All the talk about new monetary policy tools cuts two ways. On the positive side, it supports the ever-present desire to foster confidence. Central banks will also need new ways to cope with the situation that yesterday’s new tools have produced. In the less positive side, however, enthusiasm for the wonders of monetary policy can create a dangerous illusion that central bank action can somehow substitute for essential fiscal and regulatory reforms.
The Federal Reserve’s (Fed) plan to make future policy less accommodative offers a concrete illustration of the need to find new ways to implement policy. For one, claiming to have sufficient options to keep matters in hand will help calm already jittery financial markets and so improve the likelihoods of policy success. For another, the Fed needs new ways to cope with the massive amounts of liquidity with which past new tools have flooded markets. Term auction facilities, term securities lending facilities as well as quantitative easing over years have enlarged the central bank’s balance sheet from a touch over $900 billion before the financial crisis of 2008-09 to about $4.5 trillion. Old ways of manipulating short-term interest rates will have difficulty moving much more massive amounts now required. Because past new tools have also inflated bank holdings of excess reserves from $2.0 billion to some $2.5 trillion, the Fed will also need direct ways to affect the returns banks receive (or pay) on their excess reserves.
If new tools are essential in these respects, their allure runs the risk of distracting the authorities from needed fiscal and regulatory reforms. In Europe, for example, several countries have a crying need to reform their labor and product market policies. Such reform could enable them to cope better with the austerities on which Berlin insists and actually perhaps grow fast enough to discharge their debt burdens without central bank help. In Japan, demographic imperatives demand new policies that have nothing to do with money or the Bank of Japan. In the United States, growth has suffered under regulatory over-reach and long-standing problems with the tax code. Monetary policy, however imaginative, cannot answer for any of these needs and can do harm by allowing the authorities to use the promise of monetary innovation as an excuse for inaction on these critical fronts. To this extent, the upbeat, confident talk at Jackson Hole is counterproductive to say the least.