By Peet Serfontein
Monetary policy involves how a country's central bank manages money supply and interest rates to achieve specific economic goals. This usually primarily involves controlling inflation but can also include ensuring currency stability and supporting employment and economic growth. By adjusting tools such as interest rates, the central bank influences borrowing, spending and investment across the economy to help reach its objectives. Central banks have many other tools at their disposal to influence the economy as well. These tools can manage money supply, guide financial conditions and promote stability without changing policy rates.
Open Market Operations (OMOs)
In an OMO, the central bank buys or sells government securities in the open market to regulate the supply of money and bank reserves in the economy.
When a central bank purchases bonds, it injects money into the system and can indirectly lower short-term interest rates, stimulating lending and economic activity. Conversely, selling bonds withdraws money from circulation and can raise short-term rates, cooling down an overheating economy.
Central banks conduct OMOs regularly, but they have been crucial in times of crisis as well. During the 2008 Global Financial Crisis (GFC), the Fed undertook aggressive open market operations to inject liquidity into the banking system, expanding its purchases of securities and engaging in large-scale repo operations to stabilise markets. These interventions provided banks with much-needed cash and helped avert a deeper credit freeze.
Reserve requirements
Refer to the regulations that determine the minimum percentage of customer deposits banks must hold as reserves (either in cash or deposited with the central bank). By changing reserve requirements, a central bank can directly influence how much money banks can create through lending. Lowering the reserve requirement frees up funds for banks, enabling them to lend more and thus expanding the money supply. In contrast, raising the requirement forces banks to hold a larger buffer and tends to restrict credit, slowing the economy.
This tool was more prominent in the past, but it is used by all major central banks these days. In March 2020, the Fed reduced its reserve requirements to zero but in an economy like China, reserve requirement adjustments remain a regular policy lever.
Forward guidance
Forward guidance is a more modern and nuanced qualitative monetary policy tool, whereby a central bank communicates its future policy intentions or criteria to influence public and market expectations (and ultimately movements). Instead of directly intervening using traditional monetary policy tools, the bank signals how it plans to act in the future - for example, indicating that interest rates will remain low for an extended period or until certain economic conditions are met.
This, in turn, shapes the expectations of investors, businesses and consumers. If people believe rates will stay low, for instance, long-term interest rates often fall, and borrowing is encouraged. Forward guidance became especially important in the aftermath of the 2008 GFC when many central banks had cut short-term rates to near zero and needed additional ways to stimulate the economy (so-called "unconventional" policy).
This tool was more prominent in the past, but it is used by all major central banks these days. In March 2020, the Fed reduced its reserve requirements to zero but in an economy like China, reserve requirement adjustments remain a regular policy lever.
There are generally two types of forward guidance: time-based guidance, where a central bank commits to a policy stance until a specific future date, and state-based guidance, where the commitment lasts until certain economic conditions (like an unemployment or inflation threshold) are achieved.
A notable example comes from the Bank of England (BoE) in 2013, when Governor Mark Carney announced that the BoE would not even consider raising interest rates until the United Kingdom's (UK) unemployment rate fell to 7%. This clear signal was intended to reassure businesses and households that borrowing costs would remain low until the labour market improved significantly. During the Covid-19 crisis in 2020, the Fed explicitly stated it would keep rates near zero "until the economy has weathered recent events" and later refined this guidance to say rates would stay low until maximum employment was achieved.
Such forward guidance helps reduce uncertainty and anchors interest rate expectations, amplifying the effects of other policy actions. By committing (at least conditionally) to a future policy path, central banks can influence longer-term interest rates and financial conditions today, without crude intervention
Quantitative easing (QE)
Quantitative easing refers to large-scale asset purchase programmes that are typically employed once conventional interest rate cuts are either not possible or have not been effective in spurring activity. Under QE, a central bank creates new money and uses it to buy assets, typically government bonds, in the market.
By doing so, the central bank injects liquidity into the financial system. The direct effects are that bond prices go up and yields (interest rates) on those bonds go down, which helps to lower longer-term borrowing costs.
QE also helps initiate portfolio rebalancing across the market. When central banks buy large quantities of safe assets like government bonds, yields come down and investors shift to relatively riskier assets (like corporate bonds or equities), driving those prices up and further easing overall financial conditions.
Historical examples of QE abound post-GFC. The BoE launched its first QE programme in March 2009 during the GFC, when the Bank Rate had already been cut to its effective floor. In 2009 and 2010, the bank bought £200 billion of assets (mostly UK government bonds) to support the economy (~14% of UK GDP). Over the next decade, the BoE's total asset purchases would rise to £895 billion (including further rounds during the Covid-19 pandemic). The US Federal Reserve likewise undertook several rounds of QE (nicknamed QE1, QE2, QE3) starting in late 2008. The Fed's balance sheet expanded dramatically as it bought US Treasury bonds and mortgage-backed securities (MBS). More recently, during the Covid-19 shock in 2020, the Fed "resumed purchasing massive amounts of debt securities", essentially open-ended QE, to restore market functioning and support the economy. The European Central Bank (ECB) and the Bank of Japan (BOJ) implemented similar large-scale asset purchase programmes in the 2010s.
In all these cases, QE was used to combat severe downturns or deflationary risks when traditional interest rate policy was constrained. By expanding the money supply and flattening yield curves, QE provided an extra boost to economies when it was most needed. Importantly, QE is generally considered temporary and reversible - and in recent years, central banks have started "quantitative tightening" by letting bonds mature or selling assets to gradually unwind these holdings.
Macroprudential measures
Macroprudential measures are not strictly regarded as monetary policy, being that they often pertain to financial regulation, but they have become a critical part of the central banking toolkit in maintaining economic stability. Macroprudential policy refers to regulatory actions aimed at safeguarding the stability of the financial system as a whole as opposed to microprudential regulation which focuses on individual institutions. These tools came into renewed focus after the GFC, as it was recognised that asset bubbles, excessive credit growth, or other systemic risks can derail economies and undermine monetary policy goals if left unchecked.
By tightening financial conditions in specific sectors or increasing the resilience of banks, macroprudential measures can complement monetary policy. Common macroprudential tools include capital requirements, and loan-to-value (LTV) limits or debt-to-income limits for lending. Increasing bank capital requirements (or setting a countercyclical buffer) forces banks to hold more capital during boom times, so they have larger cushions to absorb losses when conditions deteriorate. LTV ratio caps restrict how much one can borrow against collateral (like a house), which helps prevent excessive leverage and housing price bubbles.
Macroprudential measures also include limits on credit growth, leverage ratios, liquidity requirements (like the Liquidity Coverage Ratio) and even sectoral lending caps. These tools are designed to strengthen the financial system's resilience and temper credit cycles.
One clear illustration of macroprudential policy in action was the buildup of buffers prior to the Covid-19 pandemic and their release during the crisis. Many countries had set positive countercyclical capital buffers in the late 2010s (i.e. making banks hold extra capital in good times); when the pandemic hit in 2020 and economies crashed, several authorities (such as the BoE and European regulators) swiftly cut those buffers to 0%, effectively allowing banks to use their capital reserves to keep lending and absorb losses. This macroprudential relaxation worked in tandem with ultra-low interest rates and QE to support credit flow during the shock. As economies recovered, regulators signalled plans to raise capital buffer requirements again to prevent future excesses. Regulation has indeed become an essential complement to monetary policy - helping to prevent financial imbalances that could impair economic stability.
In closing
Each monetary policy tool has its strengths and limitations and in practice, central banks often use them in combination. For example, in a severe downturn a central bank might cut interest rates to zero, deploy forward guidance to signal staying at zero, launch QE to further ease conditions and coordinate with regulators to relax certain macroprudential constraints - all at the same time.
Importantly, by going beyond interest rates alone, central banks have more levers to pull to achieve their respective mandates - be it price stability, full employment, financial stability, or a combination thereof.
