In defence of an unconventional monetary policy

By: Adam Posen

 

As the western economies emerge from recession, central banks are winding down their various asset purchase programs and other unconventional measures.  It is worth recalling the circumstances under which these measures were undertaken in late 2008 and earlier this year.  Credit markets were locking up to a degree that was completely unexpected. Asset prices across almost the entire range of investments and countries were moving downwards together.  Interest rates were cut aggressively, but the severity of the shock limited the positive impact in two ways: central banks fast approached the zero bound in their interest rate policies; and the impact of interest rate cuts was greatly diminished because of the dysfunctional financial system. 

            Central banks threw whatever it was they had at the problem: guarantees to various intermediaries and on specific kinds of transactions; facilities to provide liquidity and to discount a wider range of assets for a wider range of counterparties than normal; and reserves to purchase government bonds and private-sector debt instruments in the secondary markets. 

            The goal of all these measures was ultimately to prevent disaster – which along with other actions by governments they have managed to do.  Central banks pursued policies to provide a secure counterparty, reduce uncertainty, and provide sufficient liquidity for transactions to go through.  They made markets where markets were collapsing.

            Note what these unconventional measures were not.  They were not attempts to expand the money supply per se, especially since the velocity of money was declining and unpredictable.  Nor were they optimal policy setting exercises. The unconventional measures were first attempts to get ahead of mounting credit market breakdowns with aggressive direct interventions, and then to convince investors to move back into riskier asset classes. 

            Normal monetary policy by interest rate setting is like driving a new Range Rover down the autobahn on a commute: one knows how long it will take to get to the desired exit; the ride is smooth, well-marked and familiar; any particular causes of delays beyond normal traffic are clearly visible and swiftly cleared.  Unconventional monetary policy is like making the same trip in a 10 year old used Opel Vectra with a cranky transmission;  in a hurry down a rural road because the autobahn is closed; without a good map or signage; with all kinds of strange surprises blocking traffic.  You will get where you are going using these measures, but you are unsure how long it will take to get there, and you will not enjoy the ride. 

            In other words, we can be confident that unconventional monetary policies’ effect on nominal income is positive, and that our economies would have been stuck in a far worse place had these measures not been implemented.  We cannot pretend, however, to have precise knowledge of the size or timing of these measures’ impact. 

            Given this reality-based understanding, forecasts of high inflation threats from the recent large-scale creation of bank reserves are rather dubious.  If one believes in a kind of mechanistic monetarism, then it supposed matters how much money growth has exceeded the amount required to accommodate the development of the economy, irrespective of the surrounding deflationary circumstances.  Yet, when looking back at the last forty years in the G7 countries, the only periods where excessive monetary growth led to sustained rises in inflation were during the early and mid-1970s.  As we all know, there was a lot more going wrong with macroeconomic policy in those times, and many more upwards pressures on wages prices then, than we have today.

            In other instances since then, excessive monetary growth was not followed by high inflation, and sometimes was even followed by inflation declines.  Note that this statement includes instances of excessive monetary growth during the last decade for France, Germany, Italy, and the US, so the absence of connection between monetary growth and inflation is not an artifact of there having been no high monetary growth instances in recent years.  Most similarly, the Bank of Japan officially began what it termed Quantitative Easing in March 2001, buying huge numbers of Japanese government bonds and creating reserves in the banking system.  The resultant spike in narrow money growth did not result in an increase in broad money or credit growth, let alone an increase in the price level. 

            For practical policymaking, the point is that there is no evidence from relevant periods of economic history that the unconventional measures taken will result in high or sustained inflation.  The exit from these measures will require technical skill, especially for central banks which have a lot of private sector assets on their balance sheets to sell back - but the macroeconomic impact of such an exit, if any, will be in a disinflationary direction by driving down asset prices and driving up interest rates as the economy recovers.  The unconventional monetary policy measures have indeed served the pursuit of price stability as intended, although with more uncertainty about their size of impact than central banks would prefer.

Adam Posen is Senior Fellow of the Peterson Institute for International Economics and a member of the Bank of England’s monetary policy committee. 

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