IMF Assesses New Era of Monetary Policy

IMF Survey online - May 16, 2013

Several years of exceptionally low interest rates and bond buying by some advanced economy central banks have reduced the risk of deflation, stabilized the financial system, and calmed financial markets, but these unconventional policies also have potential negative side effects.

The latest analysis from the IMF is part of ongoing work to examine the role and effects of monetary policy during and after the global crisis.

Central banks in a number of countries have deployed new tools to counter the effects of the global crisis, which experts often refer to as unconventional monetary policy.

Two recent chapters in the IMF’s Global Financial Stability Report and the World Economic Outlook focused on the financial stability implications of these policies and the behavior of inflation during the crisis and the subsequent sluggish recovery, respectively.

This new work from the IMF examines the policies, their objectives, their effects at home and abroad, and what role they might play in the future.

“These policies were instrumental in ensuring financial and economic stability following the global crisis,” said Karl Habermeier, an Assistant Director in the IMF’s Monetary and Capital Markets Department. “But monetary policy cannot do everything. Governments and banks should use the breathing space provided by these unconventional policies to move forward with needed fiscal, structural, and financial sector reforms.”

Stabilize economy, reduce risks

Central banks in the United States, United Kingdom, Japan, and euro area adopted a series of unconventional monetary policies during and after the crisis with two broad goals in mind.

The first was to stabilize financial markets by injecting cash into the financial system through direct liquidity provision and purchases of private assets.

The second was to provide further monetary policy assistance when interest rates reached zero or near zero lower bound by indicating they would keep them low for a while; and by purchasing bonds.

The two objectives, while conceptually distinct, are closely related. Both ultimately aim to support economic stability, including by reducing risks in acute phases of the crisis—notably preventing the collapse of the financial system, a depression, and deflation.

These policies achieved their goals in advanced economies, and were especially effective at the time of greatest financial turmoil, according to the IMF. Market functioning was broadly restored, and the possibility that the worst risks would resurface declined significantly.

Policies also decreased long-term bond yields, and in some cases credit spreads. Growth and price stability also benefited, although there is considerable uncertainty about the size of the impact given the long lags and unstable relations between variables and the unresolved question of what would have happened if no action had been taken.

Mixed effects on other countries

So far, emerging market economies have benefited from the policies put in place in the advanced economies, which helped to stabilize emerging market economies in much the same way.

These effects buoyed growth in emerging markets through both real and financial ties. Early unconventional monetary policy announcements buoyed asset prices globally, and likely benefited trade.

Later announcements had smaller effects on foreign assets and increased capital flows to emerging markets, which can give rise to risks and policy strains. In most cases, sound economic policies—along with macroprudential measures and in some circumstances capital flow management measures—can help manage the risks from capital flows.

Challenging path ahead, many unknowns

Looking ahead, unconventional monetary policies may continue to be warranted if economic conditions do not improve or even worsen. Should conditions worsen, with no undue risk of inflation, the policies would likely continue to be appropriate, especially if there are any new shocks to the functioning of financial markets and intermediation.

In a scenario where the economy grows moderately, the net benefits of pursuing unconventional monetary policies are more ambiguous, and weighing benefits against potential costs will be more challenging.

Governments will need to manage the potential costs or risks associated with continued unconventional measures and more generally prolonged low interest rates. These include

• Banks and other intermediaries may increase their liquidity risk in expectation of central bank intervention

• Greater risk taking behavior, spurred by accommodative monetary policies, could undermine financial stability

• Delayed reforms may hinder future monetary policy effectiveness through a conflict of objectives

• Large and potentially volatile capital flows to other countries could persist or increase, with the potential for future abrupt reversals.

An orderly end to these exceptionally easy monetary conditions may prove challenging. The IMF identified two potential main risks:

• The effects of monetary policy on the economy could be bumpy when central banks begin to tighten and shrink their balance sheets by selling off some of their assets, with a risk that long-term interest rates could rise rapidly.

• As central banks make higher interest payments on reserves and realize losses from selling assets to shrink their balance sheets, political interference could increase as central bank profit transfers to government diminish or disappear during the tightening cycle.

The IMF will continue its work on these new monetary policies. It will investigate the merits of policy options in a range of conditions, some adverse and others looking further ahead into more normal times. The IMF said it expects to release more analysis on this topic later this year.