial conditions using a Bayesian Vector Autoregression (BVAR) framework. Results suggest that large balance sheet policies have exerted a significant accommodative influence on monetary policy conditions, including away from the effective lower bound. Through historical decomposition and counterfactual exercises, the MCI provides new insights into unconventional policy’s effectiveness and unintended consequences. The framework can flexibly accommodate numerous extensions, including possibly higher neutral balance sheet under ample reserve system.
JEL classification: E51, E52, E58
Keywords: monetary policy, monetary policy conditions, financial conditions, unconventional monetary policy, central bank balance sheet, ample reserves system
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