Saturday, 11 April 2015

The limits of monetary policy

Here is Cullen Roche quoting Ben Bernanke:
"Let there be no mistake: In light of our recent experience, threats to financial stability must be taken extremely seriously. However, as a means of addressing those threats, monetary policy is far from ideal. First, it is a blunt tool. Because monetary policy has a broad impact on the economy and financial markets, attempts to use it to ‘pop’ an asset price bubble, for example, would likely have many unintended side effects. Second, monetary policy can only do so much. To the extent that it is diverted to the task of reducing risks to financial stability, monetary policy is not available to help the Fed attain its near-term objectives of full employment and price stability."
And Cullen then goes on:
That’s a pretty interesting quote. You could actually apply that perfectly to, well, using monetary policy for anything. After all, it is an inherently indirect and imprecise policy tool. It works only through indirect transmission mechanisms like overnight interest rate changes, expectations channels, wealth effects, etc. If the past five years haven’t proven that monetary policy is a rather indirect and blunt policy, then I don’t know what would.
Basically, monetary policy is weak sauce....
This is from Cullen's commentary on Ben's post about financial stability. Ben argues that monetary policy is not the right means of addressing financial stability concerns, and makes the case for greater use of macroprudential tools. The whole post is well worth reading, but I've summarised Ben's key argument here:
  • The Fed has kept interest rates very low ever since the Lehman shock. Because of Fed easy money policies, the US economy is now recovering, unemployment is at near normal levels and deflation risk is low.
  • Nonetheless, Fed easy money policies have come in for continual criticism. Initially the criticism focused on fears of high inflation, but since inflation has failed to materialise, criticism now centres around financial stability concerns.
  • Monetary policy is not the right tool to address financial stability concerns. It is too blunt an instrument to pop asset bubbles safely, and using it to address financial stability concerns may conflict with using it to achieve primary mandates of price stability and full employment. 
  • Therefore central banks should use macroprudential measures to ensure financial stability, not monetary policy
So, monetary policy is not a cure-all. It has a specific purpose, namely to influence demand in the economy so as to achieve the Fed's twin mandates of price stability and full employment. And that is ALL it should be expected to do. But that doesn't make it useless, as this tweet from Ralph Musgrave suggests:

No, Ralph, Ben never said any such thing. On the contrary, he said that monetary policy over the last few years had reduced unemployment and created recovery.

Ben acknowledges that there might be a role for monetary policy in financial stability, but expresses concern that the costs may outweigh the benefits. He cites the experience of Sweden in 2010-11, which hiked rates to take heat out of the housing market despite poor economic indicators and ended up squashing economic growth and tipping the country into outright deflation. Ben observes that current research, though limited, does not support the idea that monetary policy should be used to address financial stability concerns:
As academics (and former academics) like to say, more research on this issue is needed. But the early returns don't favor the idea that central banks should significantly change their rate-setting policies to mitigate risks to financial stability.
However, the limited remit of monetary policy does not necessarily mean that Janet Yellen's commitment to financial stability is undermined, as Cullen seems to suggest. Macroprudential measures are also part of the central bank's toolkit. They are as yet underdeveloped. untried and their effects are to some degree unknown: as Richard Sharp of the Bank of England's Financial Policy Committee explained in June 2014, central banks are engaging in "an experiment in macroprudential management". But the fact that these measures are experimental does not mean they are useless. The Bank of England successfully used macroprudential tightening in June 2014 to take some of the heat out of London's prime residential housing market. It remains to be seen how effective macroprudential measures will be on future occasions, and what their unintended consequences might be.

But Cullen goes on to make an important and far-reaching point:
....Maybe we should stop believing in the idea that central bankers can steer the economy in certain directions and fix all of the world’s problems.
Belief in central bank omnipotence has led the world to dump all responsibility for generating economic recovery and preventing further crises onto the shoulders of central bankers. Belief in the uselessness of fiscal policy has encouraged central bankers to accept that burden even when it was clearly too great for them to bear alone. And belief in the evils of deficit spending and sovereign debt has led fiscal authorities to make central bankers' job even more difficult by engaging in fiscal tightening when their economies are already on the floor. Though central bankers hardly deserve our sympathy. They have actively encouraged the denigration of fiscal policy and reification of monetary policy. "Whatsoever a man soweth, that shall he also reap...."

Unlike Ralph, I do not think monetary policy is powerless: but neither do I think it can single-handedly generate economic growth when fiscal authorities are determinedly squeezing demand out of the economy with tax rises and spending cuts.

Cullen calls for greater use of other tools - such as "regulatory changes". Err, these wouldn't in any way be related to the measures that Ben talks about, would they? Ben seems to think so:
Effective financial oversight is not perfect by any means, but it is probably the best tool we have for maintaining a stable financial system. In their efforts to promote financial stability, central banks should focus their efforts on improving their supervisory, regulatory, and macroprudential policy tools.
But Cullen goes further. He calls for tax reforms and infrastructure investment. We can disagree over the details, but in principle this is eminently sensible. When the economy is on the floor, the public sector should invest in the infrastructure that will support business in the future, and make fiscal reforms complementing, rather than counteracting, the central bank's efforts to support demand and encourage business investment. What a pity that governments around the world have done the exact opposite, hiking taxes and cutting investment.

Artificial separation of fiscal and monetary policy cripples policymaking. It is time for monetary and fiscal policymakers to acknowledge their joint role in generating economic growth and preventing future crises.


  1. Frances,

    This is all a nice example of the Tinbergen principle which was thought up the Nobel Laureate Jan Tinbergen. Basically the Tinbergen principle says something like, “For each policy objective, there should be one policy instrument and just one”. I.e. if you use one instrument (e.g. interest rate changes) to try to influence more than one policy objective, you’ll trip up. Reason is that optimising one objective is highly unlikely to optimise the second.

    As to how useful interest rate adjustments are in adjusting aggregate demand, there is evidence that they are not brilliantly effective. See:


    But my real objection to interest rate adjustments is that they are DISTORTIONARY. That is, to the extent that they work at all, they influence just lending and investment based activity and not non-lending / non-investment based activity. There is no reason, given a need for stimulus, not to boost the latter activities. I.e. interest rate adjustments are a bit like implementing stimulus by doing a helicopter drop on households where the inhabitants have red or blonde hair, while those with brown and black hair wait for a trickle down effect.

    If interest rate adjustments worked much more quickly and precisely than fiscal adjustments then there’d be a case for the former. But far as I can see they work at about the same speed.

    And finally I fully agree with your last para which says “Artificial separation of fiscal and monetary policy cripples policymaking. It is time for monetary and fiscal policymakers to acknowledge their joint role in generating economic growth and preventing future crises.”

    That “artificial separation” is one of the merits of Positive Money’s method of doing stimulus, i.e. simply creating new base money and spending it (and/or cutting taxes) when stimulus is needed. (Though there are plenty of non-PM-supporters who also advocate that form of stimulus.) That is, creating and spending base money has a fiscal as well as monetary effect, so it doesn’t matter too much which of the two does the real work.

    1. I remember that Fed paper. Yes, the insensitivity of corporate investment to interest rate changes is a concern. But that does not mean that interest rates have no effect across the economy as a whole. It just means that some sectors are more sensitive to them than others.
      You do have to be a bit careful about fallacies of composition when discussing monetary policy.

      Interest rates affect much more than "just" lending and investment based activity. Corporations are typically leveraged and much of their debt is at floating rates. So even if they don't borrow any more, reducing interest rates reduces their costs and improves their profitability, enabling them to invest and hire. Similarly, the majority of households have debt, and in the UK a fair proportion of that debt is also at floating rates: even if it isn't, debts can often be refinanced to take advantage of lower rates. Reducing interest rates therefore improves household liquidity and can encourage spending and/or saving. On the downside, however, reducing interest rates reduces the current incomes of many retirees and the future incomes of those saving for pensions. So although I don't subscribe to the belief that monetary policy "gets in all the cracks", it does get in far more of them than you seem to think.

      But my bigger concern is that you are conflating interest rate policy with monetary policy. Interest rate policy is one aspect of monetary policy - an important aspect, clearly, but not the only one. Fiscal policy is not the only alternative to interest rate policy.

      I have been suggesting cooperation between fiscal and monetary authorities for (I think) more than three years now. Shame you missed it.

      Please don't promote Positive Money on this blogsite. Their marketing is quite aggressive enough already, and in my view their ideas although interesting are flawed.

  2. Nonetheless, I have a doubt: is not important the initial level of public debt?

    1. Where borrowing for investment is concerned, the level of public debt should ideally be completely irrelevant. Public sector investment projects should be justified on the NPV of future tangible returns just as private sector projects are. There may be some public sector projects that have negative NPV returns but are justified for social reasons, but in my view failing even to attempt to estimate tangible returns from (for example) investment in educational programmes is lazy. Public sector should adopt good project finance practices.

      However, the problem for countries with high levels of public debt and/or a bad track record on meeting obligations is that their borrowing costs are likely to be sufficiently high to rule out projects that in lower-risk countries would be justifiable. So yes, the initial level of public debt does matter. And the credibility of the government matters even more.

  3. I see, thanks. So, I imagine that in spite of ZLB, debt level matters.

  4. "Artificial separation of fiscal and monetary policy cripples policymaking"

    Hence, the abandonment of IS-LM analysis, which joins fiscal and monetary policymaking in graphical form, was a tragedy.

  5. The case for combining fiscal policy to compliment rather than obstruct the current expansive monetary policy seems obvious.

    Yet, governments in many countries are holding back from making proactive use in many countries. However, it is not only politicians that are being overly cautious but central banks are also holding back from trying out macroprudential policies at a time when experimentation seems possible and at least worth a try.

    It is as if we have reach the bounds of knowledge that is within the acceptable bounds and can go no further despite the negligible effects of current policies

  6. Its not clear that even the simple connection between interest rates and inflation is trivial. If high interest rates squashes investment then that is a scarcity of goods to market, That is not price deflation that is inflation. And vice verss low interest rates more production lower prices.

  7. The more governments invest the bigger the next generation hamster wheel will become. That's not nice. In Germany the philosophy is pretty simple - the next generation did benefit from what the current was said to be a good thing. So they should work harder. But wait.

    Think. Even investments by governments are part of an artificial business from the market economies perspective. Once the redistribution does no longer work all the debt for investment will turn into consumer credit which is the very nature of government debt. It's almost impossible to pay back consumer credit.