Monetary policy in a downturn: Are financial crises special?

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

There is a consensus opinion among central bankers and policymakers that an accommodative monetary policy was instrumental in preventing a deeper recession during the financial crisis.  However, the severity of the crisis required a forceful response by the central banks, especially the need for unconventional monetary policies.  This required both liquidity support and monetary easing to prevent the implosion of the financial system and limit its destructive effect on the real economy.

However, views differ on how long monetary policy should remain accommodative.  These are some of the issues considered by Morten Bech, Leonardo Gambacorta & Enisse Kharroubi in a recent BIS WP 388 (September 2012) called Monetary policy in a downturn: Are financial crises special?

At the heart of this debate is the notion that a protracted period of policy accommodation may delay the necessary balance sheet adjustments and create a base for potential distortions such as a new credit bubble.  The impact of the expanded central bank balance sheet adds to the uncertainty.

Some would argue that any distortions will be limited in extent and that further monetary stimuli should bolster the recovery. Others fear that prolonged easing may delay much-needed balance sheet adjustments, thus entrenching weak economic performance.

The authors, in their analysis, find that monetary policy is less effective in a financial crisis, when impairments in the monetary transmission mechanism may occur, as in a balance sheet recession. In particular, the results show that the benefits of accommodative monetary policy during a downturn for the subsequent recovery are more elusive when the downturn is associated with a financial crisis and non-traditional monetary measures are used.

The authors confirm that when using traditional monetary policy easing during the downturn does lead to a stronger recovery in the case of normal downturns. However, in downturns associated with a financial crisis and non-traditional policy, this result is not clear.

Secondly, deleveraging (measured by changes in the private debt-to-GDP ratio or by the real growth of private debt) during a downturn associated with a financial crisis has a positive effect on the subsequent recovery: a 10% reduction in the debt-to-GDP ratio during the downturn leads to a 0.6 percentage point increase in the average output growth during the recovery.

The results add further confirmation of the limits to traditional monetary policy tools during a financial crisis.  However, the application of unconventional monetary policy for a prolonged period can create economic distortions and sow the seeds for next financial disaster – and create a new risk problem!

www.bis.org/publ/work388.htm