Consider an allegory1.
Say there is a dying garden that needs revival. You figure out that it needs watering. You connect a suitably long garden-hose to the nearby tap, and continue watering the plants for some time. The garden however refuses to show any improvement.
The policy questions then can be threefold.
Q1. Is there something wrong with the hosepipe? Or else you could infinitely go on turning the tap and the plants still wouldn‟t be receiving the desired quantity of water. (Are the channels of monetary transmission reliable?)
Q2. Can the garden recover alone on water? Are there other things too that need to aid its recovery? (Is monetary easing alone enough for recovery?)
Q3. If the garden isn‟t recovering, then will flooding it with water solve its problems? (Is ‘more’ monetary easing the key to a slowdown?)
Does turning on the tap necessarily ensure mean that the garden is being watered?
The god of monetary policy works (or does not!) in mysterious ways...
For one, it depends on what kind of economy it is operating in. For a developing country like India, the relevance of central bank policy rates came only with the reforms and liberalization in 1990‟s that introduced market determined rates to the economy. Infact till 1997, the RBI2 was expected to automatically monetize the government‟s fiscal deficit, effectively creating inflationary pressures at the behest of the government! India finally passed an act on fiscal responsibility as late as 20033.
Hence the effectiveness of monetary transmission in assisting recovery in a developing economy depends crucially on the maturity of its reforms.
The developed economy case is no less complex. The success of monetary policy then becomes vulnerable to the vagaries of the economy. As a simple example, suppose the dominant channel of monetary transmission for a small open economy is through exchange rates – low policy rate weakening the currency; hence encouraging exports (increasing output) and making imports expensive (increasing inflation). But during a crisis if the country is unable to keep its export sector competitive or its domestic demand for imports falters; then the rationale of lowering policy rates stands defeated.
Similarly a crisis that clogs potential monetary transmission channels like the banking system, or the housing market, or financial markets; can severely impair the effectiveness of monetary policy. These institutions would need repairing; which may not be entirely in the central bank‟s mandate. At best it could support markets by purchasing private sector assets to reduce risk premiums and improve liquidity.
And finally, monetary policy will be impotent for an economy opting for fixed exchange rate and open capital account; as per the celebrated „Impossible Trinity‟. Hong Kong finds itself on such a vertex. However real world experiences have shown that the assumptions behind the trinity are often too simplistic to hold. A number of East-Asian economies in the past decade have been able to maintain open capital markets and partially manage their exchange rate; while enjoying relatively independent monetary policy4.
Does watering the garden really help?
It is really interesting to once again draw parallels with an emerging market. In India, real GDP growth slowed down from 8.4% in FY5 2011 to an expected 6.9% in FY 20126. Fiscal stimulus will be suboptimal since India is already saddled with high fiscal deficit. The RBI, that had tightened policy rates by around 525 basis points since 2010; is now expected to reverse gears. Monetary policy here is explicitly being used to cure growth slowdown.
In many ways, economists will argue that this is precisely what the proverbial „Macroeconomics 101‟ course trained them to expect. Central banks should try to bring down long term interest rates by lowering policy rates. The basic idea behind quantitative easing is also to ultimately reduce yields, and increase expected inflation. In the process, ex-ante real interest rate, (nominal interest rate adjusted for expected inflation) ought to fall below the equilibrium rate7 for the economy, and hence stimulate aggregate demand.
But in the case of developed nations, the liquidity trap makes this theory just too good to be true! In a liquidity trap, the central bank has already reduced nominal policy rate to zero levels. But the dismal economic outlook causes people to rather hold onto cash than financial securities, effectively checkmating conventional monetary policy. The much debated „monetary‟ escape route out of the trap is for it to be expansionary enough to change public‟s perception of future inflation and interest rates. Ultimately it is the central bank telling the public that it is willing to tarnish its reputation of maintaining low inflation; till growth has credibly improved.
But if the panacea is to raise inflationary expectations...then why doesn’t the government simply raise the prices of some goods and services?
Supply side pressure on prices will easily translate into demand side inflation. More importantly, the general rise in prices should have a rapid effect on inflationary expectations...and voila, the issue is solved!
Somehow this assails common sense! How can low demand be stimulated by higher prices8?! Many would say that it reminds them of stagflation in the UK of the 1970‟s – a trap of low growth and high inflation. The funny thing is that high global commodity prices currently are building inflationary pressures in advanced economies. UK‟s CPI (Consumer Price Index) has been rising above 3% (y/y) since 2010 while US‟ CPI has risen from 1% in mid-2010 to around 3% currently9. And the magnanimous quantitative easing that these economies are currently conducting will ensure that inflation remains elevated going forward.
Hence real interest rates ought to be lower now than they would have been in the case of outright deflation. However aggregate demand doesn‟t seem to be responding to these reduced real rates. Wherein lies a partial rebuttal to the argument of exogenously raising prices – the whole idea behind lowering real interest rate is to inspire business and consumer confidence, and hence lead to increase in aggregate demand. Heightened prices alone do not solve the issue.
So too much of water doesn’t work?
Will consumers spend; businesses make investments; and banks increase lending, if interest rates are low enough. During a crisis, businesses are likely to be influenced more by the absence of demand and banks, by the risk of lending; than the low cost of funds. This could explain why much of the excess liquidity from quantitative easing has been channeled into fuelling rallies in commodities and taking speculative positions on currencies, than productively increasing lending to businesses and consumers. Infact the excess liquidity in the system effectively bails out risk takers, creates perverse incentives for debt accumulation, and creates risk for future inflation.
Or is it that equilibrium real rate is too low?
Reducing the real interest rate is basically to get it below the equilibrium rate. But suppose it is too low to begin with? The equilibrium real interest rate is theoretically determined by the intersection of an upward sloping savings curve and downward sloping investment curve. Higher consumption (and hence lower savings) raises the rate. So does a pickup in productivity growth and increase in working age population (which will increase investment demand). During a crisis people become more inclined to save; hence leading to drop in the equilibrium rate. Fiscal spending is meant to effectively counter the dis-saving of the private sector. Much of it is beyond the ambit of conventional central banking.
So simply dump monetary policy?
Suppose central banks hadn‟t reacted at all to the current crisis? For one, higher policy rates would ensure that aggregate spending to be much lower that it is presently. Also the absence of excess liquidity would keep credit spreads high in key markets causing systemic financial instability. Strains in financial markets would then spill over to the broader economy; which in turn would generate even greater market uncertainty; hence creating adverse feedback loops10.
Final prognosis: gardening can be very difficult!
The essay tries to analyze the possible challenges facing monetary policy if it had to stimulate the recovery alone. The first stop for diagnosis was the channels of monetary transmission. The essay evidences how their effectiveness varies with the economic and regulatory milieu. Next the essay shifts from the channels to the concepts of monetary policy. It argues that the stimulating demand through lowering real interest rates is not at all straight-forward. Especially with the target equilibrium rate being determined by a host of non-monetary factors. But does all this mean that expansionary monetary policy is completely useless under an economic slowdown?
The romantic-at-heart essayist feels that the importance of loved ones is best realized in their absence! The same also goes for monetary policy. Only that you can‟t sustain just on love!
An extended metaphor wherein a story illustrates an important attribute of the subject.
Reserve Bank of India, India‟s central bank.
The FRMB (Fiscal Responsibility and Budget Management) Act, enacted by the Indian Parliament in 2003.
The „Impossible Trinity‟ has voluminous academic literature to its credit, which is beyond the scope of the topic. A couple of papers where the point raised in the essay, has been highlighted include: Grenville, S. 2011. “The Impossible Trinity and Capital Flows in East Asia.” ADBI Working Paper No. 319. Tokyo: Asian Development Bank Institute; Patnaik, I., and A. Shah. 2010. “Asia Confronts the Impossible Trinity.” ADBI Working Paper 204. Tokyo: Asian Development Bank Institute.
Fiscal Year (April – March)
Advance estimates from the Government of India.
There is considerable literature on what qualifies as measures for real rates and more importantly „equilibrium‟ real rates. We progress with the essay assuming that they can be suitably defined for an economy.
Incidentally Tobin had first suggested in 1972 that a small amount of inflation could help „grease the wheels‟ of the economy since workers like to see rise in nominal wages. On the other hand, zero inflation with downward wage rigidity, could potentially lead to higher unemployment. Numerous academic studies have followed trying to either dispute the claim, or quantify the extent of „grease‟ required!
Similar trends observed in core CPI (ex-food and fuel) inflation for the US and the UK.
Also referred to as the financial accelerator. [Bernanke, Ben S., M. Gertler, and S. Gilchrist. 1996. “The Financial Accelerator and the Flight to Quality,” Review of Economics and Statistics, 78: 1-15.; Bernanke, Ben S., M. Gertler, and S. Gilchrist. 1999. “The Financial Accelerator in a Quantitative Business Cycle Framework,” in John B. Taylor and Michael Woodford, eds., Handbook of Macroeconomics, vol. 1, part 3. Amsterdam: North-Holland: 1341-93.]
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