Is monetary policy alone enough to stimulate economic recovery?

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I. Introduction

Monetary policy refers to what “[a] central bank does to influence the amount of money and credit in [the] economy … to promote maximum employment, stable prices, and moderate long-term interest rates” depending on the how the economy is performing.1 The three biggest tools that are used by the Federal Reserve (Fed) are open market operations, which are purchases and sales of assets by the Fed, changes in Federal Funds Rate, the interest rate for interbank lending, and changes in reserve requirements of banks. In an economic crisis, the Fed purchases financial assets from banks—mostly U.S. treasury bonds—through open market operations to increase banks’ reserves and bring down the interest rate by increasing demand for U.S. treasuries. By lowering the Federal Funds Rate, the Fed will try to increase interbank lending and eventually hope for increase in lending to households and businesses at a time of a recession. Furthermore, the Fed will lower the reserve requirements of banks so that banks have more flexibility in lending out money to households and businesses to stimulate recovery.

II. Limitations of Traditional Monetary Policy Tools

The goal of open market operations is to stimulate recovery by lowering interest rates. However, a central bank will not be able to lower the interest rate after the interest rate hits 0%.After the interest rate approaches zero in a time of crisis, there are not many differences from lowering it further. Japan has been facing this problem since its lost decade from early 1990s when the bubble burst. Ever since Bank of Japan (BoJ) lowered the nation’s interest rate to 0.75%in September 1995, BoJ has never increased the interest rate above 1%.2  Despite the low interest rate, the economy has failed to pick up for nearly two decades now. The Fed also tried to spur growth using lower long-term interest rate even further by executing Operation Twist in September 2011. Operation Twist is an attempt to lower long-term interest rates even further by shaking up the portfolio of the Fed’s U.S. treasury bonds with more long-term maturity bonds and less short-term treasuries. At this time, the market was expecting the Fed to take aggressive policies in response to the stagnant growth, high unemployment, and European Debt Crisis, but the S&P 500 actually fell after Operation Twist was announced on September 2011 from 1203.63to 1166.76.3 Also, interventions of central banks through open market operations, such as the Fed’s Operation Twist or Bank of England’s U.K. stimulus plans, have caused distorting effects on the market. One example is long-term yields of treasuries and gilts to fall even further, causing institutional investors to purchase these basically risk-free assets at an unacceptable rate that’ squeezes the returns out of long-term bonds. In addition, the interventions of central banks have limited portfolio management options for investors by the massive amount of bonds they areholding.4

Other attempts to boost liquidity and flow of money among banks, businesses, and households, such as lowering the Fed Funds Rate and lowering the reserve requirement ratio, have their own limitations also. In the financial crisis and European Debt Crisis, the biggest problem was a freeze in not only lending to businesses and households but also interbank lending. In 2008, banks were unsure of which bank or institution was exposed to subprime mortgage backed securities. This caused the banks to freeze and tie down their capital instead of lending it out to risky investors. Also, banks had to increase their reserves to prepare for any other shocks that may have been coming their way. The European Debt Crisis has a similar story to it. Investors were not sure of which European banks were exposed by how much to Greek bonds, and this led to a huge loss in value of mainly French and German banks and a freeze between interbank lending. Banks started to pile up cash despite the low interest rate they borrowed at from the Fed of European Central Bank (ECB). The graph below is the increasing level of excess reserves in U.S. banks and the required reserve ratio.5

 

III. Solutions Other Than Traditional Monetary Policy Tools

 

Other than the traditional monetary policy tools that includes treasury purchases, change in the Fed Funds Rate and reserve requirement ratios, the Fed or the government can look into unconventional ways to boost growth and employment. First, there is fiscal policy, which is theuse of government expenditure and tax collections to influence the economy. Keynesian Economists argue that increase in government spending and a decrease in tax rates will stimulate the aggregate demand of the economy, and this reasoning was the basis for the New Deal Programs after the Great Depression by U.S. President Franklin D. Roosevelt. This option ,however, has its own dangers. Although the U.S. has succeeded in climbing out of a recession with the New Deal Programs, this would not be applicable to several developed countries today that are plagued with government deficit spending. Hefty spending by the government without realizing that they will be unable to repay the debt has led to the European Debt Crisis, triggered by Greece, Italy, Portugal, and others. Even the U.S. faced its first downgrade of its credit rating by S&P in August 2011. Also, there is a chance of misspending like the case of Japan. The Japanese government has spent more than 4% of GDP into public investments despite its gross debt has reached approximately 200% of GDP in 2010.6 With their huge spending, Japan has created excess infrastructure, and this has still not helped the country climb out of the “Lost Decade.”

Secondly, there are unconventional purchases of assets that can be made by the Fed and the government. As shown in the graph below, the Fed increased the purchase of toxic assets and credit programs up to 1,200 billion dollars starting from 2008, which was unusual because the Fed mostly dealt with U.S. treasuries before 2008.7

 

 

This has drawn heated debates within economists and politicians with the U.S. Presidential Race heating up, and some have criticized this move for triggering inflation and not lowering the unemployment enough. However, the inflation rate under the tenure of current Fed Chairman, Ben Bernanke, has only been “an average of 2.4%” which is “lower than the 3.1% for Alan Greenspan and 6.3% for Paul Volcker.”8 The unemployment rate also has been going down recently with economic figures better than expected, which is showing how the Fed Policy has worked partially. Also, the government has made bailouts to companies in trouble through Troubled Asset Relief Program, which allowed the Treasury to aid troubled firms by purchasing stocks and massive lending. These decisions raised controversy that the government intervened with taxpayers’ money, and there were voices of concerns on moral hazard. After saving these companies that were “too big to fail,” this would last as a precedent for future crises. Nonetheless, Word Count: 1465we are only able to speculate on what could have happened if these bailouts and aid programs did not exist. Even with these policies, the global economy suffered a great deal, and who knows what would have gotten even worse without these relief programs.

III. Conclusion

No single policy is can be the perfect answer for a crisis, and every policy has its limitations. This does not mean monetary policy has lost its importance in the economics of central banks, and monetary policy will always be the first and most fundamental tool to be used by central banks. In times of severe crisis, as in the financial crisis of 2008, central banks and governments will have to consider unconventional policy tools in order to mitigate the threats of unemployment and deflation, maintain a certain level or increase liquidity, and boost aggregate demand in order to pick up the economy as soon as possible. A combination of various monetary policy tools, government actions, unconventional central bank interventions, and fiscal discipline will always have to be considered depending on the economy’s different situations and the nation’s economic structure.

 

References: 
  1. “Monetary Policy Basics,” Federal Reserve Education of the Federal Reserve,http://www.federalreserveeducation.org/about-the-fed/structure-and-funct...
  2. “The Basic Discount Rate and Basic Loan Rate,” Bank of Japan Statistics, http://www.boj.or.jp/en/statistics/boj/other/discount/discount.htm/
  3. "S&P 500 Historical Data,” Standard & Poors, http://www.standardandpoors.com/indices/sp- 500/en/us/?indexId=spusa-500-usduf--p-us-l--
  4. “Fed’s ‘Operation Twist’ Tangles Treasury Trade,” Wall Street Journal, http://online.wsj.com/article/SB1000142405297020331580457721130304241603...
  5. “Statistical Release on Aggregate Reserves of Depository Institutions and the Monetary Base October 2011,” The Federal Reserve
  6. “Economic Survey of Japan 2009: The Fiscal Policy Response to the Crisis and Achieving Fiscal Sustainability,” OECD, http://www.oecd.org/document/37/0,3343,en_2649_34595_43783525_1_1_1_1,00...
  7. “Why Are Banks Holding So Many Excess Reserves,” Todd Keister and James McAndrews,nFederal Reserve Bank of New York’s Current Issues in Economics and Finance, December 2009
  8. “Bernanke-Led Economy Proving Critics Clueless About Federal Reserve Policy,” Bloomberg, http://www.bloomberg.com/news/2012-02-08/bernanke-led-economy-proving-cr... federal-reserve-policy.html