## RETHINKING MONETARY POLICY

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**Canonical URL:** [RETHINKING MONETARY POLICY](https://www.imf.org/-/media/files/publications/fandd/article/2023/march/brunnermeier-rethinking-monetary-policy.pdf)

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### The changing macroeconomic environment and need for a new approach
- After decades of low interest rates and low inflation, the global economy is entering a phase characterized by high inflation and high levels of both public and private debt.
- The predominant intellectual framework central banks followed since the global financial crisis that began in 2008 "neither stresses the most pressing looming issues nor mitigates their potential dire consequences in this new climate."
- Key differences from the post-2008 environment:
  - "Fifteen years ago, central banks saw an urgent need to incorporate financial stability and deflation concerns into their traditional modeling of the economy and developed unconventional tools to deal with both."
  - "Since the beginning of the COVID-19 crisis in early 2020, it is also evident that fiscal policy can be a significant driver of inflation."
  - Instead of deflationary pressures, most countries are experiencing excessive inflation, creating a trade-off between raising interest rates to reduce aggregate demand and ensuring financial stability.
  - The nature and frequency of shocks have changed: demand vs. supply, specific risks vs. systemic risks, transitory vs. permanent—"It is difficult to identify the true nature of these shocks in time to respond. Central bankers need to be more humble."
- Implication: Monetary policy must be robust to sudden and unexpected macroeconomic scenario changes; policies effective in one environment may have unintended consequences when conditions change.

### Monetary–fiscal interactions and the preservation of monetary dominance
- Central bank independence is essential to monetary dominance: de jure independence (legal authority) and de facto independence (not having to worry that higher rates increase government indebtedness or default risk).
- The post-2008 period was one of monetary dominance, allowing central banks to focus on preventing deflation and to develop unconventional tools for additional stimulus.
- The COVID-19 period changed dynamics:
  - Government spending rose sharply in most developed economies; the United States provided "massive and highly concentrated support in the form of 'stimulus checks' sent directly to households."
  - Fiscal expansion appears to have been a primary driver of inflation in the United States and contributed to inflation in Europe.
  - Pandemic-era supply shocks (for example, supply chain disruptions) added to inflation pressures.
- Risk of fiscal dominance:
  - The buildup of public debt raises the possibility that deficits do not respond to monetary policy, potentially pitting fiscal and monetary authorities against each other.
  - Governments may prefer that central banks monetize debt (purchase government securities private investors won't buy).
- Conditions for preserving monetary dominance:
  - Legal guarantees alone are insufficient; central banks must remain well capitalized—frequent recapitalization from the government signals weakness.
  - Large balance sheets containing many risky assets and paying interest on reserves can produce large losses as interest rates rise, increasing fiscal pressure.
  - "The central bank must keep public opinion on its side, because the public is the ultimate source of its power and independence." Effective communication is essential.
  - A central bank ultimately maintains dominance if it can credibly promise not to bail out the government by monetizing public debt if there is a default.

### The threat of financial dominance and trade-offs with inflation control
- After the global financial crisis central banks used unconventional QE programs to purchase large amounts of risky assets once conventional interest rate stimulus was exhausted.
- Consequences of prolonged large balance sheets and QE:
  - Buildup of private debt, depressed credit spreads, distorted price signals, and high house prices from increased mortgage lending.
  - Private sector dependence on central bank liquidity; markets expect central bank intervention when asset prices fall.
  - The contractionary effect of unwinding central bank balance sheets may be more visible than the stimulus provided by QE.
- Example of risks: pension funds in the United Kingdom in 2022 faced potential losses that could have seriously distorted long-term interest rates; the Bank of England intervened to buy UK bonds to forestall a crisis after long-term rates climbed.
- Financial dominance defined: monetary policy is restricted by concerns about financial stability because the private sector, especially capital markets, depends on central bank liquidity.
- Determinants of financial dominance severity:
  - Capitalization of private banks and the smoothness of bankruptcy proceedings.
  - A well-functioning insolvency law insulates the system from spillovers and reduces pressure on central banks to bail out institutions.
- Policy implications and recommendations:
  - Rethink how monetary policy interacts with financial stability and anticipate trade-offs between price stability and financial stability—"There are always trade-offs between their goals of price stability and financial stability—even if that tension becomes clear only in the long run."
  - Restore price signals smoothly in private markets where central banks have intervened excessively.
  - Impose greater macroprudential oversight with particular focus on monitoring dividend payouts and buildup of risk in the nonbank capital markets.
  - Reconsider central banks' roles as lenders and market makers of last resort; ensure interventions are only temporary and avoid permanent asset purchases.
  - Communicate a policy framework that smooths liquidity conditions without leading to permanent asset purchases.

### Inflation expectations, anchors, and the need to act early
- After the Great Moderation of the 1980s and 1990s, inflation expectations were stable across developed economies; following the global financial crisis there were fears of deflation.
- The rapid inflation after the COVID-19 pandemic shifted concerns: "the time for deflation worries had passed; the possibility that inflation will exceed central bank targets in the intermediate term is again a concern."
- Central banks "overlearned the lessons of the 2008 crisis," abandoning traditional approaches to inflation expectations:
  - They assumed inflation had been conquered and that expectations would remain well anchored, which contributed to the initial misdiagnosis of inflation during the pandemic.
  - Under that assumption, central banks believed it was possible to run the economy hot (letting unemployment fall below the natural rate) without much risk and to make long-term commitments (forward guidance) because those commitments seemed unlikely to have long-term inflationary consequences.
  - A data-driven approach that intentionally delayed tightening—to avoid cutting output prematurely—meant central banks would wait until inflation materialized before acting.
- Complacency toward supply shocks:
  - Standard models often imply monetary policy should not fully neutralize inflation caused by supply shocks because such inflation is temporary.
  - Failure to react to supply shocks can destabilize the inflation anchor and prevent central banks from achieving their goals later.
  - Paradoxically, the Ukraine war "strengthened the inflation anchor because it gave central banks cover to explain why inflation rose so much."
- Evidence and risk:
  - "Warning signals have already emerged in recent inflation expectations data."
  - Loss of the inflation anchor would increase consumer and business uncertainty, hindering aggregate demand and supply, and impairing both central banks' ability to control inflation and economic activity.
- Policy recommendations:
  - Return to a monetary approach in which stabilizing inflation expectations is a central priority.
  - Do not wait to tighten only after inflation occurs; act as soon as warning signals flash.
  - Incorporate both households' and financial markets' expectations of future inflation, since those expectations shape aggregate demand conditions and asset prices.
  - Prioritize communication to retain public support and preserve independence.

*Source: RETHINKING MONETARY POLICY — Finance & Development (March 2023), Markus K. Brunnermeier.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2023/march/brunnermeier-rethinking-monetary-policy.pdf_