Monetary policy
Monetary authorities can use forward guidance to try to mitigate any consumer uncertainty. This is where the central bank provides the market with certainty surrounding rates. This can be effective, as it can change public expectations. Odyssean forward guidance attempts to convince markets that once the economy recovers the central bank will wait longer than usual to address increasing inflation. On the other hand, with Delphic forward guidance the central bank simply publishes what it will set the base rate at in the future. However, t here’s lots of speculation over the effectiveness of Odyss ean forward guidance since it’s heavily reliant on the credibility of the central bank. Mark Carney , the former governor of the Bank of England, has famously been labelled ‘the markets’ unreliable b oyfriend’ as he went against his promise and left rates unchanged. This shows how the implementation of forward guidance is recognized as being extremely difficult. The above constraints are particularly relevant when rates are further away from the Zero Lower Bound (ZLB) and have room to be cut more. Once rates near the ZLB economies may enter a ‘liquidity trap’ in which cutting the base rate any further can become ineffective, thereby rendering traditional monetary policy useless. At present many G7 economies around the world have found themselves exactly in this position. This is where the introduction of unorthodox monetary policies begins. The first unorthodox monetary policy that we’ll be exploring is Quantitative Easing (QE). QE is the process in which the central bank prints (electronic) money and purchases longer-term securities (illiquid assets) from the open market, in an attempt to increase the money supply. This stimulates consumption(C) and investment(I) helping increase aggregate demand (AD) (AD = C + I + G + (X-M)). QE can also depreciate the value of a country’s domestic currency because lower interest rates weaken the exchange rate. This can in theory make exports more competitive, potentially boosting AD. This said, in Japan economic growth did not materialize as a result of exceedingly loose monetary policy
over a long period of time – QE was deployed in its first guise in Japan in 2001. Nonetheless, QE is still an increasingly popular policy with the Bank of England (BOE) and many other central banks. As we can see in the graph below 1 in the wake of the 2008 global financial crisis, the BOE purchased £200 billion of government bonds in November 2009. Fast forward almost 11 years and we can see that the BOE purchased £745 billion of government bonds: that’s a 272.5% increase.
Negative interest rate policies (NIRP) can also be introduced, where the base rate is below zero. This means that borrowers are credited and people holding money with the bank are charged interest. This said, banks may be reluctant to pass on negative rates to consumers choosing to save as it could cause a flight of capital. It’s an increasingly common policy which essentially forces firms and consumers to move their money into other assets or investments with the general goal being to boost aggregate demand. Nevertheless, negative interest rates do have a few caveats. Since consumers and firms are
1 What is quantitative easing? Knowledge Bank, BOE.
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