The Monetary Policy Toolbox

Published 30 March 2017

The period of ultra-loose monetary policy will forever be associated with the Great Recession and its lingering fallout. So does the Federal Reserve’s latest rate hike signal the beginning of the end of this unprecedented period of accommodative monetary policy?

The Fed raised the benchmark federal funds rate 25 basis points on March 15 to a range of 0.75% to 1% in what was the third hike since the financial crisis. While the latest rate increase is surely a sign that the world’s largest economy is on a much firmer footing, it may not necessarily spell the end of loose monetary policy. Fed Chair Janet Yellen has sounded notes of caution about aspects of the economy and, in particular, stubbornly high unemployment. So the possibility of further rate cuts is not completely off the table.

Economists have long pondered what the long-term effects will be of this period of low interest rates and quantitative easing (QE). In the short-term, it has no doubt injected liquidity into the system and given investors incentive to purchase other assets. It has also kept interest rate payments on bonds depressed at a time when Governments are still exercising some form of fiscal caution. But the question occupying economist minds now is not so much that of the long-term impact of ultra-loose monetary policy but what will happen when more central banks begin to pull the plug.

Meanwhile, many in the financial services industry have been asking themselves a bigger and more pertinent question — what will happen if another recession suddenly strikes? With interest rates still so low and QE still in effect across the Eurozone and Japan, an economic shock could leave many countries vulnerable and with a lack of monetary tools.

But what this recession should have taught us is that unconventional situations require unconventional responses. Just as QE was an unorthodox measure pursued in the early 2010s, central banks still have some options in their toolbox should Governments not want to resort to fiscal action. In a series of blogposts, former Fed Chair Ben Bernanke has raised the specter of three policy choices central banks could pursue: negative interest rates, targeting long term interest rates and helicopter money.

Negative interest rates are already in effect in several countries (Denmark, Japan, etc). Under this measure, rather than banks receiving interest on reserves held with central banks, they are charged a fee on reserves above a certain threshold. The end goal is to make banks shift to short term assets, pushing down their yields. This will (hopefully) result in declines in a broad range of longer-term interest rates (mortgage rates, corporate bond yields).

The policy has been met with a mixed reception. Some believe banks will simply pass on the cost of holding reserves to customers who, in turn, will withdraw savings and hoard cash — hurting the very financial institutes such a policy is meant to help.

Long-term interest rates could be an alternative. Central banks have generally targeted short-term interest rates, but have pegged interest to long term treasury debt in the past (noticeably during WW2). To see how such a peg could function, imagine the overnight interest rate is 1% and the five-year Treasury rate is 3%. The central bank would announce it intends to hold the five-year Treasury rate at 2% or less and stand ready to buy any Treasury security maturing up to five years at a price corresponding to a return of 2%. Given the inverse relationship between yield and bond price, the central bank would effectively be offering to pay more than the initial market value.

The problem here is credibility. How can investors be sure central banks will hold interest rates down? Any serious doubts could see investors sell off their treasury bills en masse, leaving the central bank owning most of them and generating much uncertainty over interest rates.

Helicopter money, meanwhile, is an unconventional tool intended to give a one-time tax rebate for the entire population financed by an expansion in money supply that will never be repeated. In theory, this should stimulate consumer spending and increase inflation. However, much like long-term interest rates, there is a problem with credibility. How can central banks guarantee it will be a one-off occurrence? And how will they co-ordinate with the legislature to implement the policy?

The problem with unorthodox policies is precisely in the name: they are unconventional and each one carries a different set of risks that could end up backfiring. While it is extremely unlikely that these policies will be implemented, their mere existence should ease fears expressed by many in the financial industry about the limits of monetary policy. While central banks cannot solve everything, they still have a few tricks up their sleeves should things truly turn sour.

Inigo Rudio