The focus of the major central banks is firmly fixed on “normalising” monetary policy after the unprecedented interventions of the past decade. But they are also now turning their attention to a longer term issue: after normalisation, will the new monetary policy framework be robust in the face of the next recession?
The answer depends partly upon how “normal” the new normal will be. One possibility is that the next recession will not occur until wage and price inflation have returned sustainably to their pre-2008 averages (4 per cent and 2 per cent respectively in the US), while the equilibrium short term real interest rate, r*, is also back to its norm of 2-3 per cent.
Under those circumstances, the nominal policy rate ahead of the economic downturn would probably be in the region of 4-5 per cent, leaving plenty of scope for rates to decline as the recession took hold. Problem solved!
However, such a reassuring outcome seems unlikely, especially outside the US. The core problem is that r* may well be held down by structural problems, including demographics, low productivity growth, higher risk aversion and, in some countries, fiscal consolidation.
A permanently lower r* creates two main difficulties for central banks:
A further problem is that inflation and inflation expectations may not actually be as high as 2 per cent. Both the ECB and the Bank of Japan (BoJ) have struggled to keep inflation expectations in line with their targets. To the extent that they fail to do this, the minimum level for real interest rates will get stuck above -2 per cent, and the maximum level of monetary stimulus will be correspondingly reduced.
For a recent Brookings Paper, Fed authors Michael Kiley and John Roberts conducted simulations on the main macroeconomic models used by the Fed to demonstrate the likely effects of a permanent decline in r* to only 1 per cent, roughly half its pre-2008 level. They conclude that the Fed’s policy rate “should” be below the effective lower bound (ELB) about 30-40 per cent of the time in order to keep average inflation at 2 per cent. Of course, this is impossible.
This means that interest rate policy alone could not deliver the optimal setting for monetary policy over long periods during the economic cycle, not only in the extreme conditions of a serious recession. The situations in Japan and the Eurozone are probably much worse.
When the central banks faced this situation during the Great Recession, they resorted to asset purchases and forward guidance to increase the degree of monetary accommodation after policy rates had reached the ELB. These unconventional instruments would be available to them again, but there are doubts about their effectiveness.
Central bank balance sheets are still bloated, and further increases could come up against political and market constraints. Experience suggests that even large additional purchases may have little effect on risk premia in the bond market, the channel through which they are supposed to work.
Forward guidance had some impact in the last recession, mainly by extending the market’s expected duration of zero short rates and thereby reducing bond yields. There is scope for this to work again in the US, since short rates are currently expected to rise and bond yields are around 3 per cent. The Kiley/Roberts paper is optimistic that forward commitments to maintain rates at zero until inflation or activity targets have been reached can be effective in the US.
But that is unlikely to be the case in the Eurozone or (especially) Japan, where expected rates are already super-low and forward guidance may not therefore change the future path for rates by a meaningful amount.
What else could be done? Alan Blinder recently floated two suggestions: price level targets instead of inflation targets, and/or caps on long-term interest rates. However, both ideas entail clear disadvantages.
Price level targets could be useful if they are credible, since future expected inflation would rise automatically whenever the CPI level falls below the target path in a recession. There would have to be a period in which inflation is above 2 per cent to return price levels to target, which would help to reduce the forward-looking real interest rate.
But the abandonment of the 2 per cent inflation target might undermine central bank credibility. Furthermore, if central banks are unable to hit the price levels implied by a 2 per cent per annum path in the first place, why should they be expected to meet even higher inflation targets to restore prices to target in the future? Non-credible price targets are worse than useless.
Finally, what about caps on long term bond yields? The yield curve control policy in Japan has operated smoothly so far, but has not yet increased inflation expectations or the inflation rate. Moreover, the potentially difficult exit from the yield cap has not yet been attempted. It could lead to market instability.
So are the central banks out of ammunition? Not entirely. The Fed might, with luck, be able to handle a normal recession with its established weapons. But an extreme American recession would be another matter entirely.
And the ECB and BoJ have already encountered a shortage of monetary options. Come the next recession, both could be in serious trouble.