Thematic Blogspot: Rethinking Monetary Policy in Times of Secular Stagnation
With nominal interest rates at (or close to) 0 in major economies since 2009 (IMF, 2009), risks of secular stagnation (see our WS Thematic Blogspot) raise a key question: what are the challenges central banks face to support recoveries and foster long-term growth?
The Zero Lower Bound Constraint: UMPs and Exit Strategy
What alternative monetary policy tools at the zero lower bound? The zero lower bound (ZLB) refers to Central Banks being constrained to further stimulate the economy when policy rates are taken down to zero (IMF, 2010). According to Mishkin, it is a much more serious problem than central bankers anticipated, far more prevalent than earlier researches suggested and not short-lived at all. Unconventional Monetary Policies (UMPs) and expectations management are two central pillars to improve central banks’ reactiveness and effectiveness.
The 2008 financial crisis reminded decision-makers of the limits of conventional countercyclical policies (Jordi Gali, 2014). As policy rates hit the zero bound, Quantitative Easing (QE), first adopted as an emergency measure, became central to the policy toolkit, mainly in the US, Japan and UK. Borio and Disyatat (2009) define UMPs as central banks actively expanding their balance sheets to offset directly market prices and conditions beyond a short-term, typically overnight, interest rate horizon—required in exceptional times (ECB, 2010).
Effectiveness of QE. Has QE been effective in impacting the term structure of interest rates? An IMF Policy Paper (2013) finds that UMPs helped repair market functioning: they “lowered term premia in money market rates and increased the availability of short-term financing.” The US Large Scale Asset Purchases had large beneficial spillovers on global financial markets and Fratzscher and al. (2013) demonstrate how US QE “contributed to portfolio reallocation as well as a re-pricing of risk in global financial market”. Gagnon and al. (2011) find evidence of “long-lasting reductions in longer-term interest rates” thus alleviating credit constraints while easing banks’ deleveraging process. Kenneth Rogoff is more cautious about the effectiveness of QE given the uncertainty about the depth of distortions in the monetary transmission channel stemming from financial markets.
Is it too late for the Eurozone? The ECB engaged into credit easing by raising the scale of its liquidity-providing operations but refrained from purchasing corporate or sovereign bonds on markets. Measures followed a sequence of credit easing as part of the Enhanced Credit Support (ECB, 2014) with Outright Monetary Transactions in conjunction with three-year Long Term Refinancing Operations (3y-LTRO) in 2011 and Targeted LTRO (TLTRO) in 2014. Reza Moghadam and Pelin Perkmen (2014), in an IMF blog entry, stress that a lesson from the Japanese deflation experience is the need to act forcefully before deflation sets in.
Despite Claeys and al. (2014) blaming the ECB for not having eased monetary conditions earlier, some economists argue QE would not be effective in the Eurozone. The intermediated system prevailing in the Eurozone cannot be compared to market-based economies such as the UK or the US. Sylvia Merler writes that Eurozone banks are not actually short of liquidity, especially after years of exceptionally low interest rates—as reflected in the mixed success of the first auction of the ECB’s TLTRO program. According to Daniel Gros, lower long-term rates for government bonds in the Eurozone are thus unlikely to improve corporations’ financing conditions. Claire Jones raised concerns about the adequate targeting of the ECB loans while Angeloni questioned their effectiveness in bailing-out banks.
A key issue is whether there are sufficient liquid assets in the eurozone that the ECB could purchase. Reza Moghadam, in an IMF blog on QE, writes that with a small market for securitized bank assets, for corporate bonds, and liquid but concentrated bank bonds, sovereign bonds are the only viable option, with purchases that should be across the board as is the inflation problem. Armand Beaude and Per Yann Le’Floch, in a WS BlogSpot, look at specific proposals. Luis Garicano and Lucrezia Reichlin, in a VoxEU article, argue that the main issue with QE in the eurozone is that the ECB faces a quandary on what to buy. They propose that the ECB buys ‘Safe Market Bonds,’ i.e., synthetic bonds formed by the senior tranches of EZ national bonds combined in GDP-weighted proportions. The ECB would merely announce the features of the synthetic bonds it will purchase. The market would create the bonds in response, thus avoiding new EZ-level institutions or funds. For Peter Kazimir and Yanis Varoufakis, the ECB should consider buying European Investment Bank bonds if it eventually decides to go for quantitative easing. The EIB could finance an investment program through issuing bonds that would then be bought up on secondary markets by the ECB (reported by Reuters).
Pisani-Ferri and Wolff (2012) argued further that macroeconomic heterogeneity in the Euro Area is a main obstacle to successful ECB’s interventions. According to Ashoka Mody, this heterogeneity resulted in a mixed impact on yield curves and a relative failure to provide for a sufficient monetary stimulus to the weakening Eurozone economies. On the contrary, De Santis and Surico (2013) highlights banks ‘response to monetary policy (e.g: elasticity of loan rates to official rates) varies across countries depending mainly on the structure of capital markets.
Exiting UMPs: will it hurt? Policymakers face a timing trade-off with QE: exiting prematurely could tip economies back into recession; exiting too late could sow the seeds of future financial instability. The BIS warned policymakers about downside financial risks and advised central bankers to start raising interest rates (Mojmír Hampl). To mitigate those two risks, Barwell and Chadha highlight the successful use of forward guidance by the BoE, which has been relying on a wide range of macroeconomic indicators to limit market volatility. Alessi and Detken (2009) come up with an effective warning signal that “predict up to 95% of costly asset price boom/bust cycles with a lead time of between five and six quarters”.
How about risks of spillovers? Koichi Amada argues that central banks should not worry about harmful capital-flow withdrawals from emerging markets but rather focus on setting appropriate inflation targets and interest rates. Uncertainty remains on the consequences of desynchronised monetary policies with the US tightening vs. Japanese and European further easing (Reuters, 2014).
Managing Financial Instability: Repairing the Monetary Transmission Channel
Repairing the intermediation role of banks. The growing role of capital markets to the credit supply (Adrian and Shin, 2009) has direct consequences on the monetary transmission channel: financial markets impact both the composition and leverage of banks’ balance sheets. Rising risk aversion and financial innovation, especially in the securitization market, disrupted the bank lending channel inciting central banks to pay more attention to financial (in)stability issues. In the Euro Area, repairing the intermediation role of banks entails shattering the sovereign-bank interdependence (Bruegel, 2012), prudently engaging into asset-backed securitization on SMEs and consumers’ loan markets (Brunnermeier and Sannikov, 2014) and completing the regulatory reform agenda of the banking sector (BIS, 2013).
Financial stability and the “leaning against the wind” debate. According to Nouriel Roubini, Mario Draghi has already learned the lessons from the Japanese experience of Abenomics and tries to replicate it into a Euro-compatible framework. While paying more attention to the interlinkages between monetary, financial and real spheres, he recognizes financial accelerator effects where asset prices and credit market conditions amplify the (in)effectiveness of monetary transmission channels to the real economy.
Economists from Euro Intelligence consider that central banks’ responses in the aftermath of the crisis were a major reversal to the Greenspan doctrine which rejected any relevance of monetary intervention to smooth and prevent asset-price booms and busts. Brunnermeier and al. (2012) take an even stronger position assuring that monetary policy failing to lean against the “build-up of imbalances and systemic risk in normal times are not credible in crisis times”.
A Taylor rule-based model augmented with asset prices and credit variables improve macroeconomic stabilization: leaning against the wind is especially desirable in the case of supply-side shocks (BIS, 2013). Should economies tolerate high unemployment for the sake of financial stability (Free Exchange, 2014)? The FED endorses this viewpoint as confirmed by Janet Yellen’s spring speech although the net costs of reduced inflation, contractionary pressure and worsened employment situation might be substantial (VoxEU, 2014).
If central banks incorporate financial stability into their core mandate as Eichengreen and al.(2014) suggest, they may face conflicting objectives between inflation and financial targets. How to deal with the financial excesses arising from long-lasting expansionary monetary policy in a situation of low growth and deflationary risks? Expanding macroprudential surveillance to systemic interactions (Bruegel, 2013) rather than leaning against the wind might be a more effective tool according to Simon Wren-Lewis.
What role for UMPs in the longer run? Daluiso and Papadia (2013) suggest that large asset-purchase programs reflect central banks’ weakened control over interest rates. They should be used as long as there is a disruption in the monetary transmission channel: they stand as emergency resort tools but not as permanent instruments to maintain financial stability.
Nevertheless, and regardless of the zero lower bound constraint, asset purchase programs better deal with financial stability than traditional interest rate monetary policy because they limit the side effects of risk-taking. Bekaert and al. (2013) show a behavioural channel: monetary easing nurtures risk taking as financial managers are incentivized to turn toward riskier illiquid assets in a low rate environment. Central banks may lose control over financial cycles and ultimately over policy rates if following financial stability objectives.
What are the practicalities associated with a financial stability function? Cardiff Garcia (2014) refers to Bernanke’s separation principle between central banks’ core function of policy rate setting based on short-term rates and extended function of financial stabiliser based on long term rates. The latter does not only depend on the expected path of short-term rates but also on term premia. This stands as a plea for central banks to engage massively in asset purchases and QE so as to impact expectations, level of confidence hence ultimately flatten the yield curve.
The rise in global liquidity leads to three subsequent types of risks: slow balance sheet repair as observed in the Euro Area, strengthened risk-taking channel and late-cycle financial risks (Caruana, 2014). The Annual BIS Report (2014) emphasizes the disconnect between financial “markets’ buoyancy and underlying economic developments globally. Monetary conditions fostered a search for yield” for the past years but should now soon normalise so as to avoid another harmful balance sheet recession.
Monetary Policy Coordination
Blossoming late-cycle financial risks in advanced countries raise concerns about global liquidity stop-and-go processes (Caruana, 2013) that could ultimately harm emerging markets. The question of monetary coordination becomes even more crucial to deal with counterproductive spillovers due to trade and financial linkages (iMF direct).
Rules-based vs. discretion-based monetary policy. Both Harold James (2013) and Josh Zumbrun (2014) support rules-based policy making resting on domestic objectives. It anchors economic agents’ expectations and avoids contradictory policies when central banks try to reach both domestic and international objectives. They view monetary policy making is similar to a Nash equilibrium that requires no coordination at the global level: each country follows the most beneficial monetary policy which results in the best international outcome. This provides a justification for the stance of G7 Finance Ministers and Central Bank Governors (2013) who confirmed “monetary policies have been and will remain oriented towards meeting (their) respective domestic objectives using domestic instruments“. In addition, John B. Taylor (2013) emphasized the relative small gains from international monetary coordination. For James, the Great Depression precedent provides an example of catastrophic central-bank cooperation.
Financial safety and spillovers management. Paolo Manasse (2012) argues that a “global problem calls for a global solution” when referring to the Eurozone crisis. Because of financial and trade integration, only a joint implementation of monetary policies can take into account spillovers, enhancing potential gains from coordination. This is even truer in times of secular stagnation whereby central banks’ policy is constrained by the ZLB (Blanchard, Ostry and Ghosh, 2013).
Because “only central banks have the balance sheet leverage to respond to volatile capital flows on the necessary scale”, Edwin Truman (2013) proposes to reinforce the role of international policy managers, such as the IMF or the BIS. As independent organizations, both are well suited for nudging policy makers toward cooperative outcomes, for helping achieving the adequate level of global liquidity and limiting negative spillovers. Eichengreen and al. (2011) urge for the creation of an International Monetary Policy Committee that would publically highlight inconsistencies in central banks’ policies. This requires strong assumptions that would be hard to overcome: (1) recognition of spillovers by advanced economies that further requires updating central bank mandates (Eichengreen and al., 2014), (2) existence of a best coordinated outcome.
Monetary and currency wars. Coordination serves to shield from currency and monetary wars (Bénassy-Quéré and al., 2014). Emerging markets highly criticized UMPs implemented by developed countries because of the side effects induced from large capital inflows (IMF working paper, 2014). Strong currency appreciation and renewed market volatility endanger the conduct of independent monetary policies due to asset prices and interest rates being more correlated globally (BIS, 2014).
Strains on coordination. Collaborative behaviors are more difficult to reach when both the size and sign of cross-border policy effects differ across countries (Blanchard, Ostry and Ghosh, 2013). To maximize the gains from coordination requires: (1) the identification of large and clear gaps between coordinated and non-coordinated outcomes and (2) the explicit contribution of each player—raising the question of how countries at different stages of the economic cycle could ever coordinate monetary policies.
