When the unconventional becomes conventional

Claudio Borio of BIS in this speech:

The tools central banks use for crisis times are becoming increasingly indistinguishable from those they employ for normal times; the unconventional is becoming conventional. The tools in question have proved more effective than generally expected in influencing financial conditions, but appear to exhibit diminishing effectiveness and have long-term side effects. Partly as a result, the wide-ranging and forceful emergency measures taken to address the Covid-19 crisis have further reduced the policy room for manoeuvre. An economy with small safety margins is exposed and vulnerable. As soon as conditions allow, the priority will be to rebuild policy buffers, not just in monetary policy, but also in prudential and fiscal policies. Monetary policy will face a particularly tough twin challenge: economic, owing to the limited responsiveness of inflation to economic slack; and intellectual, given the popularity of the notion of the natural interest rate – a real rate fully independent of monetary policy. That notion puts central banks in a straightjacket.


What does all this mean for policy? I would suggest that it points to the need for a broader view. We need to recognise the limits of monetary policy as well as the importance of flexibility in the framework, which would allow sufficient weight to be placed on the longer-term factors on which monetary policy has a significant influence. And we need to think of what other policies can do. Hence the need to ensure that, for these policies too, adequate buffers are in place.

This applies to both prudential and fiscal policies. Pre-existing buffers in both areas have been instrumental in enabling the necessary policy support in the response to the Covid-19 crisis. Strong bank capital and liquidity buffers have allowed supervisors to encourage banks to keep credit flowing, and those countries with higher fiscal headroom have been able to respond more forcefully.6

At some point, though, there will be a need to rebuild the buffers. This is true for banks, as the crisis transitions from the liquidity to the solvency phase; and it is true for fiscal policy, as the imperative is to ensure that it remains on a sustainable path, which is essential for financial, macroeconomic and price stability.

Last but not least, while policy buffers promote badly needed economic resilience, the key to more robust and sustainable growth is structural reforms. Unfortunately, after a brief phase post-GFC, they have lost momentum. The current crisis offers an unexpected opportunity to regain it.

To conclude: building policy buffers is essential – in monetary policy, just as in other areas. The challenge ahead is how. After all, if something is valuable, it must be worth paying a certain price for it.


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