Rethinking Monetary Policy in a Changing World

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After decades of quiescence, inflation is back; to fight it central banks must change their approach.
Author: MARKUS K. BRUNNERMEIER, Edward S. Sanford Professor of Economics at Princeton University.
Publication: F&D Magazine, March 2023.
Central claim: The predominant intellectual framework central banks have followed since the global financial crisis that began in 2008 neither stresses the most pressing looming issues nor mitigates their potential dire consequences in the current high-inflation, high-debt environment.

Economy shifting from a period of low interest rates and low inflation to one with high inflation and high levels of both public and private debt.
Key differences from post-2008 environment:
- Public debt is now high, so interest rate increases make servicing debt more expensive and have immediate and large adverse fiscal implications for the government.
- Since the beginning of the COVID-19 crisis in early 2020, fiscal policy can be a significant driver of inflation.
- Instead of deflationary pressures, most countries are experiencing excessive inflation—creating a trade-off between demand-reducing monetary policy and ensuring financial stability.
- The nature and frequency of shocks have changed: demand vs. supply, specific risks vs. systemic risks, transitory vs. permanent, making real-time identification difficult.

Conceptual framing:
- Monetary dominance: central bank independence (de jure and de facto) to set interest rates without government interference.
- Fiscal dominance: public deficits do not respond to monetary policy; fiscal pressures can constrain monetary policy.
Historical context:
- The period following the 2008 crisis was one of monetary dominance, enabling unconventional tools focused on combating deflationary risks.
- During the COVID-19 crisis, government spending rose sharply; U.S. response included “stimulus checks” sent directly to households; European responses focused on worker retention and green/digital transition spending.
Key risks and mechanisms:
- Fiscal expansion appears to have been a primary driver of inflation in the United States and contributed to inflation in Europe.
- Prospect of fiscal dominance threatens to pit monetary and fiscal authorities against one another; governments may prefer monetization of debt rather than fiscal consolidation.
- Legal independence alone is insufficient to guarantee monetary dominance; the central bank must remain well capitalized and maintain public support.
- Central banks with large balance sheets holding risky assets and paying interest on reserves may face large losses as interest rates rise, increasing pressure from fiscal authorities.

Post-2008 developments:
- Central banks used QE and became market makers of last resort, purchasing large amounts of risky assets to compress credit spreads and spur lending.
- Large purchases led to swollen central bank balance sheets that were not fully unwound for fear of economic damage.
Consequences:
- 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 banks to step in when asset prices fall.
- Unwinding central bank balance sheets may have contractionary effects larger than QE’s stimulus.
- Example warning: potential losses faced by pension funds in the United Kingdom in 2022 and Bank of England bond purchases to forestall a crisis.
Financial dominance defined:
- Monetary policy is restricted by concerns about financial stability; tightening could destabilize financial markets and provoke recessions.
- The extent depends on bank capitalization and the smoothness of bankruptcy/insolvency processes.

Historical note:
- Great Moderation of the 1980s and 1990s saw stable inflation expectations across developed economies.
- After the global financial crisis, fears of deflation dominated policy concerns.
Recent developments:
- Rapid inflation following the COVID-19 pandemic has renewed the risk that inflation expectations could separate from central bank targets (anchors).
- Central banks “overlearned” the lessons of 2008, assuming inflation expectations would remain anchored and adopting a data-driven approach that delayed tightening.
- Forward guidance and commitments to keep rates low far into the future can harm expectations if future central banks cannot keep those commitments.
- Complacent treatment of supply shocks (treating them as temporary and tolerating some inflation) risks destabilizing inflation anchors if supply shocks are persistent or recurrent.
- The Ukraine war paradoxically strengthened the inflation anchor by providing an explanation for price rises.

Monetary policy must be robust to sudden and unexpected macroeconomic changes; central banks must be more humble and prepared for multiple shock types.
Preserve and defend central bank independence by:
- Avoiding monetization of excessive government debt.
- Remaining well capitalized to resist fiscal pressure.
- Effectively communicating rationale for actions to maintain public support, especially against fiscally driven inflation.
Reassess central banks’ roles in financial markets:
- Restore price signals smoothly in private markets where central banks intervened excessively.
- Recognize trade-offs between price stability and financial stability and anticipate tensions arising from large balance sheets.
- Impose greater macroprudential oversight focusing on dividend payouts and risk buildup in nonbank capital markets.
- Reconsider roles as lender and market maker of last resort; ensure interventions are temporary and avoid permanent asset purchases.
- Communicate a policy framework that smooths liquidity conditions without leading to permanent asset purchases.
Inflation expectations management:
- Return to a monetary approach where stabilizing inflation expectations is a central priority.
- Act as soon as warning signals flash rather than waiting for inflation to materialize.
- Incorporate both households’ and financial markets’ expectations into policy decisions because they influence aggregate demand and asset prices.

Source: Rethinking Monetary Policy in a Changing World, F&D Magazine, Markus K. Brunnermeier, March 2023

F&D March 2023: Rethinking Monetary Policy
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