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The future of monetary policy – normalization or new norms?

The Credit Suisse Research Institute assesses key challenges for central banks in coming years

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.

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.

Oliver Adler, Head of Economic Research International Wealth Management, Credit Suisse:
“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. 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 published today 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.

Normalization 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.

“The Future of Monetary Policy” report published by the CSRI is available for download at www.credit-suisse.com/researchinstitute.

In addition to assessing alternative scenarios for the future direction of monetary policy, the report recaps how central banks responded to the crisis and provides a detailed look at quantitative easing policies applied by a number of key central banks, the impact of negative interest rate policies applied by central banks outside the USA, as well as central banks’ involvement in financial sector regulation.

Stefani Kostadinova, a 22 year old economics student from the America University in Bulgaria, wrote the chapter on the effects of quantitative easing. Having her work published was part of Ms. Kostadinova’s prize for winning the CSRI Academy Challenge launched in the summer of 2016. Her paper on the future of monetary policy was deemed the clear winner among several hundreds of papers submitted on the topic from candidates from 115 universities and 51 countries.

Looking beyond short-term developments, the report further considers the future digital currencies and their potential implication on monetary policy, including a chapter dedicated to this topic authored by David L. Yermack, Professor of Finance and Business Transformation at New York University’s Stern School of Business. 

About the Credit Suisse Research Institute

The Credit Suisse Research Institute is Credit Suisse's in-house think tank. The Institute was established in the aftermath of the 2008 financial crisis with the objective to study long-term economic developments, which have – or promise to have – a global impact within and beyond the financial services.
For more information, visit: www.credit-suisse.com/researchinstitute.

Authors of the report “The Future of Monetary Policy”
Oliver Adler, Head of Economic Research International Wealth Management, Credit Suisse
Zoltan Pozsar, Director Global Strategy and Economics, Credit Suisse
David Yermack, Professor of Finance and Business Transformation at NYU’s Stern School of Business
Stefani Kostadinova