Stefan Gerlach: Monetary policy after the crisis
Address by Mr Stefan Gerlach, Deputy Governor of the Central Bank of Ireland, at the
44th Annual Money, Macro and Finance Conference, Trinity College, Dublin, 8 September
2012.
* * *
The views expressed in this address are those of the author and do not necessarily reflect those of the Central
Bank of Ireland or the ESCB. I am grateful to Colin Bermingham, León Fernández Brennan, Lars Frisell, Rebecca
Stuart and, in particular, Allen Monks for help in preparing these remarks.
1. Introduction
In recent years, in particular following the collapse of Lehman Brothers in September 2008,
central banks across the world have adopted a very expansionary monetary policy stance. In
most economies, the main factor triggering the relaxation of policy has been the very weak
outlook for economic activity stemming from a combination of balance sheet adjustments
following housing bubbles, financial markets seizing up, banks facing funding difficulties,
firms and households experiencing challenging borrowing conditions, and severe strains in
some sovereign debt markets.
The relaxation took two forms. First, central banks responded to the crisis by cutting policy
rates to an unprecedented extent and by adopting a range of "unconventional" or
"non-standard" policy measures. These initially focussed on providing liquidity to financial
institutions and systemically important markets but, over time as traditional monetary policy
became constrained by the "zero lower bound", central banks also aimed to reduce
longerterm interest rates to support the economy.1 To illustrate, the ECB responded by increasing
the size, frequency and maturity of its liquidity-providing operations and later intervened in
the markets for covered and sovereign bonds. The Federal Reserve and the Bank of
England also engaged in purchases of private and public financial assets. The Federal
Reserve also adopted a forward guidance policy, providing additional information to market
participants about the expected path of its policy rate, and explicitly targeted the level of the
yield curve through large-scale asset purchases with the intent of shifting down the entire
term structure of interest rates.2
At some future date economic conditions in the economies most exposed to the financial
crisis will recover and central banks will need to tighten monetary conditions. While there is
still a debate on the question of how the exit from the current highly accommodative policy
stance is best conducted, here I will focus on what monetary policy might look like after the
process of normalising policy has been started.
To reflect on these changes, it is useful to briefly consider the pre-crisis approach to
monetary policy. Somewhat simplified, it involved central banks setting a single short-term
interest rate on the basis of forecasts of inflation (relative to an explicit target or informal
objective) and of economic activity.3 With money markets functioning well and banks
responding to interest rate changes, the financial system played an important but subsidiary
role in setting policy. Will this approach be retained? How will monetary policy frameworks -
the goals, information variables and tools central banks use - evolve? What changes to the
framework are most likely to be adopted? Will inflation objectives be increased to allow
central banks more leeway to cut interest rates if another shock occurs? How will financial
stability considerations be integrated in the monetary policy process? The questions are
many.
Monetary policy might change for at least three reasons. First, the economic environment in
which it is set has changed dramatically. Most notably, public debts have increased sharply
since 2007 and sovereign risk premiums are in some cases large. As a consequence,
interactions between fiscal and monetary policy have grown stronger. Furthermore, financial
systems in some countries, in particular those that experienced large housing bubbles such
as Ireland, have become impaired, limiting the effectiveness of the transmission mechanism.
While central banks potentially may respond simply by adjusting policy by more than they
would otherwise do, it raises the question whether other policy tools, such as asset
purchases, can be used to support aggregate demand. Finally, unemployment rates have
risen sharply and risk putting central banks under strong pressure to pursue expansionary
policies. Public debts, the state of the financial system and the level of unemployment
change only slowly over time, so there are good reasons to believe that these changes will
impact on monetary policy for many years to come.
A second reason why monetary policy may change stems from the adoption of
unconventional policy instruments during the crisis. For instance, central banks introduced
additional liquidity facilities to address funding stress in various markets, engaged in foreign
exchange swaps to provide foreign currency to domestic banks, and intervened directly in a
number of markets. Many of these innovations have been effective, raising the issue whether
they should be used also after the crisis.
Of course, changes to the monetary policy framework need not be limited to the choice of
policy instruments. The exact design of the rest of the framework - the inflation objective or
target and the choice of information variables - is also likely to be reconsidered and changes
are possible.
The third reason why monetary policy may evolve because of the crisis is the growing
consensus that central banks need to guard against the development of financial
imbalances. However, no consensus has emerged about how to best do so. One view is that
central banks should "lean against the wind" when asset prices and credit are increasing
rapidly. Whether that is desirable depends on several factors, in particular on what the costs
might be in terms of lower economic activity. The competing view is that solely macro
prudential instruments should be relied on in preventing the formation of bubbles. If so, how
would they interact with monetary policy and is there a need for explicit coordination of
monetary and macro prudential policy? Finally, there may a reason to use macro prudential
measures but to let monetary policy play a secondary role.
In this speech I will review all three areas.
2. The monetary policy environment
What monetary policy can achieve and how it should be conducted depend crucially on the
broader economic environment. This has changed in three ways since the onset of the crisis:
debt-to-GDP ratios have risen markedly, unemployment has risen sharply and the
functioning of the financial system has deteriorated. These factors are likely to impact on
monetary policy for some time to come.
2.1. Large public debts
The most worrisome change in the economic environment in recent years is the very large
expansion of public debt in some countries. That should not have come as a surprise: there
is ample historical evidence that financial crises are typically followed by large increases in
public debt and, frequently, by sovereign debt crises (Reinhart and Rogoff 2010). Figure 1
shows that debt-to GDP ratios have risen sharply, and are projected by the OECD to
continue to rise, in many economies.
A number of developed countries have lost access to market funding over the course of the
crisis, with three euro countries (Greece, Ireland and Portugal) entering EU-IMF programs in
order to obtain official external funding.4 All three countries are currently under programmes
monitored by the "Troika" consisting of the IMF, European Commission and the ECB.
To think about the relationship between fiscal and monetary policy, it is useful to start by
considering the standard debt equation (Dornbusch 1996):
b' = (r - g)*b + d
where b denotes the debt-to-GDP ratio, r the real interest rate, g the growth rate of real GDP,
d the primary (or non-interest) budget deficit (including unusual expenses such as bank
support) as a fraction of GDP, and b' = db/dt the change of the debt-to-GDP ratio. Thus, the
debt-to-GDP ratio will grow whenever the interest rate exceeds the growth rate of the
economy - both measured either in real or in nominal terms - and unless the government is
running a sufficiently large primary surplus.
The increase in debt-to-GDP ratios in a number of countries since the start of the crisis has
mainly been due to slower growth of tax revenue, a rise in expenditures through automatic
stabilisers and, in some countries, the cost of support packages from the financial sector,
which implied a large primary budget deficit (d > 0). A second reason is that GDP growth has
declined, which has led to a large wedge between the interest rate and the growth rate of the
economy (r >> g).
How might debt-to-GDP ratios evolve in coming years? There is much evidence that
economic growth and inflation recover only slowly in the aftermath of a financial crisis.
Kannan et al. (2009) show that recessions associated with financial crises tend to be
particularly severe and recoveries tend to be slower than otherwise. These effects are further
aggravated when recessions are globally synchronised, as in the present situation. Helbling
and Terrones (2003) highlight the longer and deeper effect of financial crises that follow the
bursting of a housing market bubble, compared to other types of financial crisis. In particular,
such crises last nearly twice as long (5 years) and are associated with output losses that are
almost twice as large (8 per cent of GDP) as equity market crashes.5 This loss of output is
due, in part, to greater effects on consumption and on banking systems, which are typically
heavily exposed to real estate.
I therefore expect nominal GDP growth to be low in many countries in the coming years,
implying that the high debt-to-GDP ratios are likely to decline more gradually than otherwise.6
Another factor impacting on the evolution of the debt is the level of interest rates. The
restructuring of the Greek public debt and concerns that other governments might also be
forced to restructure their debts has led investors to demand a risk premium to hold the debt
of the most indebted countries. While such risk premiums in principle are desirable since
they provide governments with incentives to reduce debt, the fact that interest rates have
risen dramatically and unexpectedly has complicated the management of the crisis in many
countries.
A particular concern arises from the risk of vicious circles developing. Suppose long bond
yields rise. Since treasury yields serve as reference points for many other interest rates, this
would lead to a generalised increase in interest rates and therefore a slowing of the economy
(Smets and Trabandt 2012). In turn, lower growth will worsen further the outlook for public
debt, and risks triggering additional increases in yields. The fact that self-fulfilling prophesies
are possible is one reason why it is crucial to prevent risk premiums from becoming too
large.
To conclude, unfortunately there are good reasons to believe that the coming years will be
marked by a combination of low growth, subdued inflation and high interest rates that will
make it difficult for governments to reduce debt rapidly. What does that imply for monetary
policy? Smets and Trabandt (2012) note three consequences.
First, it increases the burden of monetary policy. Large increases in deficits and debt have
led fiscal policy to be tightened considerably, particularly in countries where the government
has faced problems with their access to financial markets. Tighter fiscal policy slows the
economy, requiring central banks to cut interest rates to maintain inflation at the desired
level. Of course, large contractions in fiscal policy are particularly difficult to offset if interest
rates have already been reduced to very low levels.
Second, large public debts risk ending in high inflation. In its most extreme form, there is a
risk that governments finance their spending by borrowing directly from the central bank, as
has been the case in number of historical episodes of hyperinflation.7 But the effect can be
more indirect. Suppose that the public comes to worry about the inflation consequences of
large public debts, leading inflation expectations and long interest rates to rise. If the central
bank maintains its low inflation polices, ex post real interest rates will rise, slowing economic
activity and raising unemployment. It may therefore be tempted to accommodate these
inflation expectations, at least partially, in order to support economic activity.
Of course, episodes of hyperinflation have little if any relevance to the current situation.
Central banks typically enjoy legal protection that prevents government from using them as
sources of funding. Moreover, most central banks in advanced economies conduct monetary
policy with some form of explicit inflation target or, equivalently, a definition of price stability,
making it difficult for them to aim suddenly for higher inflation in response to shifts in inflation
expectations. Finally, central banks have spent decades building up their credibility and it
seems unlikely that they would be willing to compromise this achievement. Even if they were,
inflation expectations and nominal interest rates would rapidly adjust as market participants
become aware of a changed inflation environment.
To my mind, the main problem with large public debts is not that they result in high average
inflation rates but that deviations from the central bank's inflation objective become larger
and more protracted. To understand this, suppose that inflation rose unexpectedly,
warranting a tightening of monetary policy to reduce the risk that it would stay permanently
above the objective or target. Since higher interest rates would reduce economic growth and
tax revenues, increasing the primary deficit and worsening debt dynamics, monetary policy
makers may therefore hesitate to raise interest rates in the hope that inflation would return to
its previous level on its own accord. Thus, large public debt risks leading to a worsening of
inflation control.
Finally, high public debt increases the perceived riskiness of government debt, which may
impact on the functioning of both financial markets and of the transmission mechanism of
monetary policy. Indeed, in the euro area, we have seen a strengthening of the link between
banks and sovereigns over the course of the crisis through an increase in banks' holdings of
domestic sovereign debt relative to foreign public debt (see Figure 2). This may impede
banks' ability to provide credit to the real economy during times of stress in sovereign bond
markets.
2.2. High unemployment
A second legacy of the financial crisis is a large increase in unemployment in many
economies. While unemployment can rise rapidly, as illustrated by the current episode, it
tends to decline slowly and will be a feature of the economic landscape in some countries for
many years. Indeed the OECD forecasts unemployment in the US to decline very gradually
over the next two years, falling to 7.6 per cent in 2013, while euro area unemployment is
expected to continue to rise in 2012 and 2013 (see Figure 3).
This increase in unemployment is also likely to impact on monetary policy. While no central
bank has an objective for the unemployment rate as a part of its strategy8, the deviation of
unemployment from the non-accelerating inflation rate of unemployment (NAIRU) plays an
important role in the inflation process, as suggested by standard Phillips curve analysis.
Achieving an unemployment rate equal to the NAIRU is therefore commonly seen as
essential for stabilising inflation even if the central bank has no objective for unemployment.9
Indeed, one way to think of the central bank's problem in to set interest rates to influence
aggregate demand, as captured by the unemployment rate, in such as a way as to control
inflation.
Of course, to the extent that it signals weak demand for goods and services and therefore
low inflation pressures, high unemployment merely indicates a need for more expansionary
policy. However, the NAIRU is likely to rise, perhaps sharply, after the collapse of a
financial bubble. Guichard and Rusticelli (2011) conclude that the NAIRU has increased in
a number of countries since the start of the crisis, particularly those that have been most
affected by financial and construction sector crises. The collapse in the construction sector
in Ireland, for example, has probably contributed to an increase in the Irish NAIRU.10 In the
US, various authors have highlighted the role of factors such as the housing market crisis
and the extension of unemployment benefits as having possibly increased structural
unemployment.11 More generally, the increase in long-term unemployment in a number of
countries indicates that the NAIRU has most likely increased in these countries (see
Figure 4).12
An increase of the NAIRU may be problematic for two reasons. Most obviously, it makes it
more difficult for central banks to determine how much slack there is in goods and labour
markets and therefore the appropriate level of interest rates to set. The risk of policy errors,
8
A possible exception is the Federal Reserve, which has "maximum employment" as a formal objective.
9
Of course, if the central bank did have an objective for unemployment, this would be a second reason for
monetary policy to respond to it.
10
The OECD estimates the Irish NAIRU to have increased to around 10 per cent in 2011. It is difficult, however,
to accurately estimate the NAIRU in the Irish context due to the high levels of labour market openness and
migration.
11
Evans (2011), for example, considers the possibility that structural changes in the US labour market has kept
unemployment at high levels, concluding that such factors have likely increased the NAIRU, at least
temporarily.
12
The literature in this area highlights the strong link between long-term unemployment and the NAIRU. See, for
example, Blanchard and Summers (1987) or Ball (2009).
leading to an amplification of cyclical fluctuations and a delay in the return to stability,
therefore rises. Furthermore, the public may not realise that the NAIRU has increased,
leading to strong pressures for more expansionary monetary policy. Given the rise in
unemployment rates after the crisis, pressures for central banks to "do more" will be
common. As Dornbusch (1996) warns, monetary policy makers may come under pressure
not to raise interest rates in response to rising inflation in an environment of high
unemployment, be it structural or cyclical.
2.3. Financial system weakness
A third consequence of the financial crisis is wide-spread worsening of financial sector
functioning. Credit risk has led to large spreads emerging in unsecured money markets and
liquidity to fall abruptly, particularly at longer maturities. In the euro area, interbank markets
have segmented across national boundaries, with banks in some countries effectively locked
out of these markets and forced to rely on the Eurosystem for liquidity. This has contributed
to increased divergence in funding costs for banks across the region. Credit risk concerns
have also made it more difficult for financial intermediaries to obtain funding in bond markets,
while other key funding markets have also seen a significant reduction in activity.
These developments have complicated monetary policy in several ways. Most obviously,
banks' problems obtaining funding has raised the cost and reduced the availability of credit
for firms, in particular small firms, and households. Data from the Eurosystem's Bank
Lending Survey (BLS) have shown that credit conditions have tightened considerably since
the start of the financial market crisis as a consequence of limited access to wholesale
funding markets. Hempell and Kok Sorensen (2010) show that these supply constraints have
affected credit growth, even when changes in loan demand are taken into account. Ciccarelli
et al. (2010) demonstrate that credit supply constraints in the euro area contributed to the fall
in GDP growth in the early part of the crisis and a similar effect can be observed in the US.
While actions by the ECB have mitigated the impact of the most recent turmoil on credit
conditions, balance sheet constraints may continue to impact on the ability of banks to
provide credit in a number of euro area countries.
Tensions in the financial sector have also blunted the monetary transmission mechanism
(Svensson 2010). While central banks have cut interest rate to levels unprecedented in
recent monetary history, the outlook for economic activity remains weak. To further support
the economy, many central banks have adopted non-standard monetary policy measures. To
my mind, these are arguably less effective than interest rates changes and more difficult to
calibrate in light of central banks' very limited experience using them.13 Thus, it seems
plausible that the ability of monetary policy to control demand at the zero lower bound is now
lower than previously.
Problems in the banking sector may also make it difficult for central banks to exit from the
currently highly accommodative monetary policy stance. For example, an increase in interest
rates could damage household's balance sheet directly, and banks' balance sheets indirectly
by slowing down economic growth, and increasing loan losses.14
The use of financial markets variables as information variables for monetary policy purposes
has also become more complicated. While interest rate spreads have been used by many
central banks as measures of financial market participants' growth and inflation expectations
and as indicators of the likelihood of recessions, reduced liquidity and large risk premiums in
many markets now make their interpretation more complicated. This makes it more difficult
for central banks to judge whether the current stance of monetary policy is appropriate.
3. The framework of monetary policy
Next I turn to the question of how monetary policy frameworks might evolve as a
consequence of the crisis. The framework, or strategy, is normally viewed as consisting of
four components: the goal(s) of monetary policy; any intermediate targets that are used;
information or indicator variables; and monetary policy instruments.
3.1 The objectives of monetary policy
Price stability is the overriding objective of monetary policy in most advanced economies,
although central banks frequently, if not typically, have a secondary objective of smoothing
the business cycle. Precisely how the price stability objective is pursued varies, but in many
cases a numerical definition of price stability or an explicit inflation target plays a key role.
Indeed, both the Federal Reserve and the Bank of Japan, which have neither, have recently
communicated what inflation rates they consider to be consistent with their mandates.
There is much agreement that price stability should remain the overriding goal of monetary
policy. This reflects the view that the financial crisis was not principally caused by monetary
policy but rather by weaknesses in the financial system.15 Furthermore, high inflation is costly
and there is no exploitable trade-off between inflation and growth. Moreover, price stability,
while neither necessary nor sufficient for achieving financial stability, is conducive to that end
(IMF 2010). Nevertheless, important questions concerning the framework remain. One of
these concerns is whether financial stability should be a separate goal of monetary policy,
which I discuss in the next section.
Another broad question concerns whether the design of inflation objectives should be
reconsidered. Blanchard et al. (2010) suggest that there are reasons to consider aiming for
higher inflation than most central banks did before the crisis. Suppose that the central bank's
inflation objective is 2 per cent, that the equilibrium real interest rate is 2.5 per cent, and that
inflation is at the objective and output at potential (or the unemployment rate equal to the
NAIRU). If a large contractionary shock occurred, the central bank could then reduce interest
rates by at most 450 basis points.16 If the inflation target was raised by 1 per cent, the
argument goes, central banks would have been able to cut interest rates by an additional
100 basis points, which, given that many central banks have reduced rates to (almost) the
zero lower bound, would have enabled them to provide more stimulus.
18
While true, most observers do not find this argument compelling.17, Raising inflation
objectives would increase average inflation rates and therefore inflation volatility and price
dispersion, which is costly. Seeking to achieve more room for large interest rate cuts also
presumes that there are no other policies that can be used to stimulate demand if the zero
lower bound it reached. However, during the crisis central banks have shown great ingenuity
in designing new policy tools, although, admittedly, uncertainty remains about their
15
Bean (2008) lists a number of causes, including a failure by regulatory and supervisory authorities to
appreciate the risks inherent in the 'originate-to-distribute' model; opacity in risks underlying complex
structured finance assets; excessive reliance on statistical models of risk based on past behaviour;
overdependence on ratings by investors and a failure to observe due diligence; excessive closeness of the
ratings agencies to those who were issuing debt; compensation schemes in financial institutions that
stimulated risk-taking; and a focus on short-term returns.
16
As a point of comparison, the peak rates during the last interest rate cycle were 4.25 per cent for the ECB
(July 2008 - October 2008), 5.75 per cent for the Bank of England (July 2007 - December 2007) and 5.25 per
cent for the Federal Reserve (June 2006 - September 2007).
17
See Bean et al. (2010) and Kohn (2010).
18
When asked by a journalist for his thoughts on the issue, Jean-Claude Trichet (then ECB president) described
the idea of a 4% target as "plain wrong". (http://www.ecb.int/press/pressconf/2010/html/is100304.en.html)
effectiveness and how best to apply them. Nevertheless, it is difficult to argue that short term
interest rates are the only policy instrument available to policy makers.
Moreover, the argument that central banks need more leeway to reduce interest rates
implicitly assumes that the zero lower bound will be reached frequently. A number of authors
have studied this hypothesis using simulations, concluding that an inflation objective as low
as 2 per cent did not impose much constraint on monetary policy (e.g., see Reifschneider
and Williams 2000). Given how rarely the zero lower bound has been reached in practice,
having some extra room to cut interest rates appears to be of limited value.
Some observers might be tempted to argue that raising inflation objectives is desirable
because it would help reduce the burden of the public debt. However, this would only happen
if the change in policy was not known to, or perceived by, bond holders. In the current
situation of high transparency, neither of those conditions holds. Indeed, raising the inflation
objective is likely to trigger expectations of higher inflation and increase long-term interest
rates precisely at a moment when economies remain vulnerable to contractionary shocks.19
Moreover, if inflation objectives were changed once, they could surely be changed again.
Raising them could consequently damage the credibility of monetary policy, reduce central
banks' control of long term inflation expectations, potentially making longer interest rates
more volatile and raising inflation risk premiums.
While there is still broad consensus that the level of central banks' inflation objectives before
the crisis erupted remain appropriate, a number of authors have argued that inflation
objectives could be changed in other ways. For instance, the range compatible with price
stability could be broadened. As discussed in the next section, this would enable central
banks to attach greater weight, temporarily, to financial stability objectives. A closely related
idea is to target the average inflation rate over some period of time rather than a range that
must be held at all times, as does the Reserve Bank of Australia.
Others have argued that targeting a (rising) price level may be preferable to targeting
inflation.20 Under this framework, a decline in the price level due to a contractionary shock
such as a financial crash must be offset by higher inflation in the future. In contrast, under an
inflation target, such a price level shock has no implications for future inflation. Price-level
targeting consequently raises near-term inflation expectations and therefore reduces
expected short-term real interest rates to a greater extent than is possible with an inflation
target. But targeting the price level is not unproblematic. After a large contractionary supply
shock, central banks would be required to run tighter monetary policy than under inflation
targeting, which seems undesirable.21
There are several possible changes to inflation objectives and no consensus has emerged
whether any would be desirable. My suspicion is that the benefits of further refinements of
the inflation objective are small in practice and the potential difficulties arising from a change
of the objective substantial. I would therefore not expect widespread redefinitions of inflation
objectives in the near future, although of course individual central banks may decide to do
so.
3.2 Intermediate targets and information variables
The practice of gearing monetary policy directly to the achievement of price stability has led
central banks to abandon intermediate targets or, in some cases, to replace them by model-
based forecasts of inflation. Nevertheless, in setting monetary policy, central banks continue
to rely on information variables, that is, variables that are viewed as containing important
information about financial and economic conditions but are not fully captured in the
forecasting models used.
One consequence of the crisis has been that central banks focus much greater attention on
the state of the financial sector, since weaknesses in it has been a drag on aggregate
demand and has blunted the monetary transmission mechanism.22 Since macroeconomic
models typically incorporate few, if any, financial variables from the sector (IMF 2010), much
of this analysis is conducted using a range of financial variables. To mention but a few,
central banks look at variables such as the spread between secured and unsecured
interbank rates as a proxy for credit risk in the banking sector, the level of trading in various
money market sectors, and activity in key credit markets.
While the role of the financial sector in the models used for forecasting and analysis will
increase over time, the use of information variables to capture the state of the financial
sector, which has increased sharply during the crisis, will surely continue, with the range of
indicators relied on depending on country-specific features of the financial system.
3.3 The instruments of monetary policy
The most notable change brought by the crisis has been a number of innovations in the way
in which central banks implement monetary policy. This raises the question of whether
central banks will retain some of the new instruments after the crisis has abated.
Furthermore, what will be the lasting impact of the crisis on the functioning of money markets
and how will this effect central banks' operational frameworks?
Before the crisis, central banks implemented money policy largely by setting a short-term
policy rate or by influencing short-term interbank rates (Stone et al. 2011). Of course,
changes in short-term interest rates do not on their own have much of an impact on
aggregate demand, which is much more sensitive to long-term interest rates. However, long
term interest rates are influenced by market participants' expectations of future monetary
policy. It therefore becomes important for the central bank to influence these expectations.
This can be done in many ways, in particular by the central bank being transparent about its
objectives and how it views the macro economic outlook. It is for this reason that many
central banks publish forecasts for inflation and economic activity. Some central banks in
smaller economies also publish forecasts for their own policy rates.
During the crisis central banks have undertaken a wide range of operations. While there is no
single way to ca