The role of monetary policy in addressing the crisis in the euro area

1.The term risk premium for holding on to an asset for a specific period of time;
2.The liquidity risk premium as the compensation for the possibility of incurring losses when selling the asset back to the market before maturity and at short notice; and
3.Credit risk premia of various types as compensation for the possibility of not receiving at maturity repayment for the principal because, for instance, borrowers may renege on their contractual obligations.

At the risk of oversimplifying, one can distinguish the main types of unconventional measures depending on which component in this decomposition they are aiming to address.
Forward guidance about the intended path of the central bank's monetary policy rate in the future mainly aims to manage expectations regarding the future evolution of the short-term interest rates. It thus addresses the expectations component I was referring to before. Changes in the level of the current policy rate always have an intrinsic signalling content with respect to possible changes for short-term rates in the future. But during crisis times, when short-term nominal rates are at zero or close to zero, they cannot be adjusted further down. The central bank may then engage in active communication reassuring markets that the future path of policy rates would not deviate from the current low level for a certain period or until certain observable conditions are verified.

Large-scale asset purchases, or quantitative easing, instead, mainly aim to compress the term premium. [2] This type of policy intervention works through reducing the supply of securities with long duration and increasing the supply of reserves or liquidity. With less term risk to hold in the aggregate, the market should require a lower premium to hold that risk.

The ECB's non-standard measures I mentioned earlier are geared towards addressing primarily two types of premia: the liquidity risk and the redenomination risk. The ECB's liquidity operations, such as the 3-year Long-Term Refinancing Operations (LTROs), are intended to relieve banks of liquidity and funding stress. They, therefore mainly aim to reduce liquidity risk in the money market.

Central banks have adopted different approaches as regards their non-standard measures. For instance, the Fed, the Bank of England and the Bank of Japan all engage in Large-Scale Asset Purchases. The Fed also uses forward guidance.

When viewed, however, from the perspective of the framework I just described, most non-standard measures employed by the major central banks around the globe seem remarkably similar. They aim to implement the desired monetary policy stance, in conditions in which the stance may not be smoothly and homogeneously transmitted to the economy, or where a further easing of the stance through standard policy rate adjustments is hindered by the lower bound constraint. The unifying overall goal is to improve the effectiveness of monetary policy, in ways that can support the attainment of the monetary policy objectives.

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