In the Wake of the Crisis: Leading Economists Reassess Economic Policy

I. Monetary Policy

International Monetary Fund
Published Date:
March 2012
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Questions: How Should the Crisis Affect Our Views of Monetary Policy?

Precrisis Consensus

The years before the world economic crisis began in 2007 and 2008 saw the emergence of a consensus view of monetary policy. It went roughly like this:

1. Flexible inflation targeting provides a sound framework for monetary policy.

2. The supervisory and macroeconomic aspects of monetary policy can be largely separated.

3. Departures of asset prices from fundamentals are hard to detect in real time, and the contractionary effects of sharp falls in asset prices can be greatly mitigated by monetary easing. As a result, asset prices should affect monetary policy only to the extent that they help predict goods price inflation and the output gap.

4. The zero lower bound on nominal interest rates is a minor issue. It is rarely encountered, and its consequences are likely to be modest when it is. Moreover, policymakers have powerful tools (such as targeting long-term rates and temporarily raising their inflation target) that they can use if it becomes a major constraint.

5. Monetary policy and fiscal policy are linked in the long run through the government budget constraint, but in the medium run they should and can be kept largely separate.

Postcrisis Issues Related to the Precrisis Consensus

The crisis and the policy responses to it have raised concerns about each of these ingredients of the consensus view. Taking them in reverse order:

5. To what extent have policy actions in the crisis—such as special lending facilities, measures to prevent the disorderly failure of particular financial institutions, and actions to support sovereign debt—blurred the lines between monetary and fiscal policy? Are such actions a mistake? Are they necessary in extreme circumstances? Should they be a standard part of the monetary policy toolkit?

4. Has the zero lower bound been an important constraint in the crisis? Does the failure of central banks to adopt some of the precrisis ideas for dealing with the zero lower bound reflect drawbacks of those ideas that were not understood by their proponents, or does it reflect excessive caution or lack of concern about unemployment on the part of policymakers? Should any of those ideas be adopted now? Should central banks adopt higher inflation targets when the crisis has passed? Should they target a price-level path or a path of nominal gross domestic product?

3. Should interest-rate policy respond to asset prices? If so, what asset prices—and what types of movements in those prices—should affect policy? Should central banks take a more ecumenical view of monetary policy, thinking not only of the policy rate but also of margin, reserve, downpayment, and capital requirements jointly as the tools of macroeconomic and financial stabilization policy (as many of them once were)?

2. Is it important for central banks to play a major role in financial supervision? Should changes in capital requirements and related tools be coordinated with interest-rate policy? Can regulation of systematic risk and supervision of idiosyncratic risk be separated? If central banks use a larger set of tools beyond the policy rate, can full central-bank independence be preserved, or does it need to be redefined?

1. Is inflation targeting the right framework going forward? Is the so-called divine coincidence result that stable inflation implies a stable output gap a reasonable approximation, or should central banks explicitly care about the output gap? And if so, how? Also, even when they claim to follow an inflation-targeting strategy, central banks in many emerging economies clearly care about exchange-rate movements beyond their effect on inflation. Many of them use the policy rate and manage their reserves to smooth their exchange rate. Are they right to do so?

Other Issues Raised by the Crisis

Some other issues concerning monetary policy raised by the crisis:

1. Do large expansions of central-bank balance sheets pose a significant risk of inflation? If so, through what channel: A largely conventional one of losing sight of the inflation objective and of long and variable lags? A loss of confidence in central banks and a consequent unmooring of inflation expectations? Capital losses on central banks’ balance sheets and a resulting loss of independence?

2. Is there any truth to the claim that central banks responded much more aggressively and creatively to disruptions in financial markets than to the prospect of years of high unemployment? If so, was this appropriate? And if it did occur and was not appropriate, why did it occur?

3. Do the increasingly precarious fiscal positions of many countries threaten central-bank independence?

4. How has the crisis changed the importance of international coordination in monetary policy? For example, swap lines and other arrangements among central banks were important during the crisis. And at the zero lower bound, a central bank cannot easily offset the aggregate demand effects of other countries’ exchange rates or trade policies. Do these observations have important implications going forward?

5. Should central banks change their communication policies substantially as a result of the crisis?

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