CHAPTER 17 Tools of Monetary Policy 451 lost its ability to lower long-term interest rates by lowering short-term interest rates For these reasons, many central banks around the world, including the Bank of Japan, the U.S Federal Reserve, and the Bank of England, have departed from the traditional interest-rate targeting approach to monetary policy and are focusing on their balance sheet instead, using quantitative measures of monetary policy The Bank of Canada is also considering such quantitative measures and has recently identified three alternative instruments that it would consider using in an environment with low short-term (nominal) interest rates: conditional statements about the future path of the policy rate, quantitative easing, and credit easing Because the Bank of Canada has lost its ability to influence long-term interest rates using conventional monetary policy tools, recently the Bank started making conditional statements about the future path of its policy rate in order to influence long-term interest rates The objective of such conditional commitments regarding the operating band for the overnight interest rate is to align market expectations of future short-term interest rates with those of the Bank to achieve desirable outcomes in interest rates throughout the term structure For example, on April 21, 2009, the Bank of Canada lowered the policy rate by 0.25 of a percentage point to 0.25%, and it also committed to holding the policy rate at 0.25% until the second quarter of 2010, conditional on the outlook for inflation Such a conditional commitment by the Bank of Canada to keep the policy rate at 25 basis points for a long period is expected to shape market expectations of future short-term interest rates and lower long-term interest rates, since longterm rates are averages of current and expected future short-term interest rates (plus risk premiums) CONDITIONAL STATEMENTS Quantitative easing refers to the purchase of financial assets by the central bank through the creation of excess reserves (settlement balances in the Canadian case) for banks This is the same as open market operations, but extends to include private financial assets such as corporate bonds and commercial paper By buying financial assets, the central bank affects the cost of borrowing by pushing up the price of the purchased assets and reducing their yields Moreover, by creating excess reserves for banks, the central bank encourages banks to lend more to households and businesses, thereby increasing the level of economic activity Quantitative easing is regarded as an unconventional form of monetary policy, very different from interest-rate targeting that central banks and the financial markets around the world have used over the last twenty years It targets the amount of liquidity provided by the central bank instead of targeting the price of liquidity (as interest-rate targeting does) The Bank of Japan used it during the early 2000s, as did the Federal Reserve and the Bank of England during the recent global financial crisis Quantitative easing, however, is a high-risk monetary policy tool as it runs the risk of going too far, pumping too much money into the economy and possibly creating inflation and even hyperinflation QUANTITATIVE EASING Credit easing refers to the purchase of private sector assets by the central bank in critical markets that are considered important for the effective functioning of the economy The objective of credit easing is to reduce risky spreads and improve liquidity and trading in these markets, thereby stimulating CREDIT EASING