What Will the New Normal for Monetary Policy Look Like?

By Federico Ravenna, Associate Professor and Chair in Monetary Policy and Financial Markets, HEC Montreal

What is the new normal for monetary policy across the major players in the world economy? In December 2015, the US Federal Reserve hiked its policy rate for the first time since 2006, signaling that the US recovery was expected to proceed on a robust growth path, and monetary authorities intended to be ahead of the curve as the economy keeps improving. Within four weeks, a marked slowdown in US industrial production and a downward revision of US growth forecast by major investment banks—dropping from 2.5 percent to 2.3 percent in 2016, according to Goldman Sachs—has once again increased uncertainty among financial markets about the future path of the Federal Reserve’s tightening cycle, with further increases in the interest rate put on hold at the latest January FOMC (Federal Open Market Committee) meeting. At the same time, in mid-January 2016, the European Central Bank (ECB) indicated that the downside risk to inflation has increased. Markets expect with a high probability the ECB to provide additional stimulus to the economy in March.

This news came after the global economy appeared to have settled on a path, if not of robust growth, at least of stabilization. At the end of the summer of 2015, world production started to rebound, the danger of deflations in the US and the euro area seemed to have been staved off, and, symmetrically, inflation expectations embedded in US dollar and euro swap rates finally appeared set on an upward trajectory.

The last eight years have accustomed the markets to a situation of heightened uncertainty in global economic prospects. The question still open is whether, after the great activism that both policymaking institutions and financial regulatory bodies have utilized to fend off new challenges over the past years, we are left with higher uncertainty not only about the state of the economy, but also about how monetary policy will react to new challenges. How will central banks trade off the many demands that are put on the use of the interest rate tool to govern the economy? In short, what are markets to expect monetary policy to look like after the Great Recession?

We thought we knew—an explicit or implicit inflation target, and a clear mandate to act as a lender of last resort, as during the Long-Term Capital Management crisis in 1998. If ever interest rates hit the zero lower bound, the monetary authority will steer expectations of all financial-market participants and economic decision makers with some form of “forward guidance”.

Is that all? Add to this that central banks’ balance sheets started swelling in the last eight years, with the Bank of Japan’s assets reaching 60 percent of Japan’s GDP (gross domestic product). Then the Federal Reserve tried to twist the yield curve in the US government bonds markets. And before that, in 2010, it instituted a program whereby it would buy mortgage-backed securities to address financial turmoil in this market and provide support to the housing market. Then Mario Draghi committed to do “whatever it takes to save the euro”. Then the boundary between monetary and fiscal policy became less certain, with a German constitutional court ruling that the ECB’s Outright Monetary Transactions amount to monetary financing of government deficit, prohibited by the German constitution. And the boundary between monetary policy and banking regulatory actions also became blurred, with an intense debate about how to best employ macroprudential tools aimed at reducing systemic risk in the financial- intermediation sector, and how to coordinate their use with interest-rate setting by the central bank. Not to speak of the ever-raging debate about how a central bank should act to stabilize the economy in the face of asset prices in some markets becoming disconnected from fundamentals—a phenomenon that even a country such as Canada, which has emerged relatively unscathed from the turmoil of the last eight years, has to come to grips with, now having a household-debt-to-GDP level nearly as high as the equivalent measure for US households at its peak in 2008.

How can we put all these different policies, tools, economic challenges together and make sense of them, to try and predict where monetary policy is going? Despite the best efforts of central bankers to provide a framework for markets to understand their policy actions and long-term plans—that is, to advertise what the “new normal” should be expected to look like—we are left with many questions. What will be the behaviour of monetary authorities if slow growth becomes the new normal in advanced economies, or we are faced with stagnation traps? And what if the risk-taking channel of monetary policy becomes more relevant in the coming years, with economic agents willing to take on more risk to compensate for long periods of low asset yields? The world economy has changed dramatically, and monetary policy seems to have acquired the freedom to take advantage of “escape clauses” to deviate from its standard, normal operating procedure to a much higher degree. New policy tools have been employed, but how they will be used in the future has not been made completely clear. One could argue that the activism of policymakers in the last few years has been what saved many advanced economies from disaster. It has become increasingly harder over the years to disagree with this view. This activism, though, may have left economic agents under a cloud of deeper uncertainty and lower predictability about what to expect from policymaking institutions. It may even have encouraged the suspicion that monetary authorities are ebbing towards more “discretionary” policy, the bogeyman of every central banker.

No, it is not the old debate of “discretion vs. rules”. Several lessons have been learned from the 1970s, and will stay with us. First, high inflation is always a monetary phenomenon, and anchoring inflation expectations is essential to ensure that an economy can respond to temporary inflationary or deflationary shocks minimizing unemployment fluctuations. Second, transparent communication of its monetary-policy stance and its economic justification ensures that the central bank is perceived as accountable and committed to its stated goals, and that the impact of policy actions is maximized. Third, predictability helps monetary policymakers to achieve policy objectives, by driving the markets’ expectations of their future actions on the desired course.

Predictability is maximized with a simple rule—for example, a money growth rule, or a rule setting the value of the policy interest rate depending on the state of the economy. The persistence of the near-zero interest rate target of the Federal Reserve after 2011, or the repeated bouts of quantitative easing, have been according to many way less than predictable. Adair Turner, who headed the UK Financial Services Authority during the financial crisis of 2008-2009, claimed instead that simple rules focusing on stabilizing inflation led to neglecting the buildup of risk that produced the Great Recession. Ben Bernanke, chairman of the Federal Reserve in the same period, advocates what is known as a “targeting rule”: providing to the public a numerical target for the inflation rate, set at 2 percent, and backing the policy framework with analyses and projections to justify how each of the Federal Reserve’s actions will drive the economy over the near-to-medium time horizon towards fulfilling its inflation and employment targets. This approach has also been called constrained discretion.

If the monetary authority is faced with complex challenges, faces more fragile tradeoffs than in the past, and has proved to be able to adapt its actions and tools to new and unexpected economic imbalances, how can it also be predictable? One may fear that using a so-called flexible inflation-targeting approach, the “flexible” part of the approach will become preponderant.

Financial markets would be wise not to expect major central banks to adopt simple instrument rules—the need for more flexibility has proved itself too important. Yet the current situation cannot be sustainable without central banks themselves ending up adding to the pervasive uncertainty in the global economy. Forward guidance may not be sufficient: the markets have learnt that central banks may act under pressure to do “whatever it takes” to prevent economic crises—and that’s a good thing—but where the next economic crisis will come from, and what constitutes an economic crisis, is left unclear.

Somehow, central banks will have to find a way to give themselves rules to follow so as to make themselves more predictable, and accept the need to revise those rules more often. Sticking to a general framework for policy and relying over time on a series of escape clauses would instead add too much uncertainty to the policy process. The FOMC issued for the first time in 2012 a formal description of its policy framework, and re-approves it every January. The Bank of Canada stipulates with the Canadian government an agreement, renewed every five years, enshrining its policy mandate—currently, an inflation-targeting regime. These kind of agreements can gradually change and evolve, and can provide a balanced avenue for gradually optimizing the policy framework, while reducing the uncertainty associated with rules perceived as too flexible, discretion perceived as not constrained enough—and the unpredictability of a policy process that is rapidly evolving.

It’s a balancing act, of course, since central banks do not want to lose their hard-earned credibility and run the risk to unanchor inflation expectations. Against this concern, though, should be the preoccupation of enhancing predictability, and ensuring the markets do not have to second guess the policymaker as to when an escape clause will be activated or policy will deviate from its predicted, “normal” path.

A bigger concern looms: the longer we wait to adjust a mandate, the larger the incentive not to adjust it. That is, the longer the inertia in fine-tuning the policy framework regularly and gradually over time, the bigger the fear that a small change in the rules will be perceived as a key signal to which financial markets and economic agents may overreact. Preventing the market from expecting fine tuning of the policy mandate at regular intervals may buy central banks only an apparent sense of reducing uncertainty, since the longer the wait, the higher the bar becomes for any change, preventing it to start with. Then we would be left with a “new normal” made up of more and more second-guessing of policymakers, and possibly more policy uncertainty.

References

http://chairepolitiquemonetaire.hec.ca/en/Affiliations: HEC Montreal; DIW Berlin; CIRANO