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Symposium 2015

Solution for Monetary Policy - Lessons Learned from the Crisis and the Post-Crisis Period

The Challenge

With the onset of the Financial Crisis 2008 many central banks worldwide considerably eased their monetary policies. Some central banks, like the Federal Reserve, the European Central Bank, and the Ba ...

With the onset of the Financial Crisis 2008 many central banks worldwide considerably eased their monetary policies. Some central banks, like the Federal Reserve, the European Central Bank, and the Bank of England, quickly reached the zero-lower-bound on nominal interest rates; these central banks then started conducting extraordinary measures like quantitative easing and forward guidance. There is some consensus that this massive monetary stimulus in the first, ‘acute’, phase of the crisis was largely appropriate, preventing a second Great Depression. However, since then, discussion has turned toward how long monetary policy should remain highly expansionary, because of doubts about the effectiveness of expansionary monetary policy in the aftermath of banking crises. Moreover, expansionary monetary policy over a long period of time might be associated with adverse side effects such as financial instability, asset price bubbles, slower structural adjustment, distorted investment decisions, and inflation.

More Flexible Inflation Targeting and Greater Emphasis on Financial Stability

In the past few years we have witnessed perplexing inflation dynamics—inflation has remained surprisingly low despite ultra-loose monetary policy in many countries. Key central banks are struggling to bring inflation back to their targets even as their economies recover. The financial markets are currently reacting very sensitively to changes in the rate of inflation in the euro area, with the view prevailing that every further drop flags up rising deflation risks. The fact that declining commodity prices actually serve as important economic stimuli tends to be ignored. Hence, every decrease in inflation fuels market expectations of additional monetary easing on the part of the ECB.

From an ECB perspective temporary deviations from its price norm are acceptable as long as medium-term developments stay in line with it. But for more than two years now the Eurozone inflation rate has been markedly below the ECB’s definition of price stability and is forecast to fall significantly short of it in 2016 as well. This is why the ECB emphasizes again and again that its policy of monetary accommodation aims to firmly anchor medium- and long-term inflation expectations below but close to 2%. For both financial market players and forecasters, however, adaptive elements are likely to play a role in shaping expectations—short-term inflation forecasts in particular correlate with current inflation rates.

At an opportune moment—once the controversial debate about deflation risks has abated—the ECB should correct its price norm to gain more flexibility. It would make sense to return to a target range which could be 1–2% (instead of 0–2% until May 2003). Temporary deviations from this range should be tolerated in future as well. The greater flexibility should be used to practice more “leaning against the wind.” The main arguments for this are (in addition to the adverse side effects of expansionary monetary policy over a long period of time mentioned above): Despite current deflation worries a “too loose for too long” policy can fuel inflation fears over time. When exit is delayed, it will probably be less smooth than at an earlier point of time as risk positions on financial markets adjust to the low level of interest rates. The bigger the risks on the books are, the greater the setback potential. A boom-bust scenario should be avoided. Monetary policy should also ensure financial stability instead of focusing too much on inflation on which it obviously has limited influence. Leaning against the wind is not easy, but it is worth trying.

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