Manuel Sánchez: The powers and limits of monetary policy
Remarks by Mr Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the Cato
Institute's 33rd Annual Monetary Conference "Rethinking Monetary Policy", Washington DC,
12 November 2015.
* * *
Thank you very much for inviting me to be here today. It is an honor to participate this year in
another monetary conference organized by the Cato Institute.
Monetary policy is powerful when focused on what it can clearly accomplish. But negative
consequences can occur when it takes on ancillary objectives. Some of its capabilities are
well known, while others are still in the process of being properly understood. Hence,
addressing the question of what it can and cannot do should be approached with modesty.
Today, I would like to present my views on this issue by first discussing positive impacts
expected from monetary policy. Second, I would like to examine potential negative effects.
Third, I will touch on the need for time consistency to make policy reliable. Fourth, I will
briefly discuss monetary challenges faced by emerging economies in the current context of
the extraordinarily accommodative monetary stances of advanced nations. And finally, I will
draw some conclusions.
As usual, my remarks are entirely my own and do not necessarily reflect the views of the
Bank of Mexico or its Governing Board.
What positive impacts can monetary policy have?
The most indisputable contribution monetary policy can make to the wellbeing of any society
is price stability. As succinctly stated by Milton Friedman, "inflation is always and everywhere
a monetary phenomenon," and hence, monetary policy can control it.1
The benefits of price stability are well known. It provides a favorable framework for efficiency
and economic growth. High inflation, on the other hand, breeds wasted resources, and, when
unexpected, can generate consumption and investment errors. It can even fuel a loss of
confidence in a country's currency.
The widespread acceptance of monetary policy to control persistent changes in the average
level of prices has led central banks to establish price stability as their primary objective. In
practice, central banks understand this as a minimum inflation rate, say 2 or 3 percent,
consistent with factors such as innovations and consumer responses to relative price
changes not properly accounted for by traditional price indexes.
In light of this definition, pursuing price stability may encompass averting the risk of deflation,
a fear recently manifested by several monetary authorities in advanced nations. Regarding
deflation, the following four comments are in order.
First, some deflation can theoretically be justified in terms of economic welfare. Friedman
advanced the argument that one way the economy can achieve the long-run optimum
quantity of money is with a rate of deflation that makes the nominal rate of interest equal to
zero. Another way would be to pay interest on money balances.2
Second, large time series data reveal that there is no clear negative relationship between
deflation and economic growth across countries. Furthermore, in the postwar period, bouts of
deflation have been milder and less persistent than before, with average growth during
deflation years exceeding that of inflation years.3
Third, recent low inflation largely resulting from declining commodity prices, notably energy,
has sparked deflation scares in several developed countries. However, these risks should be
properly assessed. Falling inflation stemming from reductions in relative prices, while
beneficial to consumers, may not persist, given that some of the causes behind them are
necessarily transitory, such as overinvestment in the energy industry.
Fourth, as with the fight against inflation, monetary policy is well equipped to forestall
unwelcome deflation. The historical international record of the ends of episodes of deflation
proves this to be the case.4
The existence of a Zero Lower Bound (ZLB) for policy interest rates in environments seen to
be flirting with deflation has long inspired economists to conduct research. Approaches taken
have engendered controversy over the power of monetary policy at the ZLB. However,
recent large-scale asset purchases undertaken by central banks in advanced countries
confirm that the possibilities for monetary policy do not end at the ZLB.5
Finally, under emergency conditions of financial market distress, central banks may perform
the role of lenders of last resort. One example can be found in the extraordinary actions of
the U.S. Federal Reserve during 2008. Provision of needed liquidity helps restore normal
market conditions. This should always be done at a penalty rate and against sufficient
collateral, following Bagehot's advice, and as a temporary measure, to avoid moral hazard.6
What positives is monetary policy less certain to achieve?
While there is broad consensus on the ability of monetary policy to control inflation over time,
there is less agreement on other goals it could pursue. One tendency, accentuated in the
wake of the financial crisis of 2008-2009, is to assign additional objectives to monetary
policy.
Two goals stand out. One is the long-standing aim to boost economic activity. It is widely
accepted that long-term growth depends on real factors such as investment in both physical
and human capital, as well as total factor productivity. Their behavior over the long haul is
independent of monetary policy, and hence, the long-term neutrality of money should hold.
Where the short term is concerned, there is controversy over the capacity of monetary policy
to stimulate the economy. Under conditions of full employment, completely anticipated
expansionary monetary policies are expected to produce inflation. Rational expectations
models incorporating frictions such as imperfect information or price rigidities have been
3
See Borio. C. et al. (2015). "The Costs of Deflation: A Historical Perspective," BIS Quarterly Review, March;
and Ryska, P. (2014), "Deflation and Economic Growth in Long-Term Perspective," Charles University in
Prague, Institute of Economic Studies Working Paper 18/2014.
4
An examination of the role of monetary policy in exiting deflation can be found in Bordo, M. and A. Filardo
(2005). "Deflation and Monetary Policy in a Historical Perspective: Remembering the Past or Being
Condemned to Repeat it?" Economic Policy, 20(44). To review the Japanese experience with deflation, see
Ito, T. and F.S. Mishkin (2006). "Two Decades of Japanese Monetary Policy and the Deflation Problem," In Ito,
T. and A.K. Rose (eds.), (2006). Monetary Policy under Very Low Inflation in the Pacific Rim, NBER-EASE,
Vol. 15, Chicago: University of Chicago Press.
5
For monetary possibilities at the ZLB, see Goodfriend, M. (2000). "Overcoming the Zero Bound on Interest
Rate Policy," Journal of Money, Credit, and Banking, 32(4).
6
See Bagehot, W. (1873). Lombard Street: A Description of the Money Market, New York: John Wiley & Sons,
(reprinted 1999).
used to replicate short-run tradeoffs between inflation and unemployment. However, given
the long and variable lags with which monetary policy acts, attempts to exploit those
tradeoffs can result in output instability. International experience with high and volatile
inflation during the 1970s and 1980s illustrates this danger.7
Under the shadow of the global crisis, many developed countries have held extremely loose
monetary policies for a prolonged period of time. This has been possible, apparently, thanks
to the relative stability of long-term inflation expectations. Some studies suggest that
extraordinary accommodation has supported economic activity, although the degree to which
this has happened is still subject to debate. Meanwhile, negative side effects may be
accumulating.8
Another goal which in recent years has gained prominence is to request that monetary policy
safeguard financial stability. Although financial instability is a somewhat ambiguous notion, it
is generally referred to as a situation in which financial markets exhibit dislocations to the
extent that their functioning is impaired, with adverse impacts on economic activity.9
Aside from fulfillment of the central bank's role as lender of last resort, the best monetary
policy can do for financial stability is to avoid becoming a source of problems, notably, by
deviating from the primary goal of price stability. For example, monetary policy can react
preemptively to aggregate demand pressures that may endanger the inflation target. As a
beneficial byproduct, this measure may contribute to the maintenance of financial stability by
indirectly attenuating incentives for financial excesses.
Even though monetary policy may thus aid financial stability, it can hardly take the task on as
an objective in itself. To begin with, such a goal cannot be translated into an unambiguous
quantifiable target. Hence, the evaluation of its attainment is cumbersome.
Perhaps more importantly, if pursuing financial stability is meant to include identifying
potential asset price bubbles, leaning against them, and trying to prick them, this may be
close to an impossible task. One essential characteristic of bubbles that lead to crises is that
they do not obviously look like bubbles until they implode.
The authorities have no comparative advantage in identifying financial bubbles. But even if
they did have a crystal ball to tell bubbles apart from healthy growth, monetary instruments
may be ill suited to the purpose. For example, higher interest rates in an emerging economy
meant to deflate a bubble fed by substantial capital inflows may actually exacerbate the
problem by attracting more flows.
Therefore, financial stability should be regarded as a separate objective to be tackled with
non-monetary tools. The first line of attack to reduce financial systemic risk should be to
maintain a sound regulatory and supervisory framework, which includes strict capitalization
and liquidity rules as well as clear resolution schemes for financial institutions.
In short, the biggest risk with additional goals, as Friedman warned almost fifty years ago, is
that monetary policy may end up not accomplishing what it is most suited to do in the pursuit
of what it is less suited to do.10
What negative impacts can monetary policy produce?
As with other policies, monetary actions can produce negative effects. Although in some
cases, these may be unintended, in others, likely costs are taken on because they are
assumed to be outweighed by expected benefits.
A leading traumatic case occurred during the Great Depression in which the U.S. Federal
Reserve did not meet an increased demand for liquidity and allowed a contraction in the
money supply, resulting in widespread deflation, worsened financial panic, and plummeting
economic activity. More often than not, in many economies, excessive monetary expansion
has led to periods of significant inflation.
Additionally, monetary policy that is too easy may be a cause of financial problems.
Specifically, it can trigger the search for yield and the undertaking of too much risk. For
instance, a loose stance may have contributed to the run up of the U.S. credit and housing
bubbles prior to the big financial crisis. Debate over the importance of this element, relative
to other policies, continues to this day.11
Furthermore, the increasingly extraordinary monetary accommodation in advanced countries
since the global turmoil, which has included massive asset purchases for a long time and, in
some cases, negative policy interest rates, may be engendering financial imbalances, not
only in these economies but also in other nations.
Other negative impacts may include the undertaking of quasi-fiscal operations blurring the
independence of monetary policy, incentives for governments to postpone needed fiscal and
structural adjustments, fewer motives for business to improve efficiency and distorted
resource allocation, questionable income redistribution, and future difficulties controlling
inflation.12
Some of these costs may take time to become evident, thus allowing expansionary monetary
policies to claim principally benefits. However, should significant problems arise, policy could
lose credibility. An objective evaluation of causes of any possible negative effects will by
necessity take time.
The need for time consistency
Given its capabilities and bounds, it is desirable for monetary policy to focus on price
stability. Effectiveness hinges on the authorities' commitment to this goal. In addition, the
strategy must be well understood by the public. Complexities are inherent in this endeavor.
One is political pressure or principal-agent problems that call for deviation from the price
stability target. For instance, resistance to interest rate hikes is far stronger than to cuts, and
it may sometimes come from interest groups with high stakes in the matter.
Another complication might stem from the existence of more than one goal, which may make
the rationale for monetary policy decisions hard to convey. One more may come from the
lack of clarity regarding the way policymakers react to available information.
As a consequence, monetary policy can easily be time inconsistent. This and dependence on
high-frequency data can force economic agents to spend a great deal of time and resources
second-guessing monetary policy actions.
One way to facilitate coherence and clarity is for central banks to express long-term guidance
for their future actions in a form that may approximate a policy rule. There is evidence that
periods when monetary policy is rule-like largely coincide with good economic performance.13
This should not be interpreted as using a rigid, mechanical rule for monetary policy, but a
way to make it systematic and predictable. With long-term guidance, specifics are secondary
as long as they lead to the goal and policy makers follow through. Deviations from strategy
under extraordinary circumstances can be clarified when they are warranted.14
Challenges for emerging economies
Emerging economies confront their own challenges for appropriately conducting monetary
policy. On the one hand, these countries need to control inflation, especially in light of long
histories of significant price instability. During the postwar period, developing economies
have commonly lagged advanced countries in these efforts, frequently because of fiscal
dominance. To this day, some countries still suffer from high inflation and struggle to control
it, within relatively weak macroeconomic policy frameworks, especially in matters related to
fiscal discipline.
On the other hand, emerging-market authorities have always had to consider the decisions of
major central banks and the effects on their economies. In the present context, loose
monetary stances in advanced nations may have triggered spillover effects on emerging
economies via capital flows, including ample foreign-currency (FX) lending, and rises in
financial asset prices. Expectations for the unwinding of lax policies have started to turn the
tables on these impacts, as reflected by a weakening trend for emerging market currencies,
among other tendencies.15
In the attempt to moderate these effects, many financial authorities have responded with
measures frequently justified as macroprudential policies. In particular, initially, many central
banks cut policy rates. In fact, there is evidence that in recent years monetary policy in
emerging economies has tended to become looser than what would have been granted by
their own price stability mandates. Many economies also implemented FX intervention to
accumulate international reserves, while some added capital flow restrictions.16
Recently, several countries have reversed these measures. Barriers to capital flows have
been relaxed and international reserves have been used, while monetary policy has
frequently remained accommodative, potentially implying contradictory policy directions. In
some cases, however, monetary stances have begun to be tightened. A concern in some
emerging economies is high pass-through from currency depreciation to inflation.
Trying to counteract external monetary policy effects may have resulted in some costs to
central banks in emerging markets. These may include possible moral hazard from investors'
expectations of being protected from losses in risk positions, increased uncertainty regarding
policy measures, as well as damaged progress towards the attainment of price stability.
In fact, in some cases, it has become clear that imbalances have largely resulted from
misguided domestic policies, such as excessively stimulative fiscal and financial measures.
Thus, blaming problems on foreign lax monetary stances may have distracted countries from
correcting internal fragilities in a timely way.
A challenge in the current global scenario is for central banks to pursue price stability in the
face of upcoming monetary normalization in the United States, while at the same time taking
into consideration possible spillovers to the extent that they may have some bearing on
achievement of their inflation targets.
Concluding remarks
The recent global financial crisis has generated increasing demands on monetary policy. The
top risk of overburdening monetary policy with possibly incompatible objectives is diminished
credibility. Hence, setting realistic expectations of what it can and cannot do is all the more
important.
The greatest contribution monetary policy can make to society is price stability. Given the
long-term neutrality of money, any attempt to use it to boost growth is by nature limited. With
respect to financial stability, the best monetary policy can do is to avoid provoking problems,
notably, by neglecting inflation control.
Monetary policy can obviously engender adverse impacts. Some may take time to surface.
But if significant problems arise, policy can lose effectiveness. Furthermore, monetary policy
can be time-inconsistent, and to avoid difficulties from this issue, the intentions of decision
makers must be transparent. An explicit long-term strategy goes a long way to facilitate
coherence and clarity.
Emerging economies confront specific challenges in the wise use of monetary policy. Many
of these countries have histories of high inflation and are struggling to leave it behind. Also,
they must act within the world scenario in such a way that they do not deviate from the
objective of price stability.