Is Conventional Monetary Policy Dying?
By Spandan Banerjee
I t is now common knowledge that after the 2008 Global Financial Crisis, the major economies across the world were plunged into a deep mess as unemployment figures skyrocketed and many countries faced debt crisis in the aftermath, notably the Euro Zone Crisis which shook countries like Greece and Italy badly. This presented a major challenge before the central bankers of the world. They were saddled with another 1930s Great depression style crisis and as the world was much more interconnected and the economies much more globalised now, the ripples of the Lehmann Brothers collapse were to be felt far and wide. They started their rescue efforts by leveraging their conventional monetary policy tools to give a boost to the falling economy. They slashed the short-term interest rates to decrease the borrowing costs of commercial banks so that they would be encouraged to increase credit supply. This worked to a certain extent till the short-term interest rates fell to zero, effectively getting stuck at something called the zero lower bound. By conventional monetary logic, you could not slash interest rates below zero. As the policymakers in the Government and the legislature across different countries were unwilling to go full throttle on the fiscal policy option, due to worries about the size of the national debt and fiscal deficit, and instead settled on medium size fiscal stimulus packages which were deemed inadequate by many Post Keynesians in particular, it was left to the Central Banks to find the right mix of inflation and unemployment. As their conventional options had been already exhausted, they had to turn to a mix of unconventional tools like Forward Guidance and Quantitative Easing (QE) to give a boost to the recovery process.
Let us now turn to the main measures the major central banks of the world took after the 2008 Global recession broke out. These include policy measures by the US Fed, Bank of England (BoE), the European Central Bank (ECB), and the Bank of Japan (BoJ). Notably, the BoJ was practising unconventional monetary policy from a much earlier point of time as Japan had plunged into prolonged deflation in the late 1990s.
The severity of the economic crisis and the impairment behind using conventional monetary tools forced the central banks to use their balance sheets in an unconventional way to augment liquidity. The Central Bank of the advanced economies took the lead in this regard. The Quantitative Easing (QE) programmes were launched by the US, the UK and Japan in different forms.
The collapse of Lehmann Brothers triggered the financial crisis in the US which left the economy reeling with high rates of unemployment and low rates of growth. The Fed launched successive rounds of QE to give a boost to the economy through the financial markets. The first two rounds of QE reactivated financial markets but failed to spur growth. Under operation Twist in September 2011, the Fed launched a third round of QE which involved purchasing back of long-term securities and selling of short-term securities in order to bring the long-term real interest rate down. The intention was to increase the money supply and spending activity in the real economy so as to give a boost to economic growth and also subsequently reduce unemployment. It continued for a while and then the Fed later started to ease out of the Bond buying program.
In March 2009, the Bank of England (BoE) started its asset purchase programmes which consisted almost exclusively of government bonds from the non-bank private sector. Subsequently, the Funding for Lending Scheme (FLS) was put in place in July 2012 with the aim of incentivising banks and building societies to boost their lending to the UK real economy.
There have been a variety of other unconventional monetary policy tools like Forward Guidance, negative interest rates and TLTRO (Targeted Long-Term Refinancing Operations) which have been pretty useful in comparison to traditional monetary policy tools which have lost their edge because of zero lower bound limits.
The unconventional monetary policies have had varying degrees of success. While in advanced economies the QE programs increased the size of central bank balance sheets substantially and as a result, the intended effects didn’t initially get transferred to the real economy, later rounds saw a substantial fall in yields from both Government Treasury bonds and private bonds by a substantial range of about 20–80 points. This made holding bonds in lieu of money less attractive and thus increased money supply and as a result, spending also increased. This gave an impetus to reducing unemployment. Expectedly inflationary pressures should have also occurred but the inflation rate remained way below target in most advanced economies. This might be due to persistently anchored inflation expectations.
The emerging economies, which were supposed to be insulated from the spillover shocks of the Global recession, actually suffered bouts of instability in various degrees. They adopted unconventional policies too and there were high capital inflow pressure and inflationary pressures as a result. Though, as the emerging economies were more protected due to domestic buffers, they recovered relatively quickly.
The world reeled from the shock of the 2008 crisis for a long time and it took almost 7 years for the US to recover all of its lost jobs. With the post-recovery economy in a nascent stage, another major disruptive event has occurred with the COVID 19 pandemic striking this year. The fear of the unknown virus forced countries to go into an unforeseen lockdown virtually shutting every economic activity. The adverse impacts of the lockdown lasting months were very evident in developing economies like India where a good number of jobs (about 2 crores) were lost over the course of the shutdown.
In such a situation, conventional monetary policy is being deemed more and more irrelevant as tools like bank rate-setting or repo rate changes are failing to send the right signals to the markets with consumer spending not picking up due to fear of the virus.
This means that the stage is set for the application of fiscal policy tools and unconventional monetary policy instruments on a larger scale.
This graphic from Bloomberg shows that countries are deciding to delve deeper and deeper into hitherto unexplored realms of monetary policy. The Fed is buying different types of bonds and diversifying QE efforts, the ECB is getting creative with negative interest rates, and Australia is adapting Japanese style strategy to control bond yields.
Even India, which has largely relied on conventional tools for monetary policymaking till now, is opening up more and more to alternative instruments such as yield control and forward guidance.
With global economic outlook still uncertain, it is likely that the monetary policy will be extra loose for a prolonged period of time, probably more than the 2008 Financial crisis period, as the COVID 19 crisis is likely to be much more destructive than the 2008 recession.
The need to prop up economies has not only forced Central Banks to stretch their boundaries and explore new options, but it has also propelled them towards working with their fiscal counterpart, the Government.
The Modern Monetary Theory (MMT), which tells us not to worry about the size of the fiscal deficit as money can come from anywhere at all times as long as the Government wants it to come (given it has a sovereign currency), provides some key insights into how the present crisis might be resolved with a mixture of fiscal and monetary policy. It emphasises that the Government should keep spending money till it stretches the limits of the real economy and starts causing inflationary pressures and that the money can always be brought by a simple adjustment in the Central Bank’s balance sheets. The Government expenditure will put money in people of hands and encourage them to spend. Investment in social security programmes and a job guarantee will even push the recovery further and propel a cycle of self-fulfilling growth. So Central Banks have to look even beyond the scope of their duties and coordinate with their fiscal counterparts if necessary, even though the two are supposed to be separate.
Anyway, it seems that in the near and foreseeable future, conventional monetary policy tools are likely to become more and more obsolete and irrelevant and replaced by the new normal and conventional type of monetary policy. Back to back major economic disruptions within a span of 12 years spanning across the world have a major role to play in the decline of the usefulness of conventional monetary policy tools. We must be prepared for such crisis in the future because they can strike anytime and adopting unconventional tools of monetary policy as we have discussed and also having a greater role for fiscal policy seem to be good ways to do that. Also, recovering from the present crisis also requires a prudent mix of measures like Forward Guidance and negative interest rates and also fiscal policy measures like economic stimuli packages of a large scale. Unfortunately, conventional tools of monetary policy don’t seem to have a place in the world of the future.
REFERENCES
- https://economictimes.indiatimes.com/news/economy/policy/the-year-unconventional-monetary-policy-turned-conventional/articleshow/78088216.cms
- Deepak Mohanty: Unconventional monetary policy — the Indian experience with crisis response and policy exit, Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the Reserve Bank Staff College (RBSC), Chennai, 26 December 2013.
Originally published at https://www.studentsofeconomics.com.
