The powers and limits of monetary policy.

• Author: Sanchez, Manuel

Monetary policy is powerful when focused on what it can clearly accomplish. But negative consequences can occur when it takes on ancillary objectives. Some of its capabilities are well known, while others are still in the process of being properly understood. Hence, addressing the question of what it can and cannot do should be approached with modesty.

I would like to present my views on this issue by first discussing positive impacts expected from monetary policy. Second, I would like to examine potential negative effects. Third, I will touch on the need for time consistency to make policy reliable. Fourth, I will briefly discuss monetary challenges faced by emerging economies in the current context of the extraordinarily accommodative monetary stances of advanced nations. And finally, I will draw some conclusions.

What Positive Impacts Can Monetary Policy Have?

The most indisputable contribution monetary policy can make to the well-being of any society is price stability. As succinctly stated by Milton Friedman (1963), "Inflation is always and everywhere a monetary phenomenon"; hence, monetary policy can control it. (1)

The benefits of price stability are well known. It provides a favorable framework for efficiency and economic growth. High inflation, on the other hand, breeds wasted resources, and, when unexpected, can generate consumption and investment errors. It can even fuel a loss of confidence in a country's currency.

The widespread acceptance of monetary policy to control persistent changes in the average level of prices has led central banks to establish price stability as their primary objective. In practice, central banks understand this as a minimum inflation rate, say 2 or 3 percent, consistent with factors such as innovations and consumer responses to relative price changes not properly accounted for by traditional price indexes.

In light of this definition, pursuing price stability may encompass averting the risk of deflation, a fear recently manifested by several monetary authorities in advanced nations. Regarding deflation, the following four comments are in order.

First, some deflation can theoretically be justified in terms of economic welfare. Friedman (1969) advanced the argument that one way the economy can achieve the long-run optimum quantity of money is with a rate of deflation that makes the nominal rate of interest equal to zero. Another way would be to pay interest on money balances.

Second, large time series data reveal that there is no clear negative relationship between deflation and economic growth across countries. Furthermore, in the postwar period, bouts of deflation have been milder and less persistent than before, with average growth during deflation years exceeding that of inflation years (see Borio et al. 2015, Ryska 2014).

Third, recent low inflation largely resulting from declining commodity prices, notably energy, has sparked deflation scares in several developed countries. However, these risks should be properly assessed. Falling inflation stemming from reductions in relative prices, while beneficial to consumers, may not persist, given that some of the causes behind them are necessarily transitory, such as overinvestment in the energy industry.

Fourth, as with the fight against inflation, monetary policy is well equipped to forestall unwelcome deflation. The historical international record of the ends of episodes of deflation proves this to be the case. (2)

The existence of a zero lower bound (ZLB) for policy interest rates in environments seen to be flirting with deflation has long inspired economists to conduct research. Approaches taken have engendered controversy over the power of monetary policy at the ZLB. However, recent large-scale asset purchases undertaken by central banks in advanced countries confirm that the possibilities for monetary policy do not end at the ZLB. (3)

Finally, under emergency conditions of financial market distress, central banks may perform the role of lenders of last resort. One example can be found in the extraordinary actions of the U.S. Federal Reserve during 2008. Provision of needed liquidity helps restore normal market conditions. This should always be done at a penalty rate and against sufficient collateral, following the advice of Bagehot ([1873] 1999), and as a temporary measure, to avoid moral hazard.

What Positives Is Monetary Policy Less Certain to Achieve?

While there is broad consensus on the ability of monetary policy to control inflation over time, there is less agreement on other goals it could...