An aggressive central bank response in the form of easier monetary policy was key to containing the global financial crisis in major advanced economies, and it has supported a very slow recovery. Today, however, two interrelated issues have risen to the fore of the policy debate. First, what tools can be used to add monetary stimulus to anemic economies? Second, how should policymakers think about monetary policy in the future, given that the zero lower bound (ZLB) on interest rates will apparently be hit more frequently.
Regarding both issues, given the current discussion and evidence, my view is that little can be done by central bankers themselves. In critical periods, monetary policy must be conducted in conjunction with fiscal policy, and the timing of both is key to success. Perhaps this explains the better performance of the US economy versus other rich counterparts and the rapid recovery in many emerging-market economies.
After cutting rates to virtually zero, central banks across the advanced world implemented a range of unconventional monetary policies. But these tools have all but reached a point of exhaustion. Forward guidance on interest rates and quantitative easing in the form of asset purchases were successful in keeping borrowing costs down. However, the expansion of central bank balance sheets seems close to its limit, particularly given the distortions these policies can create in financial markets. Negative interest rates for bank deposits at central banks have been the latest tool in the monetary policy arsenal. Of course, the negative policy rate is only slightly negative and the scope for deeper cuts is narrow. Moreover, it is not clear whether it is an effective tool for adding stimulus. Bank profitability and the industry’s very business model have come under pressure, mainly because banks cannot charge negative rates to retail deposits, affecting the whole pricing of bank products. Along these lines, Brunnermeier and Koby have argued that there is a “reversal rate,” below which further reductions into negative territory may be contractionary for the economy.
Even if monetary policy has done all it can to support economic growth, keeping the current stimulus in place certainly helps prevent any deterioration in the outlook. Still, monetary policy’s relative weakness shifts the onus to fiscal policy for any major economic stimulus. This does not apply to all rich countries. The United States is leaving the ZLB constraint as the Federal Reserve begins raising interest rates, albeit quite gradually, making such concerns less pressing. The challenge for US authorities is how to prepare to conduct monetary policy in the next recession. For the rest of the major advanced economies, monetary policy is still in full-accommodation mode—and recoveries still haltingly under way.
The next question is what to do to increase monetary power in the future. This is particularly relevant given the neutral rates have declined over time. If, for example, a neutral (nominal) monetary policy rate—one seen as neither boosting nor retarding growth and inflation at its target level—is 5 percent, the central bank could go five percentage points into expansion before reaching the ZLB. If the neutral rate is now 2 percent, as seems to be the case, there are only two percentage points of cut before the need for opening the toolkit of additional policies. This is a serious problem if we consider that during the entire period 2002–2004 the official federal funds rate was more than two percentage points below the Holston-Laubach-Williams estimate of the neutral rate. The same has happened from late 2008 until December 2015, when the Fed started cautiously raising official interest rates.
What are some other options for boosting below-target inflation? Increasing the central bank’s inflation target, following a price level target, and nominal GDP targeting are all alternative approaches to monetary policy that suggest a permanent or transitory increase in the rate of inflation. Permanent increases in the target would suggest going from 2 to 4 percent. It is difficult to argue that 4 percent is price stability, but recent research has shown the costs of such an increase may not be very large. Had the rate of inflation been 4 percent in the United States before the crisis, there would have been more policy space for the Fed to act. However, the effectiveness of such measures would have required expectations to remain anchored at that level.
A price level target would attempt to compensate for past losses or excesses, seeking an average inflation rate that remains as much below the official target as it does above. In the last four years, average US consumer prices have barely exceeded 1 percent. Hence, a price level target would target inflation of 3 percent in the next four years. This conduct may be more troublesome in economies that only recently defeated elevated inflation, because overshooting could signal a lack of commitment. Moreover, it is also difficult to commit to deflation after a period of high inflation. Finally, the moving target, beyond communications quarrels, would also require expectations to move together with the target, since otherwise output volatility would increase.
The other alternative is to target nominal GDP—approximately the sum of inflation and growth. When growth is low, inflation should go up, and vice versa. This framework includes implicit output stabilization. However, in addition to the problems of a moving inflation target, there is the problem of determining potential growth, in order to calibrate the rule. There are many other practical issues, such as what to do with revisions of GDP, which sometimes can be quite significant.
All of the alternatives above require an increase in inflationary expectations. In order for inflation to go up, all price and wage setters need to believe that inflation will indeed go up. This is not easy; indeed, it seems to be a titanic task. Policy announcements are not enough to convey strong commitment if they are not fully transmitted into inflationary expectations. In most models used to evaluate these options, inflationary expectations adjust to the new target. But, in reality, perhaps the main problem with raising the inflation rate is how to do it, without losing control over it. Inflation expectations seem to be stickier than what traditional macroeconomic models would suggest.
Japan is an interesting case on the difficulties of moving inflation once it has settled at depressed levels for a long time. The country has been trying to increase inflation for a long time. The most recent and very committed experience started with Prime Minister Shinzo Abe’s “Abenomics” experiment in 2013, when the Bank of Japan announced an inflation target of 2 percent. A very significant policy of quantitative and qualitative easing was announced. The yen has depreciated from about 80 per US dollar to 105 recently; the central bank assets have almost tripled, reaching levels close to 100 percent of GDP. For comparison purposes the US Fed has about 25 percent of GDP on its balance sheet. But inflation in Japan is currently negative, and core inflation, which excludes food and energy prices, is slightly positive. Inflation expectations reach 2 percent around 2020. This shows that expectations as well as actual inflation are difficult to move from where they have been for a long time. The Blanchard-Posen proposal of a coordinated price and wage increase in Japan would raise inflation transitorily, but it is difficult to persist if expectations do not respond.
Once advanced economies have built credibility after decades of stability, it is tough to suddenly renege on that anchor, while a moving inflation target poses its own challenges. Central bankers will be reluctant to choose this option, not only because of the costs of higher inflation and the potential questioning of the price stability mandate, already very relevant issues, but also because the cost of not achieving higher and stable inflation would undermine the credibility of both, the central bank’s commitment to a new inflation target and the competence of policymakers.
One important lesson from the crisis for advanced economies is that they need to avoid large recessions, and for that they should focus on financial stability and making their financial systems more resilient. This will not be achieved through monetary policy.
Perhaps the United Kingdom, with its tumbling pound, is the only country that has succeeded in increasing inflationary expectations. But it will be doing so for the wrong reasons—the type of political and economic uncertainty usually reserved for emerging markets.