by Don Alexander, MBA
Associate, RSD Solutions Inc.
The major advanced economies are maintaining extraordinarily accommodative monetary conditions, through low policy rates and the continued expansion of their balance sheets through new rounds of unconventional policy measures. These extraordinarily accommodative monetary conditions are being transmitted to emerging market economies (EMEs) in the form of undesirable exchange rate and capital flow volatility. As a consequence of EME efforts to manage these spillovers, the stance of monetary policy is highly accommodative globally. The limits to monetary policy, in the current environment, are addressed in the latest 2011 BIS Annual Report.
There is widespread agreement that, during the crisis, decisive central bank action was essential to prevent a financial meltdown and that in the aftermath it has been supporting faltering economies. Central banks have had little choice but to maintain monetary ease because governments have failed to quickly and comprehensively address structural impediments to growth.
However, there are limits to what monetary policy can do; such as provide liquidity, but it cannot solve underlying solvency problems. Failing to appreciate the limits of monetary policy can lead to central banks with conflicting objectives, with potentially serious adverse consequences. Prolonged and aggressive monetary accommodation has side effects that may delay the return to a self-sustaining recovery and may create risks for financial and price stability globally as actual achievements fall short of expectations.
The global monetary policy stance taken by central banks is unusually accommodative. Policy rates are well below benchmark measures while central bank balance sheets continue to expand. Against the background of weak growth and high unemployment, sustained monetary easing is natural and compelling. However, there is a growing risk that monetary policy, by itself, cannot solve all issues such as solvency or deeper structural problems. It can buy time, but conversely may delay the return to a self-sustaining recovery. Central banks need to recognize and communicate the limits of monetary policy, making clear that it may not address the root causes of financial fragility and economic weakness.
The combination of weak growth and low rates, and efforts to manage the spillovers in emerging market economies, has helped to spread monetary accommodation globally. This has resulted in a build-up of financial imbalances and increasing inflationary expectations could have negative repercussions on the global economy. Central banks need to account for global spillovers from domestic monetary policies on financial and price stability.
Finally, central banks need to beware of longer-term risks to their credibility and operational independence. There can be a gap between expectations and the actual results delivered by monetary policy. This could complicate the eventual exit from monetary accommodation and threaten central banks’ credibility and operational autonomy. It is reinforced by political economy risks arising from the combination of balance sheet policies that have blurred the line between monetary and fiscal policies, on the one hand, and the risk of unsustainable fiscal positions, on the other.
The lesson for risk management is that monetary policy will not solve all the problems and some hard decisions are required.
For more on this, follow the link: www.bis.org/publ/arpdf/ar2012e4.htm
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