Is monetary policy alone enough to stimulate economic recovery?

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Dan Vasko's picture

Introduction

In recent decades, monetary policy continuously took over the key role in smoothing business cycles. During the so called “Great Moderation”, mild recessions were wiped out rather easily by decreasing reference interest rates, mostly based on Taylor rule. However, the recent large adverse shock originating in the US housing market caused a financial crisis followed by a global crisis of real economy that got out of control of conventional monetary policy. United States and almost all European countries got stuck in the situation of liquidity trap which led to rethinking of the traditional techniques in monetary policy.

This essay will describe differences between monetary policy transmission in tranquil times and the situation of liquidity trap, highlight the assumptions of efficient policy making in liquidity trap and suggest innovations for inflation targeting that might be used for stimulating economic recovery.

Liquidity traps

Traditional framework of monetary policy is very simple. Under inflation targeting regime1, central bank compares its inflation forecast with inflation target. It decreases interest rates to stimulate the economy whenever the prediction is below the target and vice versa. However, if adverse shock is too large, central bank depletes this instrument by lowering the interest rate to almost zero (short term nominal interest rates cannot fall below zero). Open market operations, the prevailing policy instrument in advanced countries, become inefficient as markets are indifferent between money and bonds2. In such situation, higher inflation expectations are desirable because they would decrease real interest rates3 and therefore stimulate the economy.

US got into this situation at the end of 2008 and the FED has since then used quantitativeeasing4 (QE) several times to avoid deflation and start inflation expectations. QE has three channels of how to influence inflation. First, it increases the amount of money in the bank reserves. However, in times of financial crisis, there is usually not sufficient demand for borrowing and thus, the money will not get into real economy. Second, it will increase demand for government bonds and therefore, it should increase its price and decrease the yield. Nevertheless, this channel is based on expectations about the yield curve that is partly determined by the future short-term interest rates. The last transmission channel is direct inflation expectations of the markets. In other words, we argue that in times of financial turmoil, quantitative easing will stimulate the economy only under the assumption that central bank succeeds in changing inflation expectations - persuading markets about higher inflation in the future.

One way of doing so is by explicit communication about the future path of interest rates. This was recently done by the FED announcement about prolonged period of interest rates close to zero (probably till the end of 2014). Such rhetoric should make the long-term bonds more attractive, increase their price and decrease yields. In reality, this effect was only partial and temporary; FED did not succeed entirely in persuading the markets that it will actually hold these low interest rates for so long. Such policy also leads to either long period of cheap money and thus increased leverage and risk of future asset bubbles and high inflation or, in case of not fulfilling the rhetoric, damage of the central bank reputation.

Further, in order to lower the risk of getting stuck in liquidity trap in the future, central bankers might consider keeping increased inflation target permanently. This would give the central bank more space for expansionary monetary policy if needed and therefore ability to accommodate larger adverse shocks avoiding liquidity trap. Again, we would like to highlight the fact that if the central bank succeeds to fix the inflation expectations at this higher level, according to economic theory, the costs for the economy of a single digit and relatively low expected inflation are very low.

Obviously, this cannot be considered as a general solution and one has to consider the specifics of the economy and especially the ability of central bank to change inflation expectations. Moreover, inflation forecast, especially probability of deflation and also specifics of the transmission channels in the particular country should be taken into account. Last but not least, policy makers should not neglect the effect of permanent higher inflation on exchange rate, especially in the case of small open economies.

Also, we are aware of the fact that the public in advanced countries has little experience with increasing inflation targets and it might take some time to adjust the expectations. Increased monetary policy transparency and intense communication should help to speed up this process.

Last but not least, this measure should be in compliance with legislation as in most of the central bank acts, the main objective of the central bank is to “maintain price stability” without specification of the term.

Conclusion

Situation in the global economy in the last five years led to rethinking of traditional monetary policy and development of new approaches and techniques. This essay suggests that the policy makers should consider the option of escaping liquidity trap with the costs of permanents light increase in inflation, but without significant loss of the central bank credibility. Thus the central bank should not lose its ability to influence inflation expectations and it might perform disinflationary policy in the future if needed.

In general, there are three main values that the central bank should care for under any circumstances – its independence, credibility and the real economy. The suggested approach of increasing the inflation target (temporarily or permanently) has no effect on the independence, it should not harm the credibility in case of fulfilling the inflation target and it would serve as a significant positive impulse for the real economy. In other words, we believe that under the assumption of the ability of the central bank to influence the inflation expectations towards its new target, this technique should be enough to stimulate the economy, keeping costs at minimum.

References: 
  1.  WOODFORD, Michael (2007): The Case for Forecast Targeting as a Monetary Policy Strategy,Journal of Economic Perspectives, Vol. 21, No. 4, pp. 3-24
  2. BLANCHARD, Olivier, Dell’Ariccia Giovanni, Mauro Paolo: Rethinking Macroeconomic Policy,IMF staff position note, February 2010, SPN/10/03
  3.  Bank of England, Monetary Policy Division (2009): Quarterly Bulletin 2009 Q2 – QuantitativeEasing, pp. 90-100
  4.  REUTERS (2012): In historic shift, FED sets inflation target, available online (2012-01-26):http://www.reuters.com/article/2012/01/26/us-usa-fed-inflation-targetidU...
  5. FINANCIAL TIMES (2012): FED set path for three years of low rates, available online (2012-01-26): http://www.ft.com/cms/s/0/337d5e68-4772-11e1-b847-00144feabdc0.html#axzz...