While the United States are recovering after the financial crisis and unemployment is decreasing despite low growth, the Eurozone has returned to a recession. Inflation is low on both sides of the Atlantic and monetary policy rates are close to zero. What are the monetary policy options for central bankers in these times to improve the economic situation?
On Tuesday, 21 May, James Bullard, President and CEO of the Federal Reserve Bank of St. Louis, held the IMFS Distinguished Lecture on invitation of the Institute for Monetary and Financial Stability (IMFS) and the U.S. Consulate General Frankfurt on possible approaches of monetary policy in a low rate environment. The central banker argued in favor of quantitative easing (QE), which implies the purchase of government debt by central banks.
Bullard presented the different monetary policy measures that central bankers could use in a low rate environment: 1) Do nothing, keep the interest rate close to zero for an extended period of time and wait. This could lead to a mildly deflationary situation, warned Bullard. 2) Implement “forward guidance” by announcing future monetary policy measures, for example, maintaining the near zero rate even if the economy is recovering. According to the Fed member, this would also be problematic. The announcement would have to be perfectly credible to stimulate consumption and investment in the private sector. Otherwise no real effects could be expected. On the contrary, the promise could even send a pessimistic signal to the private sector that might interpret the central bank’s move as a reaction to a possible long-lasting depression. 3) Charge or rather “grant” negative interest rates on banks’ reserves or 4) do a twist operation: Exchange government debt with a short duration for debt with a longer duration. Bullard explained that these last two options were not very effective.
In Bullard’s view, the best policy option was quantitative easing: “Quantitative easing is closest to standard monetary policy, involves clear action and has been effective.” The US central bank should therefore continue their quantitative easing program. Bond purchases should be adjusted to the economic performance and inflation rate.
For the Eurozone, Bullard recommended a GDP-weighted quantitative easing program: The European Central Bank (ECB) should buy government bonds of all Euro countries according to their share of Eurozone-GDP. In this way, it could counteract deflationary tendencies and, at the same time, calm down critics who reproach the ECB for buying government bonds to support highly indebted countries.