Sunday, June 7, 2009

Monetary policy in post-sub prime crisis era

Janet Yellen, President of the Federal Reserve Bank of San Francisco, makes a few interesting points about the world where the existing monetary policy consensus of using the interest rate to stabilize inflation and sustain full employment and the macroeconomic orthodoxy based on the Dynamic Stochastic General Equilibrium (DSGE) model with nominal rigidities, has broken down.

1. When the credit markets are impaired by persistent counter-party risks and pervasive financial market failures, unconventional monetary policy responses like quantitative easing assume significance. The program of balance sheet expansion by the US Fed through massive purchases of agency-insured MBS, agency debt, and longer-term Treasury debt, and broader credit easing programs is aimed at bringing down private borrowing rates and thereby stimulate spending in the economy. As Prof Yellen says,

"In the ideal world of frictionless financial markets, such actions would be ineffective because private investors would simply readjust their portfolios to accommodate changes in the Fed's portfolio. But, in a world where financial markets are impaired, such balance sheet policies may influence asset prices and the economy."

2. The ongoing financial market crisis triggered off by the bursting of a bubble in sub-prime mortgage securities (and its impact on economic performance and financial stability) raises questions about whether the Central Banks should target asset prices and pop asset price bubbles. Central Banks have hitherto preferred to adjust short-term interest rates after the bubble bursts to counter the depressing effects on demand.

The problem with deflating bubbles is the difficulty in identifying bubbles, timing the intervention, and the exact extent (and nature) of intervention. However, Prof Yellen feels that credit bubbles are especially prone to "generating powerful adverse feedback loops between financial markets and real economic activity" and should therefore be modulated with monetary tightening. She writes,

"Higher short-term interest rates probably would have restrained the demand for housing by raising mortgage interest rates, and this might have slowed the pace of house price increases. In addition, tighter monetary policy may be associated with reduced leverage and slower credit growth, especially in securitized markets. Thus, monetary policy that leans against bubble expansion may also enhance financial stability by slowing credit booms and lowering overall leverage."

3. In keeping with the dual mandate of Central Banks - maximum sustainable employment and price stability - the appropriate long-run inflation has to be re-defined in light of the learnings from the recent experiences about the costs and benefits of very low inflation. In the aftermath of Japan's brush with zero-bound and deflation in the nineties, researchers have emphasized the benefits of aggressively cutting rates when the prospect of reaching the zero bound emerges, and of using clear communication about the central bank's future policy intentions and its long-run inflation goals.

But Prof Yellen differs with this approach (which was adopted by the Fed twice this decade when faced with recessions, with not so benign consequences as we are now finding out), and favors a higher inflation cushion to safeguard against an approaching zero-bound. She also expresses concerns about the cost of stabilizing output when faced with zero nominal interest rates, especially given the increased possibility (compared to the last quarter century of Great Moderation) of more frequent and severe negative shocks and economic volatility. She also feels that the "global savings glut that helped restrain real interest rates may persist or even intensify after the recession is over, leaving us with only a small cushion against reaching the zero bound".

Further, a firmly coupled world economy "has weakened the transmission of monetary policy by short-circuiting the exchange rate channel in any one country", implying that when all other countries are in recession and cutting rates, it is harder to stabilize the economy and avoid deflation. And finally, though the unconventional monetary policy responses have had the effect of attenuating the effects of the credit squeeze and economic recession, the impact of ballooning balance sheet of the Fed on inflationary expectations and pressures, remains to be seen.

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