Monetary Policy After the Crisis

September 2010

Challenges & Policy Responses

BackgroundThe Great Recession and the financial crisis

that marked its emergence put in check a lot of the consensus that MP had achieved

The crisis and emergency policy response that followed raised three policy questions:What are the effects of unorthodox tools when the

interest rate cannot be used as the main instrument? What Should The Central Bank main focus be to get

back on a solid footing recovery What should be the right level of inflationWhat is next for Monetary Policy

The Role for Monetary Policy• Changes in money supply M

The LM curve is drawn for a given supply of moneyM/P = L(r,Y)

• The Central Bank can directly affect that supply

Increase in M r falls

Shift of LM curve

• The Central Bank can also set interest rates

• A monetary policy change affects interest Rates for any Y with the spill over effects in the goods market

r

M/PM/P

r1

r1

Y

L(Y1)

L(Y2)

The Central Bank commits to setting M at whatever level is necessary to sustain

r1 in the money market

LM

Shape of LM will depend on how

CB sets its policy

The Role for Monetary Policy

Quantitative Easing: Major Players, Basic Elements

Central Banks

Banks

Companies

Households

Assets

Bonds

Price

BondsYields

R at 0

$ trillions reserve

Expanding the amount of money in the economy

Expanding the balance sheet of the Central Bank

Quantitative Easing: How It works• The Central Bank buys Government bonds• The extra demand raises bond prices and lower their yields• Lower long-term interest rates stimulate economic activities.• Banks sell their bonds to the Central bank creating reserves in

return• Banks swap low-yielding reserves for better return shares or

corporate debt.• This lowers private-borrowing costs and raises asset values,

boosting wealth and spendingDoes it work?• No guarantee that banks will lend or that companies or household

will borrow• The Bank of Japan five-years of QE in the early 2000s had barely

any effect on inflation and unemployment• The Federal Reserve Policy of QE that bought $1.75 trillion of

Treasuries and mortgage-related debt, bringing long-term interest rates down sharply had barely any effect on bank credit .

The Risk Of QE• Central Bank can loose money• Danger of Inflation• Potential to destroy confidence in an Economy• May not work if not implemented aggressively enough• Difficult to gauge how much QE is needed

Quantitative Easing: Assessing The Effects

Asset Bubbles• The consensus view, embodied in the Taylor Rule, was that the CB should

only look at inflation and prices• But this could contribute to asset price “bubbles” (i.e. unsustainable price

increases)• It follows that even when inflation (of goods and services) is low, there

could be asset price inflation indicating that the economy is overheating The Central Bank could raise interest rates, even if inflation is low, when

they perceive a bubble in asset prices• But when do you know it’s a bubble, as opposed to a sustainable increase

in prices?• Should interest rates be the instrument to “prick” those bubbles? The CB is typically also the regulator of financial markets…

“Macroprudential regulation”

Inflation: Rethinking The Right Target• Low inflation implies low nominal interest rates• If interest rates are low when a crisis hit, it is more

likely that MP will hit the zero rate lower bound.• Deflation should be avoided because it depresses

spending, and thus creates a vicious circle• Fighting inflation is very important to ensure both the

credibilty of The Central Bank and the effectiveness of monetary policy .

Interest Rates: Forecasting The OutlookThe U.S.Given the uncertainty about the recovery and the fear for a double-dip recession, the Fed is likely to keep interest rates at «Exceptionally low» levels for an extended period of at least 6 monthsCanadaRecent emerging signs of accelerating inflation and the Canadian dollar climbing to parity with the US Dollar, has led some economists to predict an earlier rate hike.Eurozone With both growth and inflation remaining moderate, The ECB is focused on gradually withdrawing the exceptional steps it took to prop-up the financial sectorChinaThe People’s Bank of China has been adopting a wait-and-see approach before developping the «heavy-duty weapon» of interest rate hikes. But with Consumer Inflation rising to 2 .8% and the benchmark one-year deposit rate at just 2.5%, there is an increasing likelihood of a rTe hike in the coming months.JapanWith deflation and rates at 0.1%, the BoJ has been under pressure to take further action. The Bank recently increased a programme of three-month 0.1% loans to Commercial Banks from Y 10,000 to Y 20,000 bn, but is resisting calls for it to buy Government bonds or other assets. Rates are likely to remain close to zero for at least a year.AustraliaExpectations are ripe for rates to reach the4.5-5% range. There is increasing concern about rising inflation, higher house prices and climbing wages.

Central Banks: The need for readjustment

• QE need to be combined with looser fiscal policy to stimulate private demand

• The governmnt should step in to boost spending by borrowing to cut taxes; send cheques to households; build Infrastructure; and if necessary extinguish underwater mortgages

• Create fiscal institutions that mimic the rigour and autonomy of Central Banks that will help the governments to commit to a target debt-to –GDP ratio.

Policy Prescriptions