Tilburg and Harvard economist Eijffinger writes with his colleague Edin Mujagic: “After US investment bank Lehman Brothers collapsed in 2008, it did not take long for advanced-country central banks to recognize that conventional monetary policy would be inadequate to contain the fallout of the ensuing crisis. So they bucked accepted theory, as set forth in standard textbooks like Principles of Economics by Greg Mankiw and Money, the Financial System, and the Economy by Glenn Hubbard, in favor of so-called “unconventional” monetary policy.
Five years later, these policies remain intact. This means that today’s undergraduates – and recent graduates – have studied economics during a period of uninterrupted reliance on near-zero interest-rate policies (ZIRP) and large-scale asset purchases, known as quantitative easing (QE). For them, a federal funds rate (the interest rate that banks charge each other for overnight loans of their reserves held at the Fed) of 5% seems as fantastic as a unicorn.
The exceptional has become the norm
More important, this inversion is likely to persist. Central banks are using so-called “forward guidance” to assure market participants that they will, to some extent, maintain ZIRP and QE for years to come. In short, what was once standard has become almost unthinkable, and the exceptional has become the norm.
To be sure, the Fed’s intention to sustain its monetary stimulus is only temporary; it will follow through on its previous pledge to “reduce the pace of its asset purchases” and ultimately exit QE as soon as sufficient growth is restored. But America’s recovery remains anemic by historical standards. Add to that the fact that the interest rate on ten-year US Treasuries spiked after Bernanke announced plans to “taper” QE – rising from 1.6% in May to 2.9% last week – and the Fed is likely to approach its policy reversal with caution.
In fact, the Fed is prepared to expand its QE program if the US recovery falters. Its recent decision suggests that it may already be feeling pressure to do so.
Of course, the Fed is not the only central bank that has been redefining conventional monetary policy. The Bank of England has indicated that it has no intention of quitting QE; like the Fed, the BoE has stated a willingness to expand the program should economic conditions warrant it. Not to be outdone, the Bank of Japan launched its own version of QE, which dwarfs that of the Fed, earlier this year. (Surely, the Nobel laureate Paul Krugman, who has long criticized the Fed for not taking QE far enough, is eagerly watching the Japanese experiment unfold.)
Meanwhile, the European Central Bank is currently awaiting approval from the German Constitutional Court to launch its “outright monetary transactions” program, which allows for unlimited purchases of eurozone government debt. Even emerging-country central banks like India’s are beginning to purchase government debt. In other words, QE is not going anywhere.
Similarly, interest-rates are likely to remain close to zero for years. The Fed does not expect to raise rates until mid-2015, and will do so only if all the stars in the economic firmament align. Moreover, the shift would be very gradual. Even in the unlikely event that the Fed raised the federal funds rate by 25 basis points at every meeting from mid-2015, the rate would stand at only 5% at the end of 2017.
Given that other central banks will also proceed cautiously, “textbook” monetary policy will probably not be the norm again until at least 2020. Even then, central bankers would continue to view expansionary monetary policy as a viable strategy to cope with deteriorating economic conditions in the future. Against this background, the term “unconventional” does not apply to ZIRP and QE.
Widespread recognition of the potential uses of ZIRP and QE may well turn out to be one of the most important outcomes of the current crisis, shaping monetary policy far into the future. Universities around the world would be well advised to consider this fundamental shift in central banks’ approach when selecting textbooks for their economics students.”
This article has previously been published at Project Syndicate
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