In the broader modern monetary policy context, central banks learn to weigh the trade-offs between output and inflation expectations and macro-financial stress conditions.

In recent years, several central banks conduct, assess, and discuss the core lessons, rules, and challenges from their monetary policy framework reviews. These central banks span the American Federal Reserve System, European Central Bank, Bank of England, Bank of Japan, and so forth. In this analytic report, we describe, discuss, and delve into the main rules, lessons, and new challenges from these recent monetary policy framework reviews.

We delve into the mainstream rules, lessons, and fresh challenges from the recent monetary policy framework reviews worldwide. Several central banks that conduct their own monetary policy framework reviews in recent years include the American Federal Reserve System, European Central Bank, Bank of England, Reserve Bank of Australia, Reserve Bank of New Zealand, Bank of Japan, and so on. The Global Financial Crisis of 2008-2009, the Covid-19 pandemic crisis of 2020-2022, inflation, output growth, and macro-financial stability continue to be the central elements of the recent monetary policy framework reviews. The long prevalent, pervasive, and mainstream monetary policy frameworks often span clear and simple policy targets for inflation, nominal GDP, the price level, and credit control in some asset markets such as the global financial markets for stocks and bonds as well as the residential real estate market. In addition to these mainstream macro policy goals, climate risk management, residential property affordability, productivity growth, macrofinancial stability, and technological advancement now arise as novel elements of the macro mandate for some central banks.

 

Since 2000, several extraordinary events have severely tested the modern conduct of monetary policy worldwide. The U.S. subprime mortgage crisis, Global Financial Crisis of 2008-2009 and subsequent European sovereign debt debacle shattered the deceptive tranquility of the Great Moderation, the decades-long phase of lower output and inflation volatility in many rich economies through the 1980s and 1990s. In the subsequent decade, central banks struggled to push inflation back to the 2% target, or the broader target range of 1% to 3%. Like a bolt from the blue, the Covid-19 pandemic crisis caused widespread financial system stress. As a result, several economies plunged into a severe macro recession. From the Russia-Ukraine war in Eastern Europe to the conflicts between Israel and Iran, Lebanon, Hamas, and the Palestinians in the Middle East, these rare geopolitical events led to the largest, most pervasive, and most persistent inflationary outbreak in half a century. On both sides of the Atlantic Ocean, several banks experienced credit constraints, strains, and failures due to short-term severe shortages of liquid assets.

 

Many central banks have risen to this challenge. Their forceful responses to macro financial stress helped stabilized the global financial system with new quantitative-easing (QE) large-scale asset purchases, negative interest rates, macro-prudential stress tests, less lenient and more rigorous Basel liquidity and capital requirements, and additional leverage limits and deposit insurance rules for banks, insurers, and other non-bank financial institutions. In due course, these macro-financial policies helped constrain collateral damage to the global real economy. In response to the recent interest rate hikes, inflation continued to return to the broader target range of 1% to 3%, or the baseline 2% target, in rich countries and global capital markets. In these recent years, global supply chains and labor markets turned out to be both robust and resilient as the real economy navigated through rare geopolitical events, wars, conflicts, bank failures, and rampant Covid infections.

 

These recent extraordinary events have left a deep imprint on the modern conduct of monetary policy worldwide. Even before the Covid pandemic crisis of 2020-2022, nominal monetary policy interest rates had reached historical troughs near the zero lower bound. In some parts of the world, especially Europe and Japan, the interest rates hovered in the negative territory. In some rich countries, central bank balance sheets have expanded to historical peaks. In recent years, public debt remains on a worrisome trajectory worldwide. Many governments continue to feel fiscal strains on different aspects of their respective budgets. In light of non-market forces such as climate change, policy uncertainty, deglobalization, longer longevity, and green energy transformation, several structural forces continue to further complicate the modern conduct of monetary policy worldwide.

 

We broadly classify the modern conduct of monetary policy worldwide into 2 major phases: (1) the Global Financial Crisis of 2008-2009 and its aftermath, and (2) the global pandemic outbreak of Covid-19 and its subsequent market consequences. These rare disasters dramatically reshaped monetary policy responses around the world. In effect, the Global Financial Crisis marked the end of the Great Moderation, the decades-long period of remarkable macroeconomic stability with lower inflation and relatively high and stable output growth in many parts and regions of the world. Under the calm surface of low inflation and steady output growth, however, macro-financial market vulnerabilities continued to build up in core residential real estate and mortgage credit markets. At the same time, private credit expansion continued through the major asset price booms. Low interest rates reinforced this pervasive private credit expansion, as many central banks chose to ease the monetary policy stance in response to the American dotcom stock market crash and the September 11 terrorist attack in 2001. After the unsustainable credit expansion and asset price boom worldwide, the Global Financial Crisis of 2008-2009 plunged many markets into the deepest recession since the Great Depression of the 1930s. Specifically, the American investment bank, Lehman Brothers filed for bankruptcy in September 2008. Some other banks, AIG and Bear Stearns, experienced financial difficulties too. Many financial institutions teetered on the verge of insolvency, vast segments of money markets froze, and global asset prices plummeted as a result.

 

Key central banks responded forcefully to the Global Financial Crisis of 2008-2009. Many central banks reduced monetary policy interest rates aggressively to the zero lower bound. Also, these central banks expanded their balance sheets significantly through large-scale asset purchases to provide liquidity support to banks, insurers, and other non-bank financial institutions worldwide. In the early phase of the Global Financial Crisis, these central banks played their respective roles of lenders of last resort. In this capacity, these central banks drew on government solvency support. As a result, the initial expansion of central bank balance sheets took the main form of government loans to financial institutions. Some central banks further continued their QE large-scale asset purchases to ease macro-financial stress conditions. As a consequence, their balance sheets expanded further with long-term government bonds and mortgage securities. In effect, these near-term QE efforts leveraged the extant bank reserves, capital requirements, and liquidity buffers.

 

In the next few years from 2010 to 2018, we saw a shallow economic recovery and persistent inflation shortfalls from the respective target ranges worldwide. Several central banks faced fresh concerns about deflation. These central banks engaged in forceful coordination to ease monetary conditions in the major rich countries. In effect, these central banks chose to build on the same QE monetary policy toolkit that they had deployed to contain the Global Financial Crisis. These central banks sought to ease financial stress conditions well beyond the short-term interest rates. Specifically, central banks substantially reduced their respective policy rates to the zero lower bound. In the special cases of European Union and Japan, their central banks further reduced their respective policy rates into negative territory. Several central banks resorted to forward guidance to signal the medium-term commitment to keeping lower interest rates for longer. With widespread fiscal-monetary policy coordination, central banks further expanded their QE large-scale asset purchases. In turn, these QE asset purchases sometimes included private-sector assets such as corporate bonds and stock market ETFs.

 

In the subsequent years from late-2019 to mid-2023, the Covid-19 pandemic crisis abruptly ended an incipient monetary policy normalization worldwide. As the global economy hit hibernation to forestall a public health catastrophe, a deep economic contraction put global macro-financial stability at risk again. In response to the new corona virus crisis, central banks reduced short-term interest rates substantially to the zero lower bound and then launched new balance sheet measures. This time was no different. Central banks combined emergency liquidity injections with bank-specific subsidies in the form of QE bond purchases. In light of these QE measures, central bank balance sheets surged to new historical highs.

 

Central banks substantially expanded their respective balance sheets through QE large-scale asset purchases in the 15-year episode from 2008 to 2023. Specifically, the American Federal Reserve System substantially boosted the size of its balance sheet to more than $8 trillion. Also, the European Central Bank raised its QE asset purchases to more than $6 trillion. In addition, the Bank of Japan increased its own balance sheet to more than $4 trillion over the same time frame, while the Bank of England expanded its own balance sheet to almost $1 trillion. As rare geopolitical events and other rare disasters happen more often, we believe central banks tend to include QE large-scale asset purchases as part of their respective conventional monetary policy toolkits in the next few decades.

 

As the global economy gradually recovered from the Covid pandemic crisis, central banks faced new inflationary pressures worldwide. Inflation was almost always and everywhere a monetary phenomenon. In many countries, inflation rose to double-digits. Global supply chains had failed to respond elastically to new fiscal-monetary coordination worldwide in response to the Covid pandemic crisis. Although the real economy eventually recovered from the public health crisis, this recovery led to the rotation of macro demand from services to goods. As a result, this rotation caused steep commodity price hikes in the subsequent Russian invasion of Ukraine. The Russia-Ukraine war further fueled the inflationary price hikes, especially for oil and natural gas resources in Eastern Europe.

 

In response to new inflationary price pressures, many central banks raised short-term interest rates in both real and nominal terms. After these serious interest rate hikes, several central banks began to dramatically shrink their respective balance sheets via quantitative tightening (QT) large-scale asset sales. Through such near-term macro episodes, these central banks had to cope with fast and furious swings in capital flows and exchange rates from the recent economic developments in the Russia-Ukraine war in Eastern Europe and the relentless conflicts between Israel and Iran, Lebanon, Hamas, and the Palestinians in the Middle East. In recent years, inflation gradually declined toward the 2% target or the broader target range of 1% to 3%. In the vast majority of small open economies, central banks weathered fresh inflationary challenges by relying on broad monetary policy frameworks, rules, and principles. The extant monetary policy frameworks, rules, and principles combined some simple single inflation targets, or broader inflation target ranges, with flexible foreign exchange intervention, macro-financial market stabilization for climate risk management, and active macro-prudential credit control for better residential real estate affordability worldwide.

 

We can draw several vital lessons from the modern conduct of monetary policy as the global economy navigates through some recent rare disasters such as the new Covid pandemic crisis of 2020-2022 as well as the Global Financial Crisis of 2008-2009.

In light of recent monetary policy framework reviews worldwide, we delve into the 5 mainstream vital lessons from the modern conduct of monetary policy, especially as the global economy navigates through several remarkable rare events. These rare events include the Great Moderation of both low and stable output growth and inflation from the 1980s to 1990s, the third wave of democratic movements for free trade worldwide from the mid-1990s to 2005, Global Financial Crisis of 2008-2009, Eurozone sovereign debt debacle of 2010-2012, and Covid-19 pandemic crisis of 2020-2022. First, central banks can de-anchor interest rate hikes to better contain inflation in support of broader price stability. Second, central banks can often apply macro-prudential policy tools, levers, and instruments to better stabilize the global financial system in rare times of severe macro-financial stress. Third, the primary unconventional monetary policies may run into their respective limits in due course. These unconventional monetary policies include QE large-scale asset purchases, negative interest rates, and forward guidance signals about the near-term paths of low interest rates, inflation, and the output gap from their respective targets. Fourth, central bank communication further complicates the global market expectations of the respective trajectories of output, inflation, and macro-financial stress conditions. Finally, foreign exchange intervention, macro-prudential credit control, and climate risk management often help central banks enhance better macro-financial stability. Below we delve into each of these 5 mainstream lessons before we further analyze the new challenges and implications for the modern conduct of monetary policy.

 

Central banks can de-anchor interest rate hikes to better contain inflation in the hot pursuit of price stability as part of the macro mandate.

In recent years, the post-pandemic experience with inflation has shown once again one of the major strengths of interest rate hikes as part of the wider monetary policy ambit. Inflation is almost always and everywhere a monetary phenomenon. Many central banks set gradual interest rate hikes to better contain inflation in support of broader price stability. By setting these gradual interest rate hikes at a reasonable pace, central banks effectively constrain money supply growth, curtail inflation, and reset the wider market expectations of future paths of output, inflation, and macro-financial stress conditions. As a result, central banks avoid repeating the historical experience of the Great Inflation of the 1970s.

 

In the post-pandemic episode, the consensus view among central banks was that global supply restrictions might combine with near-term energy shortages to boost prices substantially in another major inflationary outbreak. However, many central banks regarded the post-pandemic macro environment as disinflationary in nature. At the outset, there was a widespread global under-appreciation of the inflationary implications of macro demand stimulus from fiscal-monetary policy coordination in response to the Covid-19 pandemic crisis. As a result, it took time for central banks to react to this new macro reality. Many central banks judged inflationary pressures to be only temporary. In time, these central banks made their best efforts to signal their commitment to keeping lower interest rates for longer. Their forward guidance reshaped the broader market expectations of future paths of output, inflation, and macro-financial stress conditions. Throughout the Covid pandemic crisis, several central banks served as critical lenders of last resort to banks, insurers, and other non-bank financial institutions. These central banks envisaged a brave new world of persistent disinflationary pressures. The key monetary policy problem would still revolve around how these central banks might apply gradual interest rate hikes to reduce inflation from double digits back to the 2% target, or the wider target range of 1% to 3% per annum. Through their careful coordination of gradual interest rate hikes, these central banks managed to de-anchor output and inflation expectations with downward drifts for both core inflation and money supply growth. On balance, however, higher inflation outcomes seemed not to vary systematically with the first few interest rate hikes. Most central banks continued to apply interest rate hikes to tame inflation in due time, as the global nature and magnitude of interest rate hikes ultimately swamped the slight differences in seeking to time inflation expectations. The global nature of inflation justified the forceful responses and interest rate hikes by central banks. It would be useful to think of inflation as an evolutionary process between a low-inflation regime and an alternative high-inflation regime. When core inflation switched from low to high as a self-fulfilling prophecy, central banks would need to carefully institute interest rate hikes to better contain inflation down to the preferable target range.

 

In a low-inflation regime, inflation has several critical properties of self-stabilization. In this baseline low-inflation regime, core inflation usually arises from idiosyncratic risks or sector-specific price changes. These temporary price changes leave no or little imprint on the inflation rate itself. The co-movement of prices often reflects the common component of price changes. In practice, the common component of price changes is relatively small in a low-inflation regime. In addition, there is virtually no nexus between prices and wages across the global product and labor markets. By contrast, a high-inflation regime has no such self-stabilization properties. The key common component of price changes is significantly higher in an alternative high-inflation regime. Also, higher inflation leads to a significantly higher nexus between prices and wages across the global product and labor markets. As a result, inflation becomes more responsive to one-off inflationary shocks such as commodity price hikes, energy shortages, and sharp exchange rate fluctuations. In this alternative high-inflation regime, most central banks should carefully adjust interest rate hikes to better contain inflation in the grand and lofty pursuit of broader price stability as part of the macro mandate.

 

Central banks often apply macro-prudential policy tools, levers, and instruments to better stabilize the global financial system in rare times of severe financial stress.

Over the past couple of decades, the remarkable rare events have confirmed once again that central banks play a vital role in the broader risk management of macro-financial crises. Central banks represent the ultimate lenders of last resort to many banks, insurers, and other non-bank financial institutions. For this reason, central bank actions are often critical to help boost stock market investor confidence in the global financial system. Specifically, central banks tackle asset market dysfunction and support the efficient flows of credit loans to households and companies across the broader sector spectrum of retail and wholesale debtors. In addition to taming inflation through interest rate adjustments, central banks further tackle deflationary pressures to avoid major financial crises in different parts and regions of the world. For instance, several central banks made credible policy announcements to signal their commitment to keeping lower interest rates for longer in response to both the Global Financial Crisis and the Covid-19 pandemic crisis.

 

Some recent rare episodes of severe macro-financial stress further confirmed the importance of central bank liquidity support in foreign currency. During these rare events, most central banks would collaborate to ensure that their foreign exchange reserves suffice to safeguard against intermediary failures, extreme exchange rate fluctuations, and speculative currency attacks. In response to the Global Financial Crisis, for example, the American Federal Reserve System and European Central Bank effectively used swap credit lines to alleviate U.S. dollar liquidity shortages. These swap credit lines helped avoid the complete meltdown of the global financial system. In addition, these swap credit lines played a critical role again during the Eurozone sovereign debt debacle and the Covid pandemic crisis. Specifically, the joint announcement of better terms on the swap credit lines between 5 main central banks, as well as their wider macro-financial interactions with 9 other central banks, helped stabilize the U.S. dollar foreign exchange swap basis in April to June 2020. At the same time, the Federal Reserve System further complemented these swap credit lines with a new repurchase (repo) facility with much broader country access. In effect, this repo facility allowed many countries to deploy their foreign exchange reserves more flexibly to ease massive fire-sale pressures in the global market for U.S. Treasury bonds.

 

The recent financial crises led to a vital evolution in the role that central banks play in macro-financial crisis management. Historically, many central banks had served as the respective lenders of last resort in different countries. These central banks focused on providing emergency liquidity funds to banks, insurers, and other non-bank financial institutions. By setting up asset purchase facilities in recent decades, central banks transformed themselves into de facto market-makers and buyers of last resort. This closer contact with non-bank special-purpose investment vehicles allowed central banks to more directly influence credit default swap (CDS) spreads and secondary market spreads. In many small open economies, this new function was especially important during the Covid pandemic crisis for many central banks to alleviate severe fire-sale pressures in domestic currency bond markets as many foreign investors retreated from these markets.

 

During the Global Financial Crisis and Covid pandemic crisis, government liquidity support was critical for many central banks to extend long-term funds for additional credit risk. All this additional credit risk puts a hefty premium on closer cooperation and coordination among central banks worldwide. Central bank balance sheet size, government liquidity support, and domestic fiscal-monetary policy coordination can complicate the modern conduct of monetary policy in both normal times as well as rare times of severe macro-financial stress worldwide.

 

In some macro-financial crises, government interventions are not costless. Several central banks use QE asset purchases to absorb private-sector risks by expanding their respective balance sheets in rare times of severe financial stress. In practice, the vast majority of private-sector market participants would not be able to take on these additional risks. Central banks would naturally tend to err on the side of trying to inject too much shorter-term emergency liquidity rather than too little. As a result, moral hazard might arise because many private-sector actors would expect central banks to step in with similar monetary policy interventions in the future. This broad expectation might further temper market discipline. This moral hazard issue would probably be especially severe, vital, and relevant when central banks chose to buy fire-sale assets outright from the private sector. Hence, central banks would need to learn to strike a delicate balance between emergency liquidity support and moral hazard.

 

The key unconventional monetary policies may eventually run into their respective limits in due course.

In the years after the Global Financial Crisis, several central banks leveraged QE large-scale asset purchases, forward guidance signals about future interest rates, and even negative interest rates to ensure relatively loose, flexible, and facilitative monetary conditions in different parts of the world. These unconventional monetary policy tools, levers, and solutions were instrumental in promoting economic growth recovery and price stability. In some special cases, however, these unconventional monetary policy tools, levers, and solutions may eventually run into their respective limits in due course. Over the past couple of decades, some policy limitations might be more evident in various parts and regions of the world. Specifically, these policy limitations include significantly lower policy traction, leverage, and efficacy, as well as longer-run side effects and fiscal strains on the global financial system and real economy.

 

Many recent empirical studies show that QE large-scale asset purchases allowed central banks to further ease macro-financial stress conditions. Also, these central banks applied forward guidance signals about low interest rates and even negative interest rates to gain further policy traction, leverage, and efficacy. Specifically, QE large-scale asset purchases helped significantly reduce both bond term and credit risk spreads. At the same time, central banks had the common inclination to keep lower interest rates for longer. These resultant forward guidance signals influenced the macro market expectations of output, inflation, and interest rates further out in the future. These central banks further reduced and reshaped both bond term and credit risk spreads by dampening broader economic policy uncertainty about global trade, finance, and technology. In Europe and Japan, their central banks launched negative interest rates to inject further monetary stimulus to the respective money and capital markets for stocks, bonds, and ETFs. These unconventional monetary policies further helped stabilize exchange rates in different parts and regions of the world. At a slower, more gradual, and more reasonable pace, these central banks provided special liquidity support programs for the financial sector to bolster bank profits, loans, and private credit extensions. After all, some of these unconventional monetary policies might ultimately start to stretch their limits in light of their positive ripple effects on economic growth, inflation, and macro-financial stress conditions. When short-term interest rates hit the zero lower bound, central banks learn to face the new macro reality of limitations of unconventional monetary policy tools, levers, and instruments.

 

With respect to the resultant impact on macro-financial stress conditions, some of the realistic limitations of unconventional monetary policies are instrument-specific. The policy power of QE large-scale asset purchases weakens when asset markets are not under severe stress, because the emergency liquidity support is not at work, even if short-term interest rates hit the zero lower bound. This policy power further wanes at the margin as QE asset purchases grow incrementally over time. In effect, these QE asset purchases confront the significantly lower marginal returns to scale. In addition, negative interest rates may or may not pass through bank deposit rates because banks and non-bank intermediaries remain reluctant to cut these deposit rates below the zero lower bound for retail depositors. On this dark side of negative interest rates, special central bank loans and other liquidity support programs may or may not always encourage additional target loans and private credit extensions at the margin.

 

In terms of forward guidance signals, central banks eventually learn to confront the limits of these signals about keeping lower interest rates for longer. Although many central banks can commit to keeping short-term interest rates near the zero lower bound for the foreseeable future, near-zero rates can often lead to significantly dire macro-financial conditions for bank intermediation. This resultant adverse impact on bank intermediation suggests that central banks cannot keep near-zero interest rates for long periods. Hence central bank forward guidance signals eventually run into their respective limits in different parts and regions of the world.

 

Throughout human history, inflation often becomes less sensitive to expansionary monetary policies in a low-inflation regime. As persistently lower inflation becomes part of the macro mandate, this entrenchment of market expectations about output, inflation, and macro-financial stress conditions causes the common component of price changes to decrease substantially in time. This common component of price changes often reflects market forces such as macro demand, private credit control, foreign capital flows, and exchange rate fluctuations. In practice, monetary policy surprises cause a persistent impact on the common component of price changes. However, these monetary policy surprises have virtually no or little impact on the idiosyncratic component of price changes. For this reason, both conventional and unconventional monetary policies may eventually run into their respective limits in the longer run.

 

Do these recent QE central bank asset purchases cause asymmetric ripple effects on output, inflation, and macro-financial stress conditions? When central banks led short-term policy interest rates to the zero lower bound, these central banks turned to QE large-scale asset purchases to provide more monetary stimulus to financial markets. Against the global macro environment of sequential QE and QT episodes, one might be keen to know whether QE large-scale asset purchases made at rare times of severe macro-financial stress would lead to larger economic ripple effects than QT asset sales made under calm asset market conditions. To answer this key question, we need to consider the signaling channel, portfolio rebalancing channel, and confidence channel of QE large-scale asset purchases versus QT asset sales by central banks.

 

The signaling channel of central bank balance sheet measures often work through investor expectations. QE large-scale asset purchases often reinforce central bank commitments to keeping lower rates for longer. At rare times of market turbulence, central banks further strengthen these low-rate commitments via forward guidance. The resultant lower interest rates manifest in longer-term Treasury bond yields. In effect, QE asset purchases often put central bank money where their mouth is. As a result, QE asset purchases can help underpin the broader credibility of balance sheet announcements by central banks. 

 

The portfolio rebalancing channel works more directly through monetary quantities. Central banks launch QE large-scale asset purchases, and subsequently QT asset sales, to influence the monetary quantities of government debt securities available to private investors. Through this alternative channel, central banks apply balance sheet operations to induce private investors to adjust their portfolio positions in due course. For instance, if central banks absorb duration risk by acquiring longer-term securities, both bond term and credit risk spreads tend to decrease. The resultant lower Treasury short-term bond yields induce private investors to search for higher returns by loading up government debt securities with longer maturities and greater credit risks.

 

The confidence channel plays a more episodic role at rare times of severe macro-financial risk. Through a robust and reasonable mix of greater investor confidence and credit risk, central banks serve as lenders, market-makers, and buyers of last resort at the same time. Therefore, the positive confidence effects interact with the signaling and portfolio rebalancing channels by restoring calm macro recovery with no or minimal asset market dysfunction.

 

In response to the Global Financial Crisis and Covid pandemic crisis, central banks first designed and then deployed QE large-scale asset purchases in rare times of severe macro-financial stress. The main monetary policy goal was mending severe asset market disruptions by alleviating the macro-financial constraints on effective monetary transmission. At first, these balance sheet measures had large positive asset market effects through all of the 3 major signaling, portfolio rebalancing, and confidence channels. Not only did these balance sheet measures demonstrate key central bank commitments to keeping lower interest rates for longer, but these core asset purchases also underscored central bank commitments to keeping monetary stimulus in place as long as necessary.

 

Progressively, many asset market participants and private investors became more familiar with these new balance sheet measures. In practice, central bank forward guidance combined with better communication tools, such as FOMC minutes and dot plots, to help reinforce central bank commitments to promoting macro recovery, maximum sustainable employment, price stability, and macro-financial stability etc. At the margin, however, monetary policy surprises waned in due time, and so did their immediately visible effects on financial markets. Over several years, a larger fraction of monetary transmission took place through the portfolio rebalancing and confidence channels rather than the signaling channel.

 

Overall, the recent empirical estimates of macro demand sensitivities across many asset market participants suggest that investors require a government bond yield increase of 10 basis points for an additional absorption of debt of $250 billion over both the recent QE and QT episodes. We can ascribe any potential QE asymmetry to the more powerful positive effects of QE large-scale asset purchases that central banks launched at rare times of severe macro-financial stress, such as the Global Financial Crisis, Eurozone sovereign debt debacle, and Covid pandemic crisis. As central banks deliberately tried to avoid surprising global financial markets with QT asset sales at the dawn of economic recovery, asset market reactions, movements, and fluctuations became smaller around the QT run-off announcements. Although the signaling channel and monetary policy surprises might be weaker, the portfolio rebalancing and confidence channels had similar ripple effects on the mainstream portfolio decisions for most asset market participants and private investors.

 

Central bank communication further complicates the global market expectations of the respective paths of output, inflation, and macro-financial stress conditions.

Central bank communication has been integral to the modern conduct of monetary policy worldwide. Both the vital role and importance of central bank communication have grown significantly over several decades. Many central banks have become increasingly more transparent due to structural shifts in intellectual paradigms from the new classical monetarist school to the broader New Keynesian monetary policy framework in light of the heft of both global asset markets and financial institutions. Greater central bank transparency has been seen as vital and essential to further strengthen monetary policy efficacy, flexibility, and accountability. Since the Global Financial Crisis, central bank communication has become more complex. At least 3 fundamental factors have been responsible for increasingly complex central bank communication. First, central banks now seek to apply interest rate adjustments in response to not only incremental changes in inflation and the output gap from their respective targets but also financial stress conditions. Second, central banks can now deploy a broader variety of unconventional monetary policy tools, levers, and instruments, such as balance sheet operations via both QE asset purchases and QT asset sales, forward guidance signals about medium-term future trajectories of output, inflation, and interest rates, and even negative interest rates. The resultant wider central bank toolkit further reshapes and reinforces the nuances of monetary policy stance. Third, central banks now need to deal with the economic side effects, byproducts, and implications of several non-market forces such as post-pandemic public health care, demographic longer longevity, climate risk management, green energy transformation, and so forth. We should take into account these novel non-obvious non-market aspects of monetary policy conduct.

 

Macro-financial stress conditions often depend on not only what central banks can accomplish via various monetary policy tools, levers, and strategies today, but also how these monetary policy instruments reshape and reinforce market expectations of medium-term future paths of output, inflation, and financial imbalances. In many small open economies, macro-financial stress conditions can further emanate from trade surpluses, deficits, and exchange rate fluctuations. Even when central banks limit their monetary policy actions to relatively small, incremental, and progressive interest rate adjustments, central banks now need to explain the nuances of future trajectories of output, inflation, interest rates, and macro-financial stress conditions. Specifically, central banks should provide forward guidance on the monetary policy reaction function of key macroeconomic variables. In addition to economic growth and price stability, macro-financial stability has become part of the macro mandate for modern monetary policy conduct worldwide.

 

The nature of forward guidance changes significantly when policy rates hit the zero lower bound. At that stage, central banks apply forward guidance signals to further ease the monetary policy stance. Implicitly, these forward guidance signals provide assurance that short-term interest rates would remain lower for longer. On the one hand, central banks can commit to keeping low or near-zero interest rates over the medium term. On the other hand, this low-rate commitment reduces medium-term monetary policy flexibility. In practice, several central banks seek to better balance these trade-offs by emphasizing different degrees of conditional forward guidance signals. In theory, these forward guidance signals often encode, reveal, and reflect the historical data dependence on mainstream macroeconomic variables, such as output, inflation, both bond term and credit risk spreads, and macro-financial stress conditions worldwide.

 

The resultant increasingly transparent central bank communication can complicate the monetary policy stance. Asset market participants and private investors can no longer identify the monetary policy stance with one single variable because central banks now retain a broader menu of monetary policy tools, levers, and instruments. It is harder for banks, insurers, and other non-bank financial institutions to separate the shorter-run impact of each of these monetary policy solutions. These monetary policy solutions might sometimes be applicable for different policy goals, purposes, and macro mandates. Specifically, central banks often reshape and reinforce asset market expectations about output, inflation, and interest rates in the next few years. At the same time, however, central banks now need to explain the nuances of the monetary policy stance with no or little impact on macro-financial stress conditions. Today, these new plural considerations complicate central bank communication.

 

Foreign exchange intervention and macro-prudential credit control can help central banks better promote macro-financial stability.

While the Global Financial Crisis seemed to be a separate meteor strike, this rare disaster had followed bank failures specifically, and financial crises more generally, in both rich and middle-income markets. These key events further underscored the shorter-term trade-offs between price stability and macro-financial stability. Central banks would now need foreign exchange intervention and macro-prudential credit control to complement interest rate adjustments to better manage future financial crises in different parts and regions of the world.

 

In this broader context, foreign exchange intervention and macro-prudential credit control can play a vital role in macrofinance. These additional monetary policy tools, levers, and instruments can often help address large fluctuations in macro-financial stress conditions. Indeed, most financial crises arise from the steady accumulation of financial imbalances. These financial imbalances include extreme asset prices, returns, exchange rate fluctuations, and foreign capital flows. Over recent decades, the most fundamental paradigm shift in monetary policy frameworks worldwide has been the recent adoption of simple inflation targets for central banks in several rich and middle-income countries. With simple inflation targets, this new regime seems to combine with greater exchange rate flexibility as part of a more coherent macro-economic policy stance worldwide. Both foreign exchange intervention and macro-prudential credit control continue to enrich the broader monetary policy toolkit.

 

Foreign intervention can often help improve the short-term trade-off between price stability and macro-financial stability in at least 2 fundamental ways. First, foreign exchange intervention helps central banks incrementally build up foreign reserves to better safeguard against sudden foreign capital outflows and extreme exchange rate fluctuations. Second, foreign exchange intervention helps central banks lean against the unwelcome domestic consequences of sudden foreign capital inflows. Specifically, central banks can launch foreign exchange purchases to dampen high credit imbalances and extreme exchange rate fluctuations as strong foreign capital inflows often put upward pressure on the domestic currency. In practice, these dual functions of foreign exchange intervention remain applicable regardless of specific central bank intervention tools, levers, instruments, and strategies.

 

During some recent episodes of severe macro-financial stress, such as the Global Financial Crisis, taper tantrum, and Covid pandemic crisis, middle-income markets with larger foreign reserves experienced smaller exchange rate fluctuations. Some foreign exchange intervention helps dampen the adverse impact of sudden capital flows on domestic credit expansion. Specifically, foreign exchange purchases help dampen domestic credit supply growth in a unique cost-effective way. This relation has proven to be quantitatively similar to the expansionary effects of sudden capital inflows with short-run substantial exchange rate appreciation.

 

Also, central banks further face difficult choices, trade-offs, and decisions in foreign exchange intervention. In practice, the fiscal cost of carrying foreign reserves can be considerable. In the shorter run, foreign exchange intervention can help reduce exchange rate volatility. In the longer run, however, foreign exchange intervention may inadvertently encourage currency mismatches. The resultant macro-financial imbalances make middle-income markets more vulnerable to speculative currency attacks and global macro-financial stress conditions.

 

In contrast to foreign exchange intervention, macro-prudential credit control serves as a new addition of recent vintage to the broader modern monetary policy toolkit. Macro-prudential credit control complements micro-prudential bank regulation and supervision to enhance the strength and resilience of the domestic financial system. Central banks often calibrate macro-prudential stress tests, tools, levers, and other instruments to macro-financial variables such as private credit supply growth, new Basel regulatory capital and liquidity requirements, maximum loan-to-value ratios, and maximum debt-to-income ratios for the domestic residential real estate market. In recent years, central banks start to pay attention to domestic residential property affordability as part of the macro mandate.

 

Much like foreign reserves, these macro-prudential measures perform a dual policy function. Specifically, these macro-prudential measures help build up resilience for the wider financial system to better prepare for the next severe financial downturn. At the same time, banks, insurers, and other non-bank financial institutions better lean against the gradual and steady accumulation of domestic credit imbalances. In this positive light, central banks retain bigger and better room for monetary policy maneuver. Several recent empirical studies show that the proactive use of macro-prudential measures by central banks helps reduce the likelihood of financial crises. This result remains true regardless of whether these macro-prudential measures precede or follow interest rate adjustments. The immediate impact on private credit supply growth seems stronger through macroprudential tools, levers, and solutions in association with Basel bank capital and liquidity requirements. However, macro-prudential measures are no panacea. These macro-prudential measures serve as complements rather than substitutes for better fiscal-monetary policy coordination in the grand and lofty pursuit of financial stability. In the broader modern monetary policy context, central banks learn to weigh the trade-offs between output, inflation, and macro-financial stress conditions.

 

The new challenges for the modern conduct of monetary policy include additional fiscal strains and adverse structural supply-side forces worldwide.

Today, monetary policy decision-makers continue to weigh the trade-offs between output, inflation, and macro-financial stress conditions. The new challenges for the modern conduct of monetary policy span new fiscal strains and adverse structural supply-side forces. In many rich and middle-income markets, long-run government debt trajectories pose a clear and present threat to macro-financial stability. Many governments feel fiscal strains in different aspects of their respective budgets over recent years. Even if interest rates return to lower levels below output growth rates, the respective ratios of public debt to total GDP would likely continue to climb from their current historical peaks in the longer run. These new fiscal strains would loom larger if we took into account the additional fiscal expenditures for post-pandemic public health care, demographic longer longevity, climate risk management, green energy transformation, and so forth. For some countries, geopolitical tensions can cause defense expenditures to surge again in the next couple of decades. Indeed, the macro-financial picture would be bleaker if central banks let interest rates settle above economic output growth rates. In practice, this macro-financial picture would be more likely if the sovereign debt creditworthiness came into doubt at some point. Should we project interest rates to remain at the respective current levels, the core public debt service burden would likely rise to the historical peaks of the 1980s and 1990s, as many governments chose to refinance their Treasury bonds with longer maturities. In the worst-case scenario, sovereign debt service burdens would surge to new historical peaks well above 6% to 9% of total GDP in many rich and middle-income markets.

 

The resultant higher public-sector debt can constrain the room for monetary policy maneuver by worsening the trade-offs among price stability, maximum sustainable employment, asset market stabilization, and macrofinancial resilience. Specifically, higher public-sector debt burdens often raise the likely sensitivity of fiscal positions to policy rates. The new classic Sargent-Wallace unpleasant monetarist arithmetic analysis shows that higher inflation inevitably arises from incremental increases in money supply growth when the central bank continues to fund fiscal expenditures with Treasury bonds as part of the macro budget constraint. In the extreme, if high public-sector debt eventually cripples sovereign creditworthiness and subsequent credible fiscal policy actions, the resultant public debt burden would likely lead to substantially higher inflation through domestic exchange rate depreciation. In the worst-case scenario, the central bank cannot maintain price stability as part of the macro mandate. If the incumbent government has no or little fiscal discipline, blind, reckless, and incessant expansionary fiscal policy actions can often turn out to be unsustainable in the longer run. The resultant public debt burden inexorably derails the core trade-offs between economic growth, inflation, and macro-financial stress conditions.

 

In addition to fiscal strains, structural supply-side forces often sap global economic growth by making macro supply significantly less elastic or less responsive to shifts in macro demand. Since China, India, Indonesia, Malaysia, South Korea, Taiwan, Vietnam, and other Asian countries joined the World Trade Organization (WTO) in the 1990s and early-2000s, globalization has been a major fundamental factor for making macro supply more elastic, more robust, and more resilient through further trade integration, migration, and foreign direct investment (FDI). Today, however, geopolitical risks, tariffs, high-tech investment restrictions, and other trade tensions highlight a new slippery slope down the rabbit hole of deglobalization. In practice, this fresh mega trend of deglobalization seems to be more severe, more pervasive, and more persistent due to the recent Russia-Ukraine war in Eastern Europe and the relentless conflicts between Israel, Iran, Lebanon, Hamas, and the Palestinians in the Middle East. Meanwhile, the American government continues to escalate its trade war against China with hefty tariffs, foreign investment restrictions, and other non-tariff trade barriers from currency manipulation to intellectual property theft. In light of structural supply-side forces, deglobalization continues to be the new mega trend worldwide.

 

Several other structural supply-side forces include demographic longer longevity, climate risk management, and green energy transformation. As our modern society continues the natural course of human age progression, the demographic dividend is set to vanish in due time. At some inflection point, global population growth may start to decline with substantially lower labor force participation worldwide. Recent rare disasters show the hefty economic damage from extreme weather events. In practice, climate change is real, and we need to better prepare the global economy for these rare physical events. These climate risks seem to recur more often these days, may not be so rare in reality, and continue to destroy our productive capacity, high-skill labor, and biodiversity in different parts and regions of the world. Another structural supply-side force is the recent green energy transformation. This current transition calls for some major reallocation of technological resources, specifically electric vehicles (EV) and autonomous robotaxis (AR), to reduce carbon emissions toward the net-zero target policy goal by 2050.

 

We delve into several new implications for the modern conduct of monetary policy with some greater realism in the trade-offs between output, inflation, asset market stabilization, and macro-financial stress conditions.

Monetary policy frameworks should be robust to radically different macro scenarios. Sometimes new challenges arise from the complex interactions between structural supply-side forces and the monetary policy frameworks themselves. For instance, trade liberalization, globalization, and monetary policy frameworks that combined to focus on medium-term inflation control shaped the nature of pre-pandemic real business cycle fluctuations. In contrast to higher inflation, the steady accumulation of private credit imbalances signaled unsustainable economic booms. In the post-pandemic years, geopolitical risks and trade tensions reshaped and reinforced the immediate impact of monetary policy on the global real business cycle worldwide. Today, monetary policy frameworks should remain both flexible and fit for purpose in accordance with the macro mandate of price stability with some secondary focus on real GDP growth, economic development, and macro-financial stability.

 

In the recent monetary policy framework reviews worldwide of the early-2020s, a central consideration was how monetary policymakers regained precious room for key policy maneuver to better balance both output and inflation expectations under macro-financial stress conditions. The post-pandemic inflation surge showed that these resultant supply-side challenges were much more symmetric. Regardless of whether inflationary or disinflationary pressures would ultimately prevail in the real business cycle, monetary policy decision-makers should strike a delicate balance among output, inflation, and macro-financial stress conditions as part of the macro mandate.

 

Another major consideration of the recent monetary policy framework reviews was that the equilibrium real interest rate was structurally lower by historical standards. Monetary policy adjustments seemed to cause no, little, or minimal impact on this natural interest rate, or equivalently r-star in jargon, even over the long run. In light of this premise, monetary policy decision-makers had to regain room for maneuver on a sustainable basis by trying to push inflation up even when it was not far away from the 2% target or the broader target range of 1% to 3%. However, this strategy was risky in the sense that many macro variables were significantly less sensitive to changes in the monetary policy stance in the low-inflation regime.

 

In light of these recent considerations, we should expect monetary policy decision-makers to achieve greater realism in the trade-offs between output, inflation, asset market stabilization, and macro-financial stress conditions. These decision-makers should retain a realistic view of what monetary policy can and cannot deliver in due course. This greater realism further reshapes and reinforces domestic institutional arrangements and central bank communication tools, instruments, and strategies for better fiscal-monetary policy coordination. When inflation turns out to be higher substantially over several years, price stability becomes the sole policy goal. When inflation declines toward the 2% target or the target range of 1% to 3%, the central bank learns to weigh fresh trade-offs between multiple macro policy goals such as economic growth, maximum employment, price stability, asset market stabilization, macro-financial stability, climate risk management, and even residential property affordability. Domestic institutional arrangements should help promote and protect greater central bank independence. To the extent that the central bank remains an independent government agency, central bank independence further helps ensure better price stability, robust and steady output growth, maximum employment, and some other macro policy goals in many middle-income and rich countries.

 

This greater realism suggests 2 heuristic rules of thumb for monetary policymakers. First, these policymakers should refrain from seeking to fine-tune inflation when it already continues to evolve near the target range in a low-inflation regime. A more realistic policy goal would be keeping inflation broadly within an extant low-inflation regime. In this special case, the near-term impact of monetary policy on inflation is not material, and the current monetary policy framework benefits substantially from the positive properties of self-stabilization in relation to low inflation. Second, these monetary policymakers should respond to increasingly higher inflation with gradual interest rate hikes. In this special case, these policymakers should seek to dampen increasingly higher inflation such that it returns to the target range with no, few, or minimal self-fulfilling prophecies. After all, monetary policy surprises help contain higher inflation in the short run; nonetheless, monetary policy surprises cause little or minimal impact on lower inflation in the long run.

 

This greater realism further means avoiding testing the limits of sustainable booms. Today, monetary policy decision-makers usually weigh the hard, hefty, and serious intertemporal trade-offs between both output and inflation expectations and macro-financial imbalances. In normal times, monetary policy-makers tend to retain some room for further policy maneuver. For instance, central banks keep higher interest rates for longer to better prepare for the next severe macro-financial downturn. At the same time, these central banks better contain inflation around the target range by applying brakes on money supply growth and so inflation. In rare times of severe macro-financial stress, central banks launch interest rate cuts progressively toward the zero lower bound. These central banks sometimes provide additional monetary stimulus with QE large-scale asset purchases, forward guidance signals, and even negative interest rates. Good examples include the Global Financial Crisis and the recent rampant Covid pandemic crisis. At any pace, monetary policymakers should avoid stretching the pragmatic limits of these unconventional monetary policy tools, levers, and instruments for further monetary stimulus.

 

 

Economic policy incrementalism for better fiscal and monetary policy coordination

https://ayafintech.network/blog/economic-policy-incrementalism-for-better-fiscal-and-monetary-policy-coordination/

 

Peter Isard analyzes the proper economic policy reforms and root causes of global financial crises of the 1990s and 2008-2009.

https://ayafintech.network/blog/peter-isard-analyzes-the-proper-economic-policy-reforms-and-root-causes-of-global-financial-crises/

 

 

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