Monetary Policy – Surgery Needed

Current monetary policy is still primitive and will remain so without making use of new measures such as macroprudential policies

Monetary policy has come a long way but it is still in its initial stages of development.  Serious shortcomings mean that the tools of monetary policy are still rudimentary just as those of medicine were crude in the past.  In the same way that leeches would be prescribed for every ailment in medieval times, central banks have tended to rely solely on interest rates to manage the economy.  The tendency to “reach for the leeches” is still with us even though the global financial crisis has highlighted the flaws inherent in this approach and a range of new techniques for managing the economy have been made available.

Learning some hard lessons

Doctors often did more harm than good in antiquity due to a lack of understanding of the workings of the human body.  With our knowledge of the economy also deficient in places, economists may be guilty of causing similar damage.  Hubris led economists to believe that booms and busts could be eliminated but their faith was shown to be spectacularly misplaced.  Despite this, economists have been slow to adjust their view of the world even though their remedies are proving both ineffective and costly.

The global financial crisis and its aftermath have taught us a few valuable lessons.  The limitations of using interest rates to moderate the business cycle (both before and after recessions) are now apparent.  Higher interest rates do little to temper lending when both bankers and borrowers want more debt.  It is also becoming clear that different sectors of the economy react to interest rates in different ways.  Consumers have shown themselves willing to take on excessive debt in order to spend or to buy property.  On the other hand, businesses cannot always be enticed to borrow for investment when the economy is weak. 

The limits of monetary policy have been laid bare by the faltering economic recovery.  Low interest rates and cheap cash have spurred on some lending but not the right type to generate sustainable economic growth.  Households have taken on debt to buy property (which mostly just increases prices) rather than businesses or the government borrowing to make the economy more productive.  Surplus funds have also built up prices in the stock market which, while somewhat beneficial in the short term, will create problems down the line.  The abundance of cash in the financial system may also reduce the effectiveness of central banks’ control over interest rates. 

For a better world

Monetary policy needs to continue to develop as economists learn more about the economy and how it reacts to different policies.  Manipulating interest rates is a blunt instrument that is applied across the whole economy.  Interest rates need to be raised eventually but it seems rash to do so in response to distortions in certain sectors.  An early interest rate hike has been proposed as a countermeasure to the booming UK property market.  Yet, this is like chopping off an arm to treat an infected finger.

A more measured approach would be preferable but will take time to realise.  Techniques such as minimally invasive surgery have been developed in medicine over many years and economists should aim for similar progress in monetary policy.  Disparities between policies in theory and practice mean that trial and error will be necessary.  Using a still sickly economy to trial new policy options may seem reckless.  Yet experimentation is the main route to breaking fresh ground even in medicine where there are actual lives at risk.  Forward guidance is an example of a policy which seemed useful in theory but whose application was fraught with issues.

A wider range of policies would help deal with problems now and in the future with greater effectiveness.  These two goals can be achieved by the Bank of England trialling the much-discussed macroprudential policies such as caps on mortgages and other limits on property lending.  Having a greater range of options allows for better tailoring of policy while targeted measures enable greater freedom in setting interest rates to reflect the overall economy.  Just as modern medicine has had to advance beyond leeches, future monetary policy will need to progress past what we currently have and such an evolution will only happen as a result of taking bold actions today.