Monetary Policy After the Crisis

1. Monetary Policy After the Crisis Challenges & Policy Responses September 2010

2. Background • The Great Recession and the financial crisis that marked its emergence put in check a lot of the consensus that MP had achieved • The crisis and emergency policy response that followed raised three policy questions: • What are the effects of unorthodox tools when the interest rate cannot be used as the main instrument? • What Should The Central Bank main focus be to get back on a solid footing recovery • What should be the right level of inflation • What is next for Monetary Policy

3. The Role for Monetary Policy • Changes in money supply M • The LM curve is drawn for a given supply of money • M/P = L(r,Y) • The Central Bank can directly affect that supply • Increase in M  r falls • Shift of LM curve • The Central Bank can also set interest rates • A monetary policy change affects interest Rates for any Y with the spill over effects in the goods market

4. The Role for Monetary Policy r Shape of LM will depend on how CB sets its policy LM r r1 1 L(Y2)‏ L(Y )‏ 1 Y M/P M/P The Central Bank commits to setting M at whatever level is necessary to sustain r1in the money market

5. Quantitative Easing: Major Players, Basic Elements • Expanding the amount of money in the economy Central Banks • Expanding the balance sheet of the Central Bank $ trillions reserve R at 0 Assets Banks Bonds Price BondsYields Companies Households

6. Quantitative Easing: How It works • The Central Bank buys Government bonds • The extra demand raises bond prices and lower their yields • Lower long-term interest rates stimulate economic activities. • Banks sell their bonds to the Central bank creating reserves in return • Banks swap low-yielding reserves for better return shares or corporate debt. • This lowers private-borrowing costs and raises asset values, boosting wealth and spending Does it work? • No guaranteethatbankswilllend or thatcompanies or householdwillborrow • The Bank of Japan five-years of QE in the early 2000s had barely any effect on inflation and unemployment • The Federal Reserve Policy of QE that bought $1.75 trillion of Treasuries and mortgage-related debt, bringing long-term interest rates down sharply had barely any effect on bank credit . • The Risk Of QE • Central Bank canloose money • Danger of Inflation • Potential to destroy confidence in an Economy • May not work if not implementedaggressivelyenough • Difficult to gauge how much QE isneeded

7. Quantitative Easing: Assessing The Effects

8. Asset Bubbles • The consensus view, embodied in the Taylor Rule, was that the CB should only look at inflation and prices • But this could contribute to asset price “bubbles” (i.e. unsustainable price increases) • It follows that even when inflation (of goods and services) is low, there could be asset price inflation indicating that the economy is overheating • The Central Bank could raise interest rates, even if inflation is low, when they perceive a bubble in asset prices • But when do you know it’s a bubble, as opposed to a sustainable increase in prices? • Should interest rates be the instrument to “prick” those bubbles? • The CB is typically also the regulator of financial markets…  “Macroprudential regulation”

9. Inflation: Rethinking The Right Target • Low inflation implies low nominal interest rates • If interest rates are low when a crisis hit, it is more likely that MP will hit the zero rate lower bound. • Deflation should be avoided because it depresses spending, and thus creates a vicious circle • Fighting inflation is very important to ensure both the credibilty of The Central Bank and the effectiveness of monetary policy .

10. Interest Rates: Forecasting The Outlook The U.S. Given the uncertainty about the recovery and the fear for a double-dip recession, the Fed is likely to keep interest rates at «Exceptionally low» levels for an extended period of at least 6 months Canada Recent emerging signs of accelerating inflation and the Canadian dollar climbing to parity with the US Dollar, has led some economists to predict an earlier rate hike. Eurozone With both growth and inflation remaining moderate, The ECB is focused on gradually withdrawing the exceptional steps it took to prop-up the financial sector China The People’s Bank of China has been adopting a wait-and-see approach before developping the «heavy-duty weapon» of interest rate hikes. But with Consumer Inflation rising to 2 .8% and the benchmark one-year deposit rate at just 2.5%, there is an increasing likelihood of a r Te hike in the coming months. Japan With deflation and rates at 0.1%, the BoJ has been under pressure to take further action. The Bank recently increased a programme of three-month 0.1% loans to Commercial Banks from Y 10,000 to Y 20,000 bn, but is resisting calls for it to buy Government bonds or other assets. Rates are likely to remain close to zero for at least a year. Australia Expectations are ripe for rates to reach the4.5-5% range. There is increasing concern about rising inflation, higher house prices and climbing wages.

11. Central Banks: The need for readjustment

12. Policy Prescriptions • QE need to be combined with looser fiscal policy to stimulate private demand • The governmntshouldstep in to boostspending by borrowing to cut taxes; sendcheques to households; build Infrastructure; and if necessaryextinguishunderwatermortgages • Create fiscal institutions thatmimic the rigour and autonomy of Central Banks thatwill help the governments to commit to a targetdebt-to –GDP ratio.