In response to the extraordinarily challenging environment in the immediate aftermath of the global financial crisis of 2008, central banks in leading advanced economies have seen their mandates broadened from fairly narrowly defined macroeconomic targets, such as price stability and employment, to include financial stability.
Moreover, to achieve their targets, central banks have adopted an ever-broader range of previously untested “unconventional” policy tools, including quantitative easing and negative interest rates.
As a result, central banks have become prominent providers of assets and liquidity for sovereigns, financial institutions and shadow banks, reflected also in a manifold expansion of their balance sheets.
In its new report “The Future of Monetary Policy,” the Credit Suisse Research Institute looks at the transformative changes central banks in advanced economies have undergone since 2008.
The report concludes that the key issue for decision-makers globally remains to consider which fundamental direction monetary policy ought to take next, assessing two alternative scenarios that may evolve: a return to a pre-crisis “normal”, or an extension or amplification of recent policy trends, leading to a further blurring of boundaries between monetary, regulatory and fiscal mandates.
“Since 2008, central banks have changed their policy-making in dramatic ways, initially to prevent a major destabilization of the financial system in the immediate aftermath of the financial crisis, and thereafter to offset evolving deflation risks,” says Oliver Adler, Head of Economic Research International Wealth Management, Credit Suisse.
“The coming years will be decisive in relation to the future direction of central bank policy, depending on both economic and political developments. Even if the influencing factors are difficult to predict, we believe that the discussion of the future of monetary policy needs to be reinforced.”
Given the substantial lag between the implementation of monetary policy measures and their impact on the economy, it is – even now – difficult to pass a final judgement on the successes or failures of the post-2008 monetary policy measures.
The Credit Suisse Research Institute (CSRI) report nevertheless provides a detailed assessment of central bank policies in major advanced economies since the 2008 crisis and discusses some of the fundamental as well as operational challenges that lie ahead, including the question of whether central banks can return to the pre-crisis normal. It presents two alternative scenarios that may evolve – a normalization scenario and a “new norms” scenario.
The acceleration of economic activity since mid-2016 in both advanced and developing countries suggests that the thesis of monetary policy ineffectiveness and continued “secular stagnation” stands a reasonable chance of being disproven.
Momentum in labor markets seems to be improving in most countries and there are increasing signs that the prolonged weakness in corporate investment spending is giving way to slight acceleration. Should this be the case, the chances would also increase that central banks will follow the US Federal Reserve in gradually normalizing policy.
While instances of financial market turbulence could well occur in such a scenario, the overall outlook for investors would be moderately positive, in the view of Credit Suisse analysts. Although asset returns would likely be constrained by the high valuations that have resulted from the period of very expansionary policy, extremes should be avoidable.
However, even in such a case, the question must be addressed as to how far policy normalization can go. This will depend on both the extent of the cyclical growth recovery and inflation, and on the likely “natural” or terminal equilibrium rate of interest. If the latter is comparatively low, central banks would potentially need to resort to unconventional policy tools, should a new economic downturn set in. The issue of which of the tools tested in past years would likely be effective at that point in time will thus remain highly pertinent.
Moreover, even in a scenario of policy normalization, central banks may have to change their operational modus due to the new regulatory environment. For example, central banks will inevitably have to maintain comparatively large balance sheets for extended periods of time, so that financial institutions can meet the liquidity requirements imposed by the Basel III regulatory framework.
They are also likely to play an important role as market makers and market stabilizers for quite some time.
“New norms” scenario
In an alternative scenario, central bank policy normalization would be averted either for economic or political reasons, or a combination of both.
Should the secular stagnation hypothesis be borne out, pressures on central banks to maintain an easy stance would continue to intensify. A decision, for example, to move interest rates into more negative territory would loom earlier and thereby pose technical problems, while at the same time potentially exposing central banks to new popular pressures.
Alternatively, or additionally, pressures could intensify in some countries to finance fiscal expansion measures through some form of “helicopter money.”
Even in the absence of such an economic backdrop, the leeway for central banks to pursue independent policies that evolved in the pre-crisis period may be constrained by political intervention. This type of scenario poses certain stability risks for the Eurozone – and thereby also for Switzerland – as different members of the common currency area are likely to have diverging views regarding the appropriate policy approach. In this case, conflicting views could express themselves in significant market stress. Arguably, international policy coordination would be (further) weakened in such a scenario.