Revisiting three intellectual pillars of monetary policy.

• Author: Borio, Claudio

The Great Financial Crisis has triggered much soul-searching within the economic profession and the policymaking community. The crisis shattered the notion that price stability would guarantee macroeconomic stability: financial markets are not self-equilibrating, at least at a price that society can afford. And it showed that prudential frameworks focused on individual institutions viewed on a standalone basis were inadequate: a more systemic perspective was needed to avoid missing the forest for the trees. Hence, the welcome trend of putting in place macroprudential frameworks. But has this soul-searching gone far enough?

I shall argue that it has not. More specifically, I would like to revisit and question three deeply held beliefs that underpin current monetary policy received wisdom. The first belief is that it is appropriate to define equilibrium (or natural) rates as those consistent with output at potential and with stable prices (inflation) in any given period--the so-called Wicksellian natural rate. The second is that it is appropriate to think of money (monetary policy) as neutral--that is, as having no impact on real outcomes over medium- to long-term horizons relevant for policy: 10-20 years or so, if not longer. The third is that it is appropriate to set policy on the presumption that deflations are always very costly, sometimes even to regard them as a kind of red line that, once crossed, heralds the abyss.

From these considerations, I shall draw two conclusions. First, I shall argue that the received interpretation of the well-known trend decline in real interest rates--as embodied, for example, in the "saving glut" (Bernanke 2005) and "secular stagnation" (Summers 2014) hypotheses--is not fully satisfactory. Instead, I shall provide a different/complementary interpretation that stresses the decline is, at least in part, a disequilibrium phenomenon that is inconsistent with lasting financial, macroeconomic, and monetary stability. Second, I shall suggest that we need to make adjustments to current monetary policy frameworks in order to have monetary policy play a more active role in preventing systemic financial instability and, hence, in containing its huge macroeconomic costs. This would call for a more symmetrical policy during financial booms and busts--financial cycles. It would mean leaning more deliberately against financial booms and easing less aggressively and, above all, persistently during financial busts.

Equilibrium (Natural) Rates Revisited

Interest rates, short and long, in nominal and inflation-adjusted (real) terms, have been exceptionally low for an unusually long time, regardless of benchmarks. In both nominal and real terms, policy rates are even lower than at the peak of the Great Financial Crisis. In real terms, they have now been negative for even longer than during the Great Inflation of the 1970s (Figure 1, left-hand panel). Turning next to long-term rates, it is well known that in real terms they have followed a long-term downward trend--a point to which I will return. But between December 2014 and end-May 2015, on average no less than around $2 trillion worth of long-term sovereign debt, much of it issued by euro area sovereigns, was trading at negative yields. At their trough, French, German, and Swiss sovereign yields were negative out to a respective 5, 9, and 15 years (Figure 1, right-hand panel). While they have ticked up since then, such negative nominal rates are unprecedented. And all this has been happening even as global growth has not been far away from historical averages, so that the wedge between growth and interest rates has been unusually broad.

[FIGURE 1 OMITTED]

How should we think of these market rates and of their relationship to equilibrium ones? Both the received perspective and the one offered here agree that market interest rates are determined by a combination of central banks' and market participants' actions. Central banks set the nominal short-term rate and, for a given outstanding stock, they influence the nominal long-term rate through their signals of future policy rates and their asset purchases. Market participants, in turn, adjust their portfolios based on their expectations of central bank policy, their views about the other factors driving long-term rates, their attitude toward risk, and various balance sheet constraints. Given nominal interest rates, actual inflation determines ex post real rates and expected inflation determines ex ante real rates. So far, so good.

But how can we tell whether market rates are at their equilibrium level from a macroeconomic perspective--that is, consistent with sustainable good economic performance? The answer is that if they stay at the wrong level for long enough, something "bad" will happen, leading to an eventual correction. It is in this sense that many economists say that the influence of central banks on short-term real rates is only transitory.

But what is that something "bad"? Here the; two perspectives differ. In the received perspective, it is the behavior of inflation that provides the key signal. If there is excess capacity, inflation will fall; if there is overheating, it will rise. This corresponds to what is often also called the Wicksellian natural rate--that is, the rate that equates aggregate demand and supply at full employment (or, equivalently, the rate that prevails when actual output equals potential output).

The perspective developed here suggests that this view is too narrow. Another possible key signal is the build-up of financial imbalances, which typically take the form of strong increases in credit, asset prices, and risk-taking. Historically, these have been the main cause of episodes of systemic financial crises with huge economic costs. Think, for instance, of Japan and the Nordic countries in the late 1980s, Asia in the mid-1990s, and the United States ahead of the Great Financial Crisis or, going back in time, ahead of the Great Depression (see Eichengreen and Mitchener 2003).

The reasoning is straightforward. Acknowledge, as indeed some of the proponents of the received view have, that low interest rates are a factor in fueling financial booms and busts. After all, intuitively, it is hard to argue that they are not, given that monetary policy operates by influencing credit expansion, asset prices and risk-taking. Acknowledge further that financial booms and busts cause huge and lasting economic damage--in fact, no one denies this, given the large amount of empirical evidence. Then it follows that if we think of an equilibrium rate more broadly as one consistent with sustainable good economic performance, rates cannot be at their equilibrium level if they are inconsistent with financial stability.

This is partly an issue of the time frame envisaged for the disequilibria to cause damage. In the received view, it is relatively short, as the focus is on output deviations from potential at business cycle frequencies. In the view proposed here, it is longer, as the focus is on the potentially larger output fluctuations at financial cycle frequencies. As traditionally measured, the duration of the business cycle is up to eight years; by contrast, the duration of financial cycles since the early 1980s has been 16-20 years (continuous and dashed lines, respectively, in Figure 2) (Drehmann, Borio, and Tsatsaronis 2012). (1)

It is not uncommon to hear supporters of the "saving glut" and "secular stagnation" hypotheses say that the equilibrium or natural rate is very low, even negative, and that this rate generates financial instability. (2) Seen from this angle, such a statement is somewhat misleading. It is more a reflection of the incompleteness of the analytical frameworks used to define and measure the natural rate concept--frameworks that do not incorporate financial instability--than a reflection of an inherent tension between natural rates and financial stability. There is a need to go beyond the full employment-inflation paradigm to fully characterize economic equilibrium.

What I have said applies just as much to the short-term rate, which the central bank sets, as to long-term rates. For there is no guarantee that the combination of central banks' and market participants' decisions will guide long-term rates toward equilibrium, just like any other asset price, long-term rates may be misaligned for very long periods, except that their misalignments have more pervasive effects.

[FIGURE 2 OMITTED]

Importantly, the point about how to think of equilibrium rates is not purely semantic. It has first-order implications for monetary policy...