Economies are on the mend, but troubles lurk

Raghuram G. Rajan

Since 2008, central banks in industrial countries have deviated from ordinary monetary policymaking in a variety of ways. They’ve tried to persuade the public through “forward guidance” that interest rates would stay low for extended periods of time. They’ve deployed programmes in pursuit of various goals.
More recently, central banks have also introduced negative interest rates and – from the Bank of Japan (BOJ), which has always been at the forefront of innovation – yield-curve targeting. And some central banks have resorted to unconventional but well-known policies such as direct exchange-rate targeting.
But now, with most central banks apparently seeking to normalise monetary policy, we should ask why these extraordinary measures were used and whether they worked. Looking forward, we should ask what effect phasing them out will have, and whether their use raises long-term concerns. By addressing these questions, central bankers will be better prepared to grapple with future crises.
Was it necessary?
It is worth recalling that markets were clearly broken after the 2007-2008 financial crisis. With credit flows frozen, it was understandable that central banks would go to great lengths to stabilise financial markets, whether the mortgage-backed securities market in the US or the sovereign-bond market in Europe.
But a second reason for central banks to intervene was to affect yields or prices. This was a more adventurous objective, given that central banks typically manage prices only indirectly, by raising or lowering the policy interest rate, not through direct intervention. But when the policy rate reached the zero lower bound, central bankers deemed it necessary to affect prices on a variety of long-term securities, sometimes by targeting a particular class of security in the hope that the effect would spread across classes.
A third reason for central bank intervention was to signal a commitment to preferred monetary policies. For example, if a central bank announced a programme to purchase government securities, the implication was that it would not tighten monetary policy while the programme was in effect. Regardless of the programme’s stated intent, its corollary effect was to signal “low-for-long” interest rates.
Central banks have cited all of these justifications for pursuing occasionally aggressive – or innovative – monetary policies. But as an ex-central banker, I would include another reason, one that monetary authorities rarely mention: they are prisoners of their inflation-targeting mandate.
Did it work?
Though we have not seen a negative disinflationary spiral, inflation has remained stubbornly low. Central bankers have thus constantly upped the ante on monetary innovation – that is, new instruments that might theoretically boost inflation – even though the ineffectiveness of their instruments has become increasingly apparent. But did any of the innovative instruments work? In terms of stabilising markets, yes, some policies seem to have been quite effective, either because a deep-pocketed player came in to buy securities, or because central banks put their weight behind markets.
In sum, central banks’ extraordinary policies have probably had a positive effect in terms of repairing markets and signalling long-term accommodative monetary policies. But their effect on real activity remains uncertain.
So, what happens when policies are reversed? The nice thing about expectations is they get front-loaded. We may have already seen what happens when a central bank changes signals: during the “taper tantrum” of 2013, a general sense that the Fed might terminate QE and start raising interest rates triggered market turmoil and drove interest rates up.
Markets have since stabilised, but it remains to be seen if unconventional policies’ effects on financial-asset prices will be reversed when the policies are. As central banks start shrinking their balance sheets in 2018, longer-term bonds will be returned to the market, and the market’s holdings of excess reserves will be extinguished. Bond issuers will need to find more private buyers, but private buyers will have funds to buy more bonds. As this asset swap takes place, long-term interest rates can be expected to rise somewhat. And if markets are worried about the eventual stock they’ll have to absorb, the rise in interest rates could be rather abrupt.
What next?
One final question concerns the role of central banks’ domestic mandates in encouraging the kind of extraordinary policies we have seen in recent years. In the past, central banks have essentially said, “Give us a mandate, and don’t place constraints on how we achieve it.” But while this formula may have worked fine when the primary problem was high inflation – and when central banks’ primary instrument was the policy rate (and some marginal tweaks to liquidity) – it no longer works when the problem is low inflation.
Far-reaching operational freedom without a practical scientific understanding of how to achieve the mandate is a dangerous combination for central banks. They have come under intense pressure to innovate; and, at the same time, there are few assets they cannot buy, and even fewer borrowers they cannot fund.
Central bankers would of course prefer to avoid any discussion of their function and mandate. But, rather than waiting and hoping for the public spotlight to move somewhere else, they would be better off conducting a sober assessment of their policies over the last few years. It is incumbent upon monetary authorities to devise a mandate that is both reasonable and achievable, and to establish a set of actions that are permissible in achieving the mandate. Otherwise, 2018 will be just the beginning, rather than the end, of a brave new era for monetary policy.
—Writer is Professor of Finance at the University of Chicago Booth School of Business

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