There is nothing “unconventional” about money base control

Central bankers around the world talk about monetary policy as being “unconventional” when they undertake “quantitative easing” to expand the money base. This term frustrates me a great deal as there is nothing unconventional about the fact that the central bank is changing the money base.

In fact controlling the money base is exactly what central banks are doing when they undertake “normal” monetary policy. Central bankers might talk about monetary policy in terms of changing interest rates, but what central banks are doing – when they are undertaking what they consider to be “normal” monetary policy – is to control the money base to target a certain level for short-term interest rates.

In that sense there is nothing unconventional about controlling the money base – it is what central banks have always been doing. Many central bankers have just forgot it as they are used to talk about monetary policy in terms of changes in interest rates.

Therefore it is completely meaningless to talk about quantitative easing as being “unconventional” monetary policy. However, what is “unconventional” is when central bankers think that credit policy is monetary policy.

So when the ECB for example is intervening in the European sovereign bond market to distort the relative prices of for example Spanish and Germans government bond then that is credit policy. Particularly as the ECB consistently has said that any such operations will be “sterilized” – hence, the ECB will ensure that its operations have no impact on the money base. But again that is not “unconventional” monetary policy. It is not monetary policy at all – it is credit policy.

Monetary policy is two things. It is the central banks ability to increase or decrease the money base. It can do this by buying or selling assets in the market place. And second, it is the central bank’s ability to communicate about future changes in the money base (forward guidance).

Unfortunately few central bankers really seem to understand that this is what central banking should be about. Most central bankers still think “normal” monetary policy is about controlling the interest rate to hit some nominal target (mostly inflation). But central bankers can’t really control interest rates and at the same time hit another target – for example inflation. The interest rate is not even a policy instrument – it is an intermediate target. The money base is the instrument.

Therefore, it is of course also completely meaningless when the Federal Reserve earlier tried to influence the shape of the yield in its so-called operation twist and it is equally meaningless that the Fed now seems to be very concerned about what is happening to bond yields. The Fed should not care at all about bond yields.

What the Fed – and other central banks – should do is to define a very clear nominal target (the policy objective) – for example the nominal GDP level, the price level or inflation – and then undertake open-market operations – buying and selling assets – to control the development in the money base so as to hit the policy objective and it of course needs clearly to communicate about what target it has and show full commitment to hitting this.

Central banks should let interest rates and bond yields be determined by the markets. Central banks should not be in the business of distorting relative prices in the money and bond markets. The central bank’s only task is to ensure nominal stability and it should use the control of the money base and forward guidance to do this. Everything else is likely to be counterproductive.

The sooner central bankers realizes this and stop communicating about monetary policy in terms of interest rates as “conventional” monetary policy and money base control as “unconventional” the sooner they will be able to make the necessary decisions to ensure nominal stability.

The ECB’s refusal to conduct monetary policy

The best illustration of central bankers’ lack of understanding of these matters is the ECB’s policy actions. The ECB as a principle refuses to conduct monetary policy. It will not undertake actions to increase the money base even when it is totally clear that it is seriously undershooting its own official 2% inflation target.

ECB officials again and again will tell you that it is not allowed to buy European government bonds because that would be monetization of government debt. But excuse me – the job of central banks is to create money.

Money creation is at the core of what central banks should be doing. And if the ECB doesn’t feel like buying government debt to increase the money base it can always buy something else.

But the ECB seems to think there is something “dirty” about controlling the money base. It is only allowed to conduct monetary policy by hiking or cutting interest rates. But how do you think the ECB is controlling interest rates? By changing the money base! Why this obsession with interest rates?

The ECB should give up controlling interest rates and move to an open and transparent operational procedure by which to control the money base.

I fundamentally think that the ECB should announce that it in the future will stop using interest rates as a way to communicating about monetary policy and instead it should move to a system where it every month will announce the future rate of growth of the money base and that it will change its operational target of money base growth when ever needed to hit a certain nominal target (the policy objective).

The simplest way of controlling the money base for the ECB in my view would be to buy and sell a GDP-weighted basket of 2-year euro zone government bonds. Not with the purpose of influencing the relative prices of European sovereign bonds, but with the purpose of expanding or decreasing the money base.

Over the past five years the ECB (and the BoE and the Fed for that matter) has come up with a complicated set of operational procedures. Most of these procedures have had the purpose of distorting relative prices in the European sovereign bond markets. The ECB should scrap all of these schemes. There is no need for these schemes. They distort markets and have drastically increased moral hazard problems in the European financial system.

The ECB – and other central banks – should of course act as lender-of-last resort. That is a rather simple task. The central bank provides liquidity to the market (including banks) against proper collateral. Other than that the central bank should increase and decrease its money base to hit its nominal target. It is really simple.

So central bankers should stop calling changes to the money base “unconventional” monetary policy. It is perfectly normal monetary policy. But central banks should also give up the complicated and counterproductive credit policies. These credit policy is the unconventional part of “monetary” policy (it is not really monetary policy).

If central bankers acknowledged that controlling the money base is what they are in the business of doing then we could end the fruitless discussion about “exit strategies” from QE. Quantitative easing in that sense is also a meaningless term. Central banks control the quantity of base money. It can increase it and or decrease now and in the future. There is no exit strategy from that. If you have decided to have a central bank then it is because you want it to create money. There is certainly nothing “unconventional” about that – that is what central banks always have done.


As I was writing this post I came to think of the numerous mails I have exchanged with Professor Michael Belongia on this topic and related topics. So I dedicate this post to Mike and I would suggest to my readers that you take a look at some of the papers Mike have written on this topic. See for example here:

Belongia, Michael & Hinich, Melvin, 2009. “The evolving role and definition of the federal funds rate in the conduct of U.S. monetary policy,” MPRA Paper 18970, University Library of Munich, Germany, revised Aug 2009.

Michael T. Belongia, 1992. “Selecting an intermediate target variable for monetary policy when the goal is price stability,” Working Papers 1992-008, Federal Reserve Bank of St. Louis.

Mike has made numerous comments to a draft of this post among other things about how do reorganize it. This post, however, is more or the less the unedited version of the blog post, but I plan to expand this post into a bigger paper based on some of Mike’s insightful suggestions. Hopefully I will get to that soon…Input and suggestions are very welcome.

Leave a comment


  1. DIego Espinosa

     /  November 30, 2013

    Your last two posts touch on the ECB’s failure to increase the base, and the contrast with the BOJ. This makes me wonder: is there a market monetarist explanation for the performance of the STOXX? It seems unpersuaded by tight money.

  2. Even from a balance sheet perspective couldn’t it be said that large increases in excess reserves is “unconventional?”

  3. Mr. C I am also convinced that open market purchases would be the best way to change the nase. Now, lets say ecb starts doing this, would you agree that yield divergence becomes irrelevant?

    My premise is that if aggregate(for the whole EA) nominal target is achieved, the difference in yields would reflect the “real” risk, inflation, liquidity and other characteristics of respective government bonds.
    In absence of ngdp/demand shock can we expect market to price them according to the fundamentals, probably reducing current degree of divergence but enabling certain spread that would in end ensure the right pricing of individual risks?
    Im trying understand, other than MP purposes, why does a monetary union need one (or a series of converging, very low spread) rate(s)?

    My view is that high degree of convergence wasnt really warranted before the crisis so for some countries, in terms of risk free rate (bond yields) MP was really expansionary. I dont think we’ll be seeing those levels of spreads soon.

    Im bad at explaining what I think, but hope you’ll get what I was trying to ask here.

  4. troopa

     /  November 30, 2013

    ***change the Base (m0)

  5. What about introducing an indefinite refinancing operation? It wouldn’t breach the eurozone rules and the ECB could launch it with minimum fuss. I wrote something about this here:

  1. “Unconventional” monetary policy: A “snake pit” | Historinhas
  2. What the ECB Monetary Policy Is Missing | Market Moving News and Views
  3. Just leave the room whenever someone brings up interest rates | Increasing Marginal Utility
  4. Wolfgang is right – bold action needed in the euro zone to avoid deflation | The Market Monetarist
  5. Hitler’s Hillways and UK monetary policy – two interesting working papers | The Market Monetarist
  6. Time for the Fed to introduce a forward-looking McCallum rule | The Market Monetarist

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