Was unconventional monetary policy a success?

How central bankers’ extraordinary solutions have led to some profound questions about the future of monetary policy

Raghuram Rajan

Raghuram G. Rajan | Sep 25, 2017

Sections Public Policy

Collections Monetary Policy

Over the last few years, central banks in industrial countries have undertaken a variety of efforts that deviated from ordinary monetary policy. They’ve tried to persuade the public through forward guidance that interest rates would stay low for extended periods. They’ve relied on a number of programs with various acronyms, such as the long-term refinancing operation (LTRO), the Securities Markets Programme (SMP), quantitative easing (QE), and so on. Most recently, we’ve seen negative interest rates and—from the Bank of Japan, which has always been at the forefront of innovation—yield-curve targeting. And of course some central banks have resorted to unconventional but well-known policies such as direct interest-rate targeting.

These interventions suggest a series of questions that can help us take stock of what this extraordinary period in monetary policy has taught us: Why were these policies used? Did they work? What has been the effect of phasing them back out? And what long-term concerns do they raise? The answers to these questions may offer important insights to central bankers grappling with future crises.

Clearly, markets were broken after the financial crisis. The mortgage-backed securities market and the markets for sovereign bonds in Europe spring readily to mind, and a central bank inserting itself into the process and stabilizing those markets was perhaps important at that time. So the first rationale for why central banks began experimenting with unconventional monetary policy is not hard to fathom.

The second reason to intervene was to affect yields or prices, and this too was perhaps necessary at a time when the policy rate had reached the zero lower bound. Central bankers sought to affect prices on a variety of long-term instruments—sometimes a particular class of instrument, sometimes with the hope that the effect would spread across classes.

The third reason for intervention was to signal commitment to a bank’s particular monetary policy. If a central bank announced, for example, a purchase program for government securities, and it sent the message that so long as it was purchasing government securities, it would not tighten monetary policy, this effectively supported the notion that it would be keeping interest rates low for a long time. QE might have been geared in some cases toward affecting yields, but the primary intent in other cases might have been more about signaling.

These are some of the reasons central banks have offered for these increasingly aggressive—or innovative—policies. But there’s one more reason that central bankers don’t often mention, and now that I’m an ex-central banker, perhaps I can.

Central bankers know far more about how to get inflation down below the upper bound than they do about how to push it up above the lower bound.

Central banks entered the process of inflation targeting really with the focus on the upper limit of the target band of rates that they had set for themselves. Few central bankers who moved into inflation-targeting regimes believed that the problem would be the lower bound, or the lower level of the band, and that in fact they would be struggling to get inflation up into the band rather than down into it. Central bankers know far more about how to get inflation down below the upper bound than they do about how to push it up above the lower bound. And therefore, in a sense, central banks have become trapped by a mandate that they have far less knowledge about how to achieve.

The Bank of Japan has been attempting to push inflation up for close to a decade and a half now. A lot of central bankers around the world offered advice. “It’s very easy. Here’s how you do it. . . .” Unfortunately, when they themselves faced low inflation, they realized it’s not so easy. It’s not easy at all.

In this environment, you have to worry that if you throw up your hands and say, “I have no policy instruments left,” inflation expectations among the public might collapse. So you always have to claim to have one more instrument behind your back that you still haven’t brought out—the bazooka, which you will brandish if the occasion arises. But you hope and pray, or you cross your fingers when you speak about this instrument, that you never have to actually bring it out.

What this means is that central banks have to keep trying new things to push inflation up as it becomes clear to the public that the instruments the banks are currently working with have stopped being effective. So when QE has run its course, you move to negative interest rates. When negative interest rates run their course, you move to yield-curve targeting. But you have to bring out something new, because to advocate a wait-and-see approach with the existing policy instrument once it has lost public credibility means that you have given up hope, and that could be far more dangerous.

That brings us to our second question: Did any of these innovative instruments work? In the pursuit of stable markets, yes, some of them seem to have worked quite well. Markets were repaired. Perhaps the interventions worked because a big deep-pocketed player came in to buy securities; perhaps they worked simply because the central bank was putting its weight behind the markets and saying, “We’re going to be here to make sure they function.” Remember, spreads for periphery sovereign credit in Europe were growing massively until European Central Bank President Mario Draghi said the ECB would do “whatever it takes” to preserve the euro. That had a magical effect on markets.

However, insofar as the intent of these interventions was to get inflation reasonably close to where a certain bank aimed it to be, then no, they did not work. Not yet, not for any of the central banks. The Fed is probably the closest to success, to getting to about 2 percent PCE (personal consumption expenditures) inflation, but the interventions pretty much haven’t worked for anybody else. It may be a matter of time, and of course, that’s what the central banks will tell us. It’s also quite possible, though we don’t really know how to tell for sure, that central banks’ actions may have prevented a collapse of inflationary expectations. Perhaps one reason expectations haven’t hit a downward spiral in Japan and some other countries is that central banks have been constantly indicating they are committed to their mandate and aren’t willing to simply throw up their hands.

In regard to the ability of these kinds of policies to affect prices, the evidence is fairly mixed: you can see some effects if you look at a narrow window of time for a narrow class of instruments. But as soon as you expand your view, it becomes much harder to see their influence. When the Fed buys Treasuries, it has an effect on Treasuries, but it doesn’t have an effect across the spectrum of bonds—or at least, it’s much harder to make that case strongly, and the link between real investment or consumption and these kinds of policies is even harder to establish.

In sum, the effects of these extraordinary policies are probably positive for markets, positive to neutral in terms of their effects of signaling on monetary policy, and uncertain in terms of their effects on real activity. But what will happen as these policies unwind?

In the process of expanding central-banking capabilities and doing what it takes to achieve their mandate, central banks may have inadvertently exposed themselves to political scrutiny and, eventually, a loss of central-banking independence and power.

One nice thing about expectations is they get front-loaded. We already experienced, way back in 2013 when there was a sense that the Fed might terminate QE and move toward raising interest rates, what we called the “taper tantrum,” during which there was some turmoil and we saw interest rates go up quickly. Things have become more stable, but you might still expect to see a reversal of some of the price effects that unconventional monetary policies created as those policies are walked back. If central banks start unwinding their balance sheets, you might expect that, since long-term bonds are being put back into the market and the reverse is happening with excess reserves, interest rates will rise steeply because bond issuers will need to find more private buyers.

A related effect of reversing unconventional monetary policy might be felt in emerging markets. If the effect of some of these policies was to push capital to emerging markets as investors went searching for high yields, one effect of withdrawal should be to pull capital back from those emerging markets. The taper tantrum was calamitous for some of these markets because of their inability to cope with the large, sudden capital outflows they experienced. Some people make the analogy that emerging markets should welcome foreign capital as you might guests, and for the most part, they do. But like any host, they would love to know when a huge crowd of guests is expected to arrive (foreign capital often comes in a mass) and when to expect them to leave (foreign capital departs en masse also, without much notice), so that they can plan accordingly.

In any case, the macroeconomic picture in many of these markets has improved since 2013. Many have brought their current account deficits under control. The real exchange rates on their currency are at fairly reasonable levels. There’s reason to think they would cope a bit better if they faced the same challenge today.

But perhaps some of these policies of expanding central-bank balance sheets shouldn’t be phased out to begin with. There are arguments—for example, made by Harvard’s Jeremy C. Stein, Robin Greenwood, and Samuel G. Hanson—that perhaps central banks should keep their balance sheets large because they provide the vital function of creating safe, short-term instruments, and the world lacks for safe, short-term instruments. When the private sector tries to provide safe, short-term liabilities, typically it hides a lot of risks, which eventually comes back to haunt the system. So does that mean the Fed shouldn’t unwind its balance sheet much?

Conversely, there is at least one compelling reason why central banks shouldn’t make their big balance sheets a permanent feature, and it’s the political one posed by former Philadelphia Fed President Charles Plosser. As you expand your balance sheet and use it in ways that are not entirely tied to monetary policy, you expose yourself to the possibility that others may find interesting things for you to do with it. As Plosser pointed out, if the government needs $500 billion for infrastructure spending, it might say, “Hey, Fed, you’re holding a few trillion dollars worth of assets. Why don’t you just convert $500 billion of that to infrastructure assets? Might as well give us some support in our fiscal endeavors.”

Every central banker in an emerging market has had the experience of the government calling her up and telling her all sorts of interesting things it can do with her balance sheet. Usually the response has been a polite no. But if you have a large balance sheet that is being used without any connection to monetary policy, it can be hard to turn down such requests.

The incidental effects monetary policy in industrial countries can have on emerging markets, as well as the potential for politicizing central banks, both speak to the questions central bankers should ask themselves as they consider the future of unconventional monetary policy. Is a small positive effect in one country worth a large negative effect for the rest of the world? If not, should there be rules governing what kinds of policies are allowed in the international monetary system?

Moreover, how have central banks’ domestic mandates encouraged the kind of extraordinary policies we have seen? Central banks essentially said, “Give us a mandate, and don’t place constraints on how we achieve it—that is, give us operational freedom.” That may have worked fine when the primary instrument of central-bank policy was the policy rate (and some marginal tweaks to liquidity). It no longer works because there’s so much central banks can do. That is, there are no assets central banks cannot buy, and no borrowers they cannot fund. It opens the door for politicians to start questioning why it is that central banks have so much freedom. In the process of expanding central-banking capabilities and doing what it takes to achieve their mandate, central banks may have inadvertently exposed themselves to political scrutiny and, eventually, a loss of central-banking independence and power.

Raghuram G. Rajan is Katherine Dusak Miller Distinguished Service Professor of Finance at Chicago Booth. He was the 23rd governor of the Reserve Bank of India, from 2013 to 2016. 

This essay is adapted from Rajan’s keynote address at the 2017 Asian Monetary Policy Forum.