Non-conventional policies: the “new normal”
Prior to the great financial crisis 2008-09, monetary policy in most developed economies focused on operating through a short-term interest rate. The most popular conceptual reference was the “Taylor rule”, according to which a central bank would adjust its policy rate in accordance with changes in expected underlying inflation and economic growth. Exchange rates, money, and credit aggregates were widely monitored but not usually targeted directly.
The financial crises of the 2000s and 2010s transformed the operational frameworks of developed countries’ central banks, mainly for two reasons:
- Policy rates approached their lower bounds but failed to exert sufficient stimulus because natural real rates of interest had also dropped to around zero, for both cyclical and structural reasons (view post here). Moreover, the natural interest rate apparently failed to recover after the crisis (view post here). Hence, the traditional Taylor rule of policy rate setting became and remained compromised.
Trapped at their lower bound policy rates lose their power to stabilize financial conditions in the event for further adverse shocks. As a result, inflation expectations can become de-anchored (view post here) and economies are particularly vulnerable to declines in goods and asset prices. Threats to price stability are asymmetric and skewed towards deflation (view post here) because unduly tight monetary policy is harder to correct and unduly easy policy. Moreover, there is a distinct risk of self-fulfilling dynamics: inflation expectations shift lower, real rates rise, debt burdens increase and consumption and pricing power soften (view post here). Economies are vulnerable even to shocks that were previously thought of as favorable, such as declines in import prices or labor costs (view post here).
- Repeated systemic malfunctioning of financial intermediation compromised the monetary policy transmission process and eroded confidence in central banks’ stabilizing influence. Several crisis episodes gave rise to fears that the impact of monetary policy rates on yield curves, equity premia, and credit spreads might have faded. The concern was that monetary easing would be like “pushing on a string”: accommodative conventional monetary conditions no longer translated reliably into accommodative financial conditions for the economy.
These challenges have necessitated new non-conventional monetary policies to allow further monetary policy accommodation at the zero lower bound and to secure the influence of central banks on broader financial conditions. And since there is evidence of a persistent decline real equilibrium interest rates (view post here), non-conventional monetary policy seems to be the “new normal”.