The Future of Monetary Policy Shaped by the Past
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The Future of Monetary Policy Shaped by the Past

Central banks in advanced economies have been transformed dramatically over the past eight years. The latest Credit Suisse Research Institute report, "The Future of Monetary Policy", looks at the changes they had to undergo since the financial crisis and at the challenges that await them going forward. The key questions remain which direction monetary policy ought to take next and whether it is possible to return to the pre-crisis "normal".

How to Measure the "Unconventional" Measures?

Since the financial crisis of 2008, central banks have been operating in an emergency mode. In order to deal with the new post-crisis market conditions, they had to accept broadening their mandates beyond the traditionally defined macroeconomic targets, such as keeping prices stable and unemployment low, to include overseeing financial stability and economic growth. The challenge of achieving both the old and the new targets required central banks to introduce several "unconventional" tools, including quantitative easing (QE) and the negative interest rates policy (NIRP).

Evolution of Central Banks Balance Sheets

Evolution of Central Banks Balance Sheets

Local currency, indexed January 2007 = 100

Source: Datastream, Credit Suisse

While many experts agree these actions served well the purpose of stabilizing the financial system, there is much more controversy around their impact on the economic recovery. Depending on – among other economic or political factors ‒ whether the diagnosis of secular stagnation is true or false, the path central banks will take next can be either normalization or further expansion of policy trends. The CSRI report "The Future of Monetary Policy" provides detailed analyses of both QE and NIRPs, and attempts to measure their success.

Designing Their Own Destiny

Broader mandates and the challenge of pioneering new policy tools are not the only tasks central banks have been charged with during the post-crisis years. They have also become actively involved in developing the new regulatory framework aimed at healing the financial sector. The new regulations have serious consequences for central banks themselves and will influence the definition of their future role. The report points out three implications the Basel III framework has for central banks:

  1. they will not be able to reduce their balance sheets to pre-crisis levels due to the liquidity requirements;
  2. they are likely to become providers of 'safe' assets to a broader group of counterparties; and
  3. they may be expected to start playing an increasing role as funding providers, also in stable times.
Broad Asset Mix on Central Banks Balance Sheets

Broad Asset Mix on Central Banks Balance Sheets

Last data point: (Fed (4 Jan. 2017), ECB (end-Dec. 2016), BoJ (end-Sept. 2016)

Source: Federal Reserve, Bank of Japan, European Central Bank, Credit Suisse

Brave New Digital World

Although they already have plenty to cope with, this may not be the end of the changes and challenges central banks will have to face in the near future. The rapid growth of new technologies and digitalization brings novelties, which require proper embedding into the existing financial system and setting up certain rules and regulations. One such example is digital currency and blockchain technology.

At the time of writing, numerous blockchain innovations are being tested by both the private and public sectors. Stock exchanges may soon use blockchain technology as part of their clearing and settlement processes. Governments may use it to facilitate regulatory compliance and validate the identification and vital statistics of citizens. Some central banks are already looking into issuing digital sovereign currency as a substitute for the coins and banknotes that have circulated for centuries. How far central banks wish to go down this path will be determined by political considerations and by the banking sector's appetite to embrace financial technology advances.

The coming years will be decisive in relation to the future direction of central bank policy.

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What Future Holds: Normalization or a New Phase of Fiscal Dominance?

With all the transformative changes described above becoming the reality, is it possible for central banks to turn the clock back and revert to their pre-crisis operational mode? The report explores two alternative scenarios.

The first one expects central banks to follow the Fed in gradually normalizing policy, should employment continue to rise and economic activity in both developed and emerging markets accelerate further. The questions are to what extent the market will allow policy normalization and whether any new policy tools will be needed. Even under this scenario, central banks are likely to change their operational modus and adapt to the new regulatory environment.

In the 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 win, pressures on central banks to maintain an easy stance would continue to intensify, while their independence would shrink due to political intervention. 

Oliver Adler, Head of Global Economic Research International Wealth Management, Credit Suisse, concludes with an invitation to a debate: "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."