What to do When Low-for-Long Interest Rates are Lower and for Longer
IMF Blog, December 14, 2020
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Bibliographic details
- Authors: Tobias Adrian
- Published: December 14, 2020
Context and key messages
- Author: Tobias Adrian
- Date: December 14, 2020
- Central banks have been pivotal in easing financial conditions in response to the COVID-19 shock and helped avert a catastrophic downturn.
- More monetary stimulus will be needed to support economic recovery; central banks are implementing innovative new strategies to provide it.
- Policymakers must weigh the pros of more stimulus today against the cons of higher financial stability risks in the future.
- A model is presented to quantify the tradeoff between near-term support and increased vulnerability tomorrow.
New strategies for a lower-for-longer environment
- Pre-pandemic challenges:
- Central banks struggled to boost economic activity and bring inflation to target even after the Global Financial Crisis.
- A sharp decline in the neutral rate of interest reduced scope to counter low inflationary pressures.
- Even with very low yields out the yield curve, inflation remained chronically low and appeared to be pulling down long-run inflation expectations in many economies, putting downward pressure on nominal yields and eroding policy space.
- COVID-19 intensified these challenges:
- Employment collapsed, threatening a major humanitarian crisis in many economies.
- Inflation was further depressed by weak activity and falling commodity prices.
- Policy rates have been pushed to zero or below; very low yields on long-term government bonds limit scope for stimulus via purchases of these instruments.
- Recent institutional responses:
- Central banks are conducting monetary policy framework reviews to identify new ways to boost employment and inflation.
- The Federal Reserve adopted a “make-up” strategy to allow inflation to overshoot its target to make up for past shortfalls, aiming to better anchor inflation expectations and create optimism today that fuels a stronger recovery.
Financial stability tradeoffs and the risk-taking channel
- Unconventional policies under consideration:
- More aggressive use of sovereign bond and corporate debt purchases, combined with new approaches, can speed recovery from COVID-19 and future shocks.
- Risks:
- Even more accommodative policies may encourage excessive risk-taking and a build-up of vulnerabilities that pose substantial future risks.
- Role of macroprudential policy:
- Ideally, macroprudential policies should be the first line of defense against financial stability risks, consistent with Fund policy advice.
- In practice, macroprudential tools may fall short due to lack of tools for nonbank financial institutions or implementation hurdles tied to the political process.
- Modeling the tradeoff:
- A “New Keynesian” modeling framework is presented that incorporates a risk-taking mechanism:
- Easy monetary policy stimulates aggregate demand through standard channels and by relaxing financial conditions via risk-taking.
- Looser monetary policy reduces near-term risks to output and financial stability but causes financial fragilities to grow over time, increasing output risk in the medium term.
- The framework helps policymakers balance the intertemporal tradeoff associated with “low-for-long” monetary policies, including those deployed in response to COVID-19.
- Cross-border considerations:
- Monetary policy easing by major central banks can affect financial stability in foreign economies through increased risk-taking and a buildup of leverage.
- The IMF’s integrated policy framework—considering macroprudential policies, capital flow management tools, and foreign exchange intervention—can be constructive in assessing mitigation strategies.
Policy implications and recommendations
- Continue bold and innovative strategies to provide additional firepower to support faster global recovery and achieve inflation targets.
- Incorporate macro-financial stability considerations explicitly into monetary policy decision making, alongside output, unemployment, and inflation objectives.
- Actively deploy macroprudential tools where possible to contain financial stability risks, enabling more prolonged monetary accommodation and promoting faster recovery.
- Be vigilant in managing the future financial-stability consequences of accommodative policies and make those future consequences a key part of present decision making.
- Consider international spillover effects and use an integrated policy toolkit to mitigate cross-border financial stability risks.
Source: IMF Blog post by Tobias Adrian, December 14, 2020. The IMF is an organization of 191 countries.