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Tuesday,
December 15, 2020 / 5:54 PM / By Tobias Adrian, IMFBlog /
Header Image Credit: (Photo: Nerthuz By
Getty Images)
Central banks have played a pivotal role in easing
financial conditions in response to the COVID-19 shock, and helped avert a
catastrophic downturn. However, their work is far from done. Yet more monetary
stimulus will be needed to support economic recovery, and central banks are
implementing innovative new strategies to provide it.
Policymakers must weigh the pros of more stimulus
today against the cons of higher financial stability risks in the future.
While the new approaches are both necessary and
welcome, it is critical that policymakers weigh the pros of providing more
stimulus today against the potential cons of higher financial stability risks
down the road. In a new paper, I present a model for quantifying the tradeoff
between support today and vulnerability tomorrow.
New strategies for new challenges
Even prior to the pandemic, central banks were
struggling to boost economic activity and bring inflation to target. A range of
policies, including forward guidance and asset purchases, was deployed to spur
a strong recovery in employment after the Global Financial Crisis. But a sharp
decline in the neutral rate of interest reduced the scope to counter low
inflationary pressures. Even with interest rates very low out the yield curve,
inflation remained chronically low and appeared to be pulling down long-run
inflation expectations in many economies. This is a concern because it would
put downward pressure on nominal yields and further erode policy space.
The COVID-19 crisis has greatly intensified these
challenges. Employment has collapsed, threatening a major humanitarian crisis
in many economies, and inflation has been further depressed by weak activity
and falling commodity prices. While more stimulus is neede-along with better
ways to anchor inflation expectations-the post-2008 playbook won't suffice.
Policy rates have already been pushed to zero or below, and very low yields on
long-term government bonds limit the scope to provide stimulus through
purchases of these instruments.
Last month, I joined a panel hosted by the IMF, New
Policy Frameworks for a "Lower-for-Longer" World, to consider how some leading
central banks are addressing these challenges. Richard Clarida (Federal
Reserve), Philip Lane (European Central Bank), and Carolyn Wilkins (Bank of
Canada) discussed the monetary policy frameworks reviews that their
institutions have launched, focusing on new ways to boost employment and
inflation in this very low-rate environment.
The Fed recently completed its review, adopting an
innovative "make-up" strategy also being considered by other central banks: to
allow inflation to overshoot its target to make up for a period in which it has
run low, helping to better anchor inflation expectations around targets. The
prospect that the central bank will allow the economy to run hot in the
future-so that inflation can overshoot-may create more optimism today and fuel
a stronger recovery.
Financial stability tradeoffs
Central banks are also exploring how unconventional
policies already in use, such as purchases of sovereign bonds or corporate
debt, can be used more aggressively. Combined with new approaches, this can
play a critical role in speeding the recovery from COVID-19, as well as from
future shocks hitting economies. But these even more accommodative policies may
pose substantial risks down the road by encouraging excessive risk-taking and a
build-up of vulnerabilities.
Ideally, financial regulation (macroprudential
policies) should serve as the first line of defense in mitigating financial
stability risks, consistent with Fund policy advice. But that may fall short,
often reflecting the lack of tools to contain vulnerabilities such as in
nonbank financial institutions, or implementation hurdles stemming from the
political process.
Accordingly, it is crucial that monetary policymakers
incorporate macro-financial stability considerations in their decision making,
besides the path of output, unemployment, and inflation. At the "New
Frameworks" event, I presented a "New Keynesian" modeling framework that allows
central banks to quantify the tradeoff between boosting inflation and output in
the near-term and increasing financial stability risks down the road.
In the framework, easy monetary policy stimulates
aggregate demand not only through standard channels, but also through a
risk-taking mechanism. Looser monetary policy today relaxes financial
conditions and reduces near-term risks to both output and financial stability,
but also cause financial fragilities to grow over time, increasing output risk
in the medium term. The framework is designed to help policymakers balance this "intertemporal" tradeoff associated with "low-for-long" monetary policies,
including those deployed in response to COVID-19.
Macroprudential policies may influence these
tradeoffs, and the active deployment of tools to contain financial stability
would allow more prolonged accommodation and promote faster recovery. It is
also vital to consider how monetary policy easing by major central banks may
affect financial stability in foreign economies through increased risk-taking
and a buildup of leverage. The IMF's efforts to develop an integrated policy
framework in recent years-which considers how central banks can use macroprudential
policies, capital flow management tools, and foreign exchange intervention to
achieve their objectives-should be constructive in assessing how to mitigate
such risks.
Conclusions
Central banks' bold and innovative strategies to
address the challenges of a "lower-for-longer" environment post-COVID-19 should
provide additional firepower to support faster global recovery and help achieve
their inflation targets. But central banks need to be vigilant in managing the
risks to financial stability that may accompany these accommodative policies
and should make the future consequences of their present actions a key part of
their decision making.
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