The financial crisis that hit the world economy in 2008 was so severe that conventional monetary policy tools soon reached the limits of their efficiency. Central Banks were forced to use unconventional measures to stimulate the economy. One of the tools of the unconventional monetary policy was quantitative easing (QE), which helped the US and EU economies emerge from the Great Recession. Now, ten years past the financial crisis and observing decent growth rates, advanced economies are thinking of normalization of the monetary policy – raising interest rates back to their normal levels. However, so far U.S. is the only country which started moving in this direction.
Policy-makers of other developed countries are weighting the chances that by raising interest rates they will reverse the sluggish recovery. At the same time, moving away from the zero lower bound will equip monetary authorities with the tools to soften the next recession. Thus “normalization” of monetary policy has drawn a lot of attention in the academia as well as among policy-makers.
Dr. Yuriy Gorodnichenko (University of California, Berkeley) studied the QE puzzle – that it “works in practice but doesn’t work in theory”. There are three possible channels through which QE could have worked:
- forward guidance (economic agents anticipate low federal funds rate in the future and thus keep long-term interest rates low);
- “Delphic” effect (the state of the economy is bad which depresses interest rates);
- preferred habitat (securities markets are fragmented and thus purchasing of securities of one particular maturity would impact prices and yields of these securities but not of securities with other maturities).
Using the data on Treasury auctions (which is a form of QE) since 1979, Dr. Gorodnichenko and his co-author show that it is the “preferred habitat” hypothesis that explains most of the QE effect. Thus, securities’ markets are fragmented in crises and therefore direct purchases of assets have stronger effect on yields than manipulation of the short-tem policy rate.
Dr. Dmitriy Sergeyev (Bocconi University) looks at the same question (Why does QE work?) from a different perspective – bounded rationality and limited ability of people to forecast asset prices. The more forward-looking and rational economic agents are, the more neutral will QE policy be. To test this hypothesis empirically, Dr. Sergeyev looks at another quasi-QE – purchases of mortgages by state agencies like Fannie Mae and Freddie Mac – and finds that forecast errors respond to policy interventions.
Dr. Alan Auerbach (University of California, Berkeley) emphasized that fiscal stimulus in the US during the Great Recession and more recently has led to an unprecedented increase in public debt – it reached its highest value since the end of the Second World War. This in turn leads to constantly rising interest payments as a share of GDP and public spending. In such an environment, lower interest rates seem to be helpful in restraining interest payments. However, Dr. Auerbach argues that one should look primarily at fiscal space (i.e. the ability of the government to finance its obligations in the long run) rather than debt-to-GDP ratio. For example, the U.S has massive commitments to old age entitlement programs, which in conjunction with demographic change can lead its economy to unsustainable path even with a lower debt to GDP ratio.
These long-term commitments are to be paid in the future, and a lower interest rate is rather a hindrance for prefunding budget for these commitments. Therefore, lowering interest rate does not help decrease fiscal gap: what is gained from lower current debt service expenditures is lost in terms of ability to prefund the budget for future commitments. When fiscal policy is constrained, monetary policy becomes ever more important. Current normalization of interest rates provides more space for the monetary policy to counteract shocks. Also, higher interest rates have political implications putting more discipline on fiscal authorities.
These long-term commitments are to be paid in the future, and a lower interest rate is rather a hindrance for prefunding budget for these commitments. Therefore, lowering interest rate does not help decrease fiscal gap: what is gained from lower current debt service expenditures is lost in terms of ability to prefund the budget for future commitments.
Dr. Kristin Forbes (Massachusetts Institute of Technology) discussed the reasons why other developed economies failed so far to follow the US case of raising interest rates to “normal” levels. The reasons, apart from fear of halting a fragile recovery, can be a decline in the natural interest rate and a number of adverse events (e.g. oil prices shock, Greece bailout, Brexit, etc.). New macro-prudential tools can to some extent substitute for interest rate raising, so central bankers can be more cautious and keep interest rates low until they are pretty sure that growth is solid. In this situation, standard economic models which usually provide hints on when is the time to raise interest rates do not work (specifically, it seems that the Philips curve is very flat). Therefore, other approaches should be used. Dr. Forbes and her colleagues decompose inflation into trend component and cyclical component. When targeting inflation one should consider the trend (persistent component) and ignore short-term movements. If the inflation trend is rising (which is the case in the UK and the US where trend inflation has reached 2%), the central bank can raise interest rate. However, in a number of countries (France, Portugal, Japan) trend inflation is still very low. Thus, they are not advised to increase interest rates yet.
Cecilia Skingsley (Swerige Riksbank) reflected on the monetary and fiscal policy reforms in Sweden. Sweden was one of the first countries to adopt inflation targeting along with central bank independence in early 1990s. At the same time, they introduced pension reform and the following pillars of a prudent fiscal policy:
- general government net lending target (2% of GDP, later decreased to 1% of GDP and since 2019 to 0.3% of GDP across the business cycle);
- expenditure ceilings for three years ahead. These ceilings take into account fiscal space of the government and net lending target; the key principle is that proposals for expenditure increases in one particular area should be accompanied by proposals for expenditure reductions in the same area;
- balanced budget requirement for local budgets;
- 35% debt to GDP benchmark for the medium term (which is about the current level).
The division of responsibilities between monetary and fiscal policies worked quite successfully. The main role of the fiscal policy is to maintain confidence in the long-term sustainability of public finances. In times of modest demand shocks, monetary policy takes the lead in stabilizing both inflation and demand, while the government does not take any active measures – everything works via well-developed automatic stabilizers. In times of more severe shocks (like the one in 2009), fiscal policy has to be more active.
In times of modest demand shocks, monetary policy takes the lead in stabilizing both inflation and demand, while the government does not take any active measures – everything works via well-developed automatic stabilizers. In times of more severe shocks (like the one in 2009), fiscal policy has to be more active.
There is a discussion in Sweden about whether such combination of monetary and fiscal policies is too restraining for the economy. However, given the political support for the current state of things (since politicians to not want the 1990s crisis to return), policies are unlikely to change soon.
Ms. Skingsley notes that Swedish central bank has accumulated quite a lot of bond holdings during its QE program, but these should be winded down in the process of monetary policy normalization. One of the reasons for this is that large bond portfolio increases interest rates risk for the central bank – if interest rates increase, banks’ financing cost will increase (since five-year bonds in its portfolio are financed by two-week certificates).
- Extensions of new Keynesian model (fragmented markets or bounded rationality) can rationalize the workings of quantitative easing;
- Reluctance of many countries to “normalize” monetary policy may be justified (inflation trend is the indicator to consider). However, normalization is necessary to re-equip central banks with monetary policy instruments;
- Prudent fiscal policies are key to monetary policy success in taming recessions.
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