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Central Banks Test the Limitations of Monetary Policy

By Frances Coppola

Since the Great Recession of 2008-2009, developed countries have relied on central banks to fight deflation, reduce unemployment, and engender lasting growth. In pursuit of these aims, central banks have cut interest rates to unprecedented lows and bought trillions of dollars’ worth of securities through their “quantitative easing” (QE) programs. But a decade on, the world may be threatened with a new downturn—and central banks may have already hit the limits of current monetary policy. What ammunition do central banks still have, and how might using it affect inflation, interest rates, and currency exchange rates?

Low Exchange Rates May Indicate Limitations of Monetary Policy


In the last few years, the U.S.’s Federal Reserve has raised interest rates and shrunk its balance sheet. It therefore has some room to cut rates and re-start QE should the U.S. economy suffer a downturn. However, the economists Larry Summers and Anna Stansbury argue that the Fed’s room for rate cuts is insufficient to weather another major recession.1 Meanwhile, in Europe and Japan, interest rates are very low or even negative, and central bank balance sheets remain inflated by QE purchases. If there were another recession, these central banks could find their monetary policy options limited.


Negative interest rates and QE affect exchange rates. The euro and yen exchange rates have fallen against the U.S. dollar in recent years. This is partly because the Fed has been raising rates and shrinking its balance sheet, but it is also due to negative interest rate policies in Europe and Japan. Negative interest rates discourage capital inflows, whereas rising interest rates encourage them. Consequently, capital flows away from Europe and Japan into the U.S., pushing the euro and yen exchange rates down relative to the dollar.


Low exchange rates tend to benefit exporters at the expense of importers. This can increase export income but cause domestic inflation due to rising import costs, especially in countries dependent on oil imports. In the Eurozone and Japan, inflation risk may not be significant, as inflation is currently very low. However, the Eurozone and Japan are already running trade surpluses: further falls in their currency exchange rate would tend to increase these surpluses, which could aggravate global trade tensions.


Lowering the exchange rate can also reduce unemployment. The Resolution Foundation, a British thinktank, says that in the 2008 recession, a large fall in the pound’s exchange rate may have enabled firms to cut costs without sacking staff. “At the level of the firm,” they say, “wages are falling relative to the price of products, so overall labour costs can fall even if there is no reduction in the number of people employed.”2


Thus, the low exchange rates caused by very low or negative interest rates can help fight deflation and reduce unemployment. However, they tend to discourage the inward investment needed for lasting growth. And negative rates may also discourage bank lending. Banks that are charged negative rates on their deposits at the central bank can be reluctant to pass these negative rates on to their own depositors, because people and businesses may start to use physical currency instead of bank deposit accounts.


Consequently, negative rates tend to squeeze banks’ profits. As a result, banks may cut back domestic lending and look for higher rates elsewhere.3


How this Translates to Monetary Policy Limitations


If there were to be another global recession, the Fed may be unable to cut interest rates enough to protect the U.S. economy, while central banks already operating a zero or negative interest rate policy may find it difficult to cut rates at all. And doing more QE could also be of limited value. One of the principal purposes of QE is to depress yields on bonds, reducing the cost of borrowing for governments and businesses and thus encouraging productive investment.


Currently, many government and corporate bonds are trading at negative yields.4 When yields on bonds are already negative, governments and businesses are effectively being paid to borrow. If they aren’t already issuing more bonds in response, doing QE to reduce yields even further may make little difference to investment.


Six Alternative Policies Central Banks Could Consider


Many economists are addressing the concern that central banks have reached the limits of monetary policy to manage through the next recession, including with the following six policy suggestions.


  1. Higher inflation target. A 2 percent inflation target is ubiquitous among central banks in developed countries. But since the financial crisis, many central banks have found that the “zero lower bound” on interest rates (the fact that if interest rates fall much below zero, banks become reluctant to pass them on to depositors) prevents them cutting rates enough to meet this target.


    The Resolution Foundation argues that raising the target to say 4 percent, thus signaling that the central bank would allow inflation to drift higher before acting to dampen it, would over time enable central banks to maintain generally higher nominal interest rates, thus reducing the likelihood of hitting the zero lower bound. They comment that a higher target would not generate higher inflation unless it were accompanied by policy action, but stop short of recommending policies to bring about higher inflation. This is a significant omission, since they also observe that in Japan, unprecedented monetary and fiscal stimulus in recent years has proved insufficient to raise inflation to the 2 percent target.5 And they also warn that the inflation target should be raised before, not during, a recession, because when inflation is falling, as it usually does in recessions, raising the target is unlikely to be credible.

  2. Support for banks to lend when interest rates are very low. The economist Eric Lonergan identifies a possible solution to the profitability problem that very low interest rates create for banks. He proposes that the central bank should lend to banks at negative rates and accept deposits from them at zero or higher interest rates. Banks would thus be able to reduce interest rates for their own borrowers and maintain zero or positive interest rates for depositors without suffering a profits squeeze.6 At its meeting of September 12, 2019, the European Central Bank (ECB) announced such a tiered interest scheme for banks.7

  3. Private sector asset purchases. Typically, QE involves buying bonds issued by governments. But some economists advocate that QE should be expanded to include a much wider range of assets, including lower-grade corporate debt and equities. Objections to this are twofold. Firstly, it could mean the central bank taking losses on its asset holdings, which could force the government to bail it out. Secondly, it means that the central bank must make portfolio management decisions that it may not be equipped to make, and which potentially open it to political accusations that it is “picking winners.”

  4. Yield curve control. By choosing to purchase assets of differing maturities, central banks can influence the shape of the yield curve. For example, the Fed’s Operation Twist bought long-term U.S. Treasury bonds and sold T-bills, thus reducing interest rates at the longer end of the curve. The aim was to encourage longer-term investment in the U.S. economy. Japan is currently doing similar operations.

  5. Devaluing the exchange rate. In the U.S. and U.K., both of which are running large trade deficits, some economists are arguing for explicit targeting of a lower exchange rate to discourage imports and support exports, with the aim of closing the trade deficit and encouraging the development of domestic productive capacity. In the U.S., a bill proposing this approach has been put before Congress. However, if other countries were to retaliate with similar policies, exchange rate targeting might have little beneficial effect.

  6. “Helicopter money.” A growing number of economists are calling for central banks to put new money into the economy without buying assets. This is known as “helicopter money,” after Milton Friedman’s famous image of a helicopter hovering over Wall Street dropping dollar bills onto the ground below.8 Because no asset purchases are involved, helicopter money amounts to an increase in the government deficit. It therefore requires the central bank and fiscal authority to work closely together. However, the history of countries like Zimbabwe and Venezuela shows that money creation by a captive central bank can be highly inflationary.


Some observers believe central banks may be reaching the limitations of monetary policy to reign in the next recession. While they still have a range of tools at their disposal, some are controversial, and others may have limited effectiveness. Some economists say central banks are spent and call for fiscal authorities to step up.But others say now is the time to update central banks’ toolkits and establish the political and institutional frameworks needed for central banks to be effective in the next recession.10

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.


1. “Whither Central Banking?,” Summers & Stansbury;
2. “Recession ready?,” Resolution Foundation;
3. “Redeeming an Unforgiving World,” Mark Carney;
4. “Value of negative yielding debt hits record $12.5 trillion,” Financial Times;
5. “Recession ready?,” Resolution Foundation;
6. “Redesigning monetary policy,” Philosophy of Money;
7. “Press conference September 12, 2019,” European Central Bank;
8. “The Optimum Quantity of Money,” Friedman;
9. “Central Banks “Have Run Out Of Ammunition,” Says OECD’s Angel Gurria,” CNBC ;
10. “Central banks will need new tools to combat the next downturn,” Financial Times;

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