Future Direction of Monetary Policy
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Global financial markets have begun to respond to the contractionary monetary policy in developed countries. The Bank of Japan (BOJ) and the Swiss National Bank (SNB) are the only central banks that still maintain a relatively loose monetary policy.
The US Federal Reserve has started to gradually pull out of its quantitative easing program introduced in 2014 and began normalizing its policy rate by the end of 2015.The European Central Bank (ECB) is considering the same step in the termination of its asset purchase program in 2018, and is also considering ending its negative interest rate policy.
Similarly, the Bank of England (BOE) has completed the final stage of its monetary easing policy launched after the EU referendum, which decided Britain\'s exit from EU membership (Brexit) by the end of June 2016, and is considering raising its policy interest rate.
Meanwhile, the Bank of Canada (BOC) and the Reserve Bank of Australia (RBA) have sent signals that they will soon raise their interest rates.
Anticipating crises recurrence
It is almost certain that the measures taken by these central banks are preparatory measures. If a global financial crisis happens, they already have the ammunition that can be used to overcome it.
For example, the Fed (the US central bank) has a stronger position to exit from its extra-loose monetary policy compared with other central banks. In fact, even if its monetary policy normalization is successful in bringing the policy interest rate toa new equilibrium, the balance will not be higher than 3 percent.
Keep in mind that in the two tightening cycles that occurred before the global financial crisis, the Fed\'s policy interest rate was at an equilibrium level of between 6.5 percent and 5.25 percent. When the global financial crisis occurred in 2008 and recession occurred in 2007-2009, the Fed slashed its policy interest rate from 5.25 percent to 0 percent.
When the policy failed to push up the pace of economic growth in line with expectations, the Fed began launching an expansionary monetary policy, Quantitative Easing (QE), for the first time in history, which was later followed by other central banks, such as those of the European Union, Japan, and the United Kingdom.
Four options
As indicated by some monetary policy cycles in the past, even if the Fed was able to bring back the policy interest rate to 3 percent before the subsequent recession, the Fed still did not have room to maneuver effectively.
The interest rate will touch the lowest lower limit, for example, 0 percent, before impacting the real economy significantly. If that happens, the Fed and other major central banks in the world have only four options, and each option has different costs and benefits.
First, a central bank may reuse a loose monetary policy, such as QE, by buying government bonds and long-term private assets to improve liquidity and stimulate credit. However, keep in mind that by expanding the central bank’s balance sheet, there are economic costs that must be borne. It is not without risk.
Second, a central bank may reapply a negative interest rate policy, as conducted by the ECB, the BOJ, the SNB and other central banks, in addition to quantitative easing and credit easing policies. However, the negative interest policy will burden the savers, and the bank, in the end, will have to transfer it to customers.
Third, a central bank may change its inflation target, for example, from 2 percent to 4 percent. The Fed and other major central banks are informally considering using this option, because this policy alternative can increase the interest rate balance at the level of 5 percent to 6 percent, and reduce the risk of touching the zero lower bound (ZLB) in the case of a recession.
However, this option raises controversies for several reasons. One of these is that central banks have experienced difficulties in reaching a 2 percent inflation target. In order to achieve a 4 percent inflation target, they must implement unconventional monetary policy within a very long period.
In addition, a central bank’s efforts in changing the inflation target will certainly not run smoothly. If the inflation expectation is changed from 2 percent to 4 percent as it did in the 1970s, the inflation expectation will become more uncertain so that inflation will be no longer attractive to be used as a reference monetary policy again, and the price growth can surpass 4 percent.
The fourth and final option is that a central bank is recommended to lower its inflation target from 2 percent to, say, 0 percent, as recommended by the Bank for International Settlements (BIS). Lower inflation targets will reduce the use of non-conventional monetary policies when interest rates are close to zero and inflation rate is still below 2 percent.
However, most central banks are less enthusiastic about this strategy for various reasons. The first argument is that0 percent inflation and a long deflation period will result in debt deflation. If the real value of debt increases, a number of debtors may go bankrupt.
In addition, in an open economy, a0 percent inflation target will result in the strengthening of the domestic currency and will increase the cost of wages and production for exporters and companies that compete with imported goods.
As a result, domestic products are no longer competitive. Thus, in the end, if a recession reoccurs, central banks in developed countries have no choice but to lower interest rates to near 0 percent, and they will again choose one of the four policy options above to strengthen the effectiveness of their monetary policies.
Policy dilemma
Choosing among four options depends on the emphasis of the combination of risks, which include the expansion of a central bank\'s balance sheet, the cost borne by commercial banks and consumers, the probability of not achieving the inflation target, and the losses suffered by debtors and domestic producers.
In other words, central banks will always face the policy choice dilemma, like the one experienced during the 2008-2009 global financial crisis, during which the central banks ultimately used the QE non-conventional monetary policy, in the form of liquidity injection and credit easing.
TRI WINARNO
Senior Researcher of Bank Indonesia
