The economic and financial crisis is forcing monetary policy to be reinvented at a fast pace. Record cuts in official interest rates, down to the lowest limit of 0%, were not enough to relieve worrying recessionary situations. Given this situation, the implementation of unconventional stimulus measures went from being a possible but contentious option to an indispensable tool.
Broadly speaking, two unconventional types of measures have been implemented: large-scale asset purchases and the reformulation of communication policies (forward guidance). The aim of both strategies: to reduce long-term interest rates and thereby encourage investment and consumption. For the moment, the balance sheets of the main central banks have been substantially expanded and altered. Compared with its pre-crisis size, that of the Fed has tripled while the ECB has doubled its balance sheet. Moreover, the Fed has promised to keep its official interest rate at current levels until unemployment falls below 6.5%, provided medium-term inflation does not go above 2.5%.
In spite of far-reaching changes in how monetary policy is handled, growth in developed countries is still very weak. This, however, does not mean that monetary policy is not expansionary enough or that it is not having any effect. It is, above all, a reflection of the far-reaching adjustment processes that are being carried out and that, if these measures had not been taken, would have probably led to a much deeper recession.
But attempting to avoid this even more recessionary scenario is not without risk. The direct, massive purchase of assets could encourage the formation of further speculative bubbles, both domestic and foreign, or de-anchor inflation expectations and, ultimately, destroy the fundamental aim of the monetary policy: price stability.
Nevertheless, more and more people want to go further, redesigning the focus of monetary policy at its very heart. One of the proposals that is gaining most supporters consists of replacing the current inflation target with one of growth in nominal GDP. The appeal of this target is that, in the event of a shock reducing real GDP growth, the monetary authority could implement more expansionary monetary policy although this might entail a rise in inflation.
Also being debated is how financial stability fits within a central bank’s mandate. In this respect, some sectors support policy management that systematically takes asset prices into account, especially real estate and financial, in order to stop speculative bubbles from forming.
The rules and tools that will guide monetary policy in the future have yet to be determined but we are unlikely to return to the monetary policy of the past, with one tool (the interest rate) and one target (inflation). For the moment, the number of tools has been expanded; it remains to be seen how far the targets will change. Caution and transparency must be the two essential principles underlying this transition to ensure that monetary authorities do not lose their main asset: credibility.
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