Central Bank's Toolbox

What are the policy tools available with the Central Bank in a bear zero interest rate environment?

Normally a Central Bank’s preferred choice of policy tool for inflation is short term interest rate. But when happens when the interest rate drops to zero and the central banks commits to keep interest rates are near zero in the near future? What are the policy tools available with the Central Bank in such a low interest rate scenario?

QE or quantitative easing is the answer. QE, a form of asset purchase has now come to refer to several flavours of asset purchase programme. It is generally used when the traditional measures/ tools like lowering interest rates are exhausted. One version of QE is credit easing in which the aim is to support the economy by boosting liquidity and reducing interest rates when credit channels are clogged. Fed’s purchase of MBS demand for which has weakened sharply during the financial crisis fall into this category. Another type of asset purchase aims to boost the economy without creating new money. An example of this is the Fed’s ongoing Operation twist in which Fed sells short term debt and uses the proceeds to buy long term debt giving investors cash for long term debt prompting them to invest more money in other assets. QE proper is a third type – the most straightforward way is portfolio rebalancing – the investors who sell the securities to the central bank then take the proceeds and buy other assets raising their prices. Lower bond yields encourage borrowing, higher equity prices raise consumption, and both help investment and boost demand.