The 82nd Annual Report of the Bank of International Settlements, released in late June, has an interesting chapter about \”The Limits of Monetary Policy.\” For those not familiar with the organization, the BIS has been around since 1930. It\’s based in Switzerland. It serves as a sort of bank for central banks through actions like (as its website reports) \”acting as a prime counterparty for central banks in their financial transactions\” and \”serving as an agent or trustee in connection with international financial operations.\” It also produces a steady stream of research and analysis which often strikes me as interesting because of its international perspective. The opening two paragraphs of the chapter summarize the BIS perspective and concerns nicely:
\”In the major advanced economies, policy rates remain very low and central bank balance sheets continue to expand in the wake of new rounds of balance sheet policy measures. These extraordinarily accommodative monetary conditions are being transmitted to emerging market economies in the form of undesirable exchange rate and capital flow volatility. As a consequence, the stance of monetary policy is accommodative globally.
Central banks’ decisive actions to contain the crisis have played a crucial role in preventing a financial meltdown and in supporting faltering economies. But there are limits to what monetary policy can do. It can provide liquidity, but it cannot solve underlying solvency problems. Failing to appreciate the limits of monetary policy can lead to central banks being overburdened, with potentially serious adverse consequences. Prolonged and aggressive monetary accommodation has side effects that may delay the return to a self-sustaining recovery and may create risks for financial and price stability globally. The growing gap between what central banks are expected to deliver and what they can actually deliver could in the longer term undermine their credibility and operational autonomy.\”
I supported the extraordinary monetary policy actions of the U.S. Federal Reserve during the financial crises from late 2007 through 2009 and into 2010: taking the key federal funds interest rate down to zero, making short-term loans to many financial players, not just banks; and the \”quantitative easing\” of printing money for the Fed to buy Treasury bonds and housing-backed securities. But the actual recession ended about three years ago, in mid-2009. Actions that made sense as a response to the emergency conditions of 2007-2009 don\’t necessarily continue to make sense when extended for years into the future. Thus, as of August 17 of last year, I was posting on the question \”Can Bernanke Unwind the Fed\’s Policies?\”
In this spirit, the BIS writes: Decisive action by central banks during the global financial crisis was probably crucial in preventing a repeat of the experiences of the Great Depression. … However, while there is widespread agreement that aggressive monetary easing in the core advanced economies was important to prevent a financial meltdown, the benefits of prolonged easy monetary conditions are more controversial. In particular, their implications for effective balance sheet repair as a precondition for sustained growth, the risks for global financial and price stability, as well as the longer-term consequences for central banks’ credibility and operational autonomy, are subject to debate.\” Here is some additional detail from BIS on each of these three points.
\”Implications of effective balance sheet repair as a precondition for sustained growth\”
\”Ultimately, there is even the risk that prolonged monetary easing delays balance sheet repair
and the return to a self-sustaining recovery through a number of channels. First, prolonged unusually accommodative monetary conditions mask underlying balance sheet problems and reduce incentives to address them head-on. … [L]arge-scale asset purchases and unconditional liquidity support
together with very low interest rates can undermine the perceived need to deal with banks’ impaired assets. … And low interest rates reduce the opportunity cost of carrying non-performing loans and may lead banks to overestimate repayment capacity. All this could perpetuate weak balance sheets and lead to a misallocation of credit. …
\”Second, monetary easing may over time undermine banks’ profitability. … Low returns on fixed income assets also create difficulties for life insurance companies and pension funds. Serious negative profit margin problems associated with the low interest rate environment contributed to a
number of life insurance company failures in Japan in the late 1990s and early 2000s. …
\”Third, low short- and long-term interest rates may create risks of renewed excessive risk-taking. … However, low interest rates can over time foster the build-up of financial vulnerabilities by triggering a search for yield in unwelcome segments. There is ample empirical evidence that this channel played an important role in the run-up to the financial crisis. Recent large trading losses by some financial institutions may indicate pockets of excessive risk-taking and require scrutiny.
\”Fourth, aggressive and protracted monetary accommodation may distort financial markets. Low interest rates and central bank balance sheet policy measures have changed the dynamics of overnight money markets, which may complicate the exit from monetary accommodation …\”
\”The risks for global financial and price stability\”
\”While prolonged monetary easing probably has only limited potency to rekindle sustained growth in the advanced economies, its global spillover effects may be substantial. Persistently large interest rate differentials support capital and credit flows to fast-growing emerging market economies and have
put upward pressure on their exchange rates. This makes it more difficult for emerging market central banks to pursue their domestic stabilisation objectives. …
\”The prevailing loose global monetary conditions have been fuelling credit and asset price booms in some emerging market economies for quite some time now. This creates risks of rising financial imbalances similar to those seen in advanced economies in the years immediately preceding the crisis. Their unwinding would have significant negative repercussions, also globally as a result of the increased weight of emerging market economies in the world economy and in investment portfolios.
Loose global monetary policy has probably also contributed to the strength of commodity prices since 2009 …\”
\”Consequences for central banks’ credibility and operational autonomy\”
\”In the core advanced economies, if the economy remains weak and underlying solvency and structural problems remain unresolved, central banks may come under growing pressure to do more. A vicious circle can develop, with a widening gap between what central banks are expected to deliver and what they can actually deliver. This would make the eventual exit from monetary accommodation harder and may ultimately threaten central banks’ credibility. … This concern is reinforced by growing political economy risks. Central banks’ balance sheet policies have blurred the line between monetary and fiscal policy … \”
Looking at all this, I\’m reminded of the comment by William McChesney Martin, who served as chairman of the Federal Reserve through five presidents in the 1950s and 1960s, and who famously said that it was the job of the Federal Reserve was to take away the punch bowl just as the party gets going–by which he meant that a central bank should to raise interest rates early in an economic upswing, not late. The Federal Reserve policies of 2007-2009 were less like a punch bowl and more like a defibrillator designed to jolt the economy through the financial crisis. But good medical practice suggest that while a defibrillator is sensible during a crisis, you don\’t try to keep shocking the patient all the way back to good health. I am particularly struck by the BIS statement about the risks of \”a widening gap between what central banks are expected to deliver and what they can actually deliver\”–and the tacit admission that what ails the U.S. economy isn\’t likely to be fixed just by applying ever-greater jolts of monetary expansion.