The new ab­nor­mal in mon­e­tary pol­icy

Financial Nigeria Magazine - - Contents - By Nouriel Roubini Nouriel Roubini, is a pro­fes­sor at NYU’s Stern School of Busi­ness and CEO of Roubini Macro As­so­ci­ates. Copy­right: Project Syn­di­cate

Fi­nan­cial mar­kets are start­ing to get rat­tled by the wind­ing down of un­con­ven­tional mon­e­tary poli­cies in many ad­vanced economies. Soon enough, the Bank of Ja­pan (BOJ) and the Swiss Na­tional Bank (SNB) will be the only cen­tral banks still main­tain­ing un­con­ven­tional mon­e­tary poli­cies for the long term.

The US Fed­eral Re­serve started phas­ing out its as­set-pur­chase pro­gram (quan­ti­ta­tive eas­ing, or QE) in 2014, and be­gan nor­mal­iz­ing in­ter­est rates in late 2015. And the Euro­pean Cen­tral Bank is now pon­der­ing just how fast to ta­per its own QE pol­icy in 2018, and when to start phas­ing out neg­a­tive in­ter­est rates, too.

Sim­i­larly, the Bank of Eng­land (BoE) has fin­ished its lat­est round of QE – which it launched af­ter the Brexit ref­er­en­dum last June – and is con­sid­er­ing hik­ing in­ter­est rates. And the Bank of Canada (BOC) and the Re­serve Bank of Aus­tralia (RBA) have both sig­naled that in­ter­est-rate hikes will be forth­com­ing.

Still, all of these cen­tral banks will have to rein­tro­duce un­con­ven­tional mon­e­tary poli­cies if an­other re­ces­sion or fi­nan­cial cri­sis oc­curs. Con­sider the Fed, which is in a stronger po­si­tion than any other cen­tral bank to de­part from un­con­ven­tional mon­e­tary poli­cies. Even if its nor­mal­iza­tion pol­icy is suc­cess­ful in bring­ing in­ter­est rates back to an equi­lib­rium level, that level will be no higher than 3%.

It is worth re­mem­ber­ing that in the Fed’s pre­vi­ous two tight­en­ing cy­cles, the equi­lib­rium rate was 6.5% and 5.25%, re­spec­tively. When the global fi­nan­cial cri­sis and en­su­ing re­ces­sion hit in 2007-2009, the Fed cut its pol­icy rate from 5.25% to 0%. When that still did not boost the econ­omy, the Fed be­gan to pur­sue un­con­ven­tional mon­e­tary poli­cies, by launch­ing QE for the first time.

As the last few mon­e­tary-pol­icy cy­cles have shown, even if the Fed can get the equi­lib­rium rate back to 3% be­fore the next re­ces­sion hits, it still will not have enough room to ma­neu­ver ef­fec­tively. In­ter­est-rate cuts will run into the zero lower bound be­fore they can have a mean­ing­ful im­pact on the econ­omy. And when that hap­pens, the Fed and other ma­jor cen­tral banks will be left with just four op­tions, each with its own costs and ben­e­fits.

First, cen­tral banks could re­store quan­ti­ta­tive- or credit-eas­ing poli­cies, by pur­chas­ing long-term govern­ment bonds or pri­vate as­sets to in­crease liq­uid­ity and en­cour­age lend­ing. But by vastly ex­pand­ing cen­tral banks’ bal­ance sheets, QE is hardly cost­less or risk-free.

Se­cond, cen­tral banks could re­turn to neg­a­tive pol­icy rates, as the ECB, BOJ, SNB, and some other cen­tral banks have done, in ad­di­tion to quan­ti­ta­tive and credit eas­ing, in re­cent years. But neg­a­tive in­ter­est rates im­pose costs on savers and banks, which are then passed on to cus­tomers.

Third, cen­tral banks could change their tar­get rate of in­fla­tion from 2% to, say, 4%. The Fed and other cen­tral banks are in­for­mally ex­plor­ing this op­tion now, be­cause it could in­crease the equi­lib­rium in­ter­est rate to 5-6%, and re­duce the risk of hit­ting the zero lower bound in an­other re­ces­sion.

Yet this op­tion is con­tro­ver­sial for a few rea­sons. Cen­tral banks are al­ready strug­gling to achieve a 2% in­fla­tion rate. To reach a tar­get of 4% in­fla­tion, they might have to im­ple­ment even more un­con­ven­tional mon­e­tary poli­cies over an even longer pe­riod of time. More­over, cen­tral banks should not as­sume that re­vis­ing in­fla­tion ex­pec­ta­tions from 2% to 4% would go smoothly. When in­fla­tion was al­lowed to drift from 2% to 4% in the 1970s, in­fla­tion ex­pec­ta­tions be­came unan­chored al­to­gether, and price growth far ex­ceeded 4%.

The last op­tion for cen­tral banks is to lower the in­fla­tion tar­get from 2% to, say, 0%, as the Bank for In­ter­na­tional Set­tle­ments has ad­vised. A lower in­fla­tion tar­get would al­le­vi­ate the need for un­con­ven­tional poli­cies when rates are close to 0% and in­fla­tion is still be­low 2%.

But most cen­tral banks have their rea­sons for not pur­su­ing such a strat­egy. For starters, zero in­fla­tion and per­sis­tent pe­ri­ods of de­fla­tion – when the tar­get is 0% and in­fla­tion is be­low tar­get – may lead to debt de­fla­tion. If the real (in­fla­tion­ad­justed) value of nom­i­nal debts in­creases, more debtors could fall into bankruptcy. More­over, in small, open economies, a 0% tar­get could strengthen the cur­rency, and raise pro­duc­tion and wage costs for do­mes­tic ex­porters and im­port-com­pet­ing sec­tors.

Ul­ti­mately, when the next re­ces­sion strikes, cen­tral banks in ad­vanced economies will have no choice but to plumb the zero lower bound once again while they choose among four un­ap­peal­ing op­tions. The choices they make will de­pend on how they weigh the risks of bloat­ing their bal­ance sheets, im­pos­ing costs on banks and con­sumers, pur­su­ing pos­si­bly unattain­able in­fla­tion tar­gets, and hurt­ing debtors and pro­duc­ers at home.

In other words, cen­tral banks will have to con­front the same pol­icy dilem­mas that at­tended the global fi­nan­cial cri­sis, in­clud­ing the “choice” of whether to pur­sue un­con­ven­tional mon­e­tary poli­cies. Given that fi­nan­cial push is bound to come to eco­nomic shove once again, un­con­ven­tional mon­e­tary poli­cies, it would seem, are here to stay.

Nouriel Roubini

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