The post-crisis evolution of monetary policy frameworks
In the aftermath of the Global Crisis, central banks in advanced economies faced a number of challenges in designing monetary policy frameworks suitable for the post-crisis environment. Inflation has remained persistently low and continues trending downwards in many economies. The crisis urged central banks to pay more attention to financial stability concerns. With nominal interest rates at the effective lower bound (ELB), central banks ran out of conventional monetary policy ammunition to stimulate the economy. Against this background, it was argued that the monetary policy strategies used by central banks so far were too constrained to fight deep recessions and paid too little attention to financial conditions (Constâncio 2017, Hartmann and Smets 2018).
In a recent paper (Samarina and Apokoritis 2020), we survey the international experience of central banks in the last 12 years and evaluate how they modified their frameworks to address the challenges mentioned above. Specifically, we examine 14 central banks in advanced economies1 and identify changes in their frameworks during 2007-2018. The following aspects are examined: formulation of the inflation target, monetary policy mandate, central bank communication, and monetary policy toolkit.
The formulation of the inflation target
The definition of the inflation target has not become broader. In fact, while most central banks did not modify the level of the target, some switched to narrower inflation targets. This includes cases when central banks adopted a strict point target (the US, Japan), removed a tolerance band around a point target (Sweden),2 or shifted from a target range to a point target with (New Zealand) or without (South Korea) a tolerance band. The purpose of these adjustments included, among others:
- better anchoring inflation expectations around a (mid)point of the target;
- reducing inflation uncertainty;
- strengthening commitment to a price stability objective;
- enhancing transparency and predictability of monetary policy.
Next, three central banks lowered a (mid)point of the inflation target – from 3% to 2% (Czech Republic, South Korea) or from 2.5% to 2% (Norway) – as they expected lower future inflation due to, among other things, domestic structural factors, a downward trend in prices of tradable commodities, and an appreciation of domestic currencies.
Most central banks continue formulating their inflation targets symmetrically. That is, they are equally concerned if inflation is persistently below or above the target and treat inflation-undershooting and overshooting in the same way. Two central banks with asymmetric targets include the Bank of Japan and the ECB. Since September 2016, the Bank of Japan has implemented a framework of quantitative and qualitative monetary easing (QQE) with yield curve control, which involves an ‘inflation-overshooting commitment’ in the context of low realised inflation. This means that the Bank will expand the monetary base until inflation exceeds the 2% target and stays above it in a stable manner.
As for the ECB, the Governing Council aims to keep inflation ‘below, but close to, 2%’ and is committed to avoiding both inflation that is persistently too high or too low. However, the ECB’s reaction to inflationary and disinflationary shocks may be perceived asymmetrically. The ‘close to 2%’ goal may be treated as a hard ceiling, implying that inflation-overshooting is considered less desirable than undershooting, as it violates the price stability objective (Rostagno et al. 2019).3
Finally, the horizon of the inflation target remains commonly defined in the medium term without a specific length. The exception is the Bank of Japan which used to formulate the price stability objective in terms of reaching an inflation target in the medium to long term, but in July 2018 modified it by aiming to achieve a price stability target “at the earliest possible time”.
Monetary policy mandate
We evaluate changes in monetary policy frameworks also in terms of mandate. All of the central banks we analyse operate a flexible regime that puts some weight on output stabilisation; this aspect has not changed in recent years. Most central banks have not adapted frameworks to include an additional goal of monetary policy. The exception is the dual mandate in New Zealand where, since April 2019, monetary policy objectives have included price stability and full (maximum sustainable) employment. Financial stability has not become a formal objective of monetary policy, although this proposal has been frequently discussed by central banks and academics (Blinder et al. 2017). However, financial stability has been included as a separate mandate of national central banks that lies outside of the monetary policy scope.4
Central bank communication
Forward guidance has been used as an unconventional communication tool under conditions of the ELB on policy rates and low inflation, with the aim of increasing the effectiveness of monetary policy by clearly stating future policy intentions. This is known as ‘Odyssean’ forward guidance, which implies a central bank’s commitment to future monetary policy actions.5 Forward guidance can be classified as open-ended, time-contingent, or state-contingent. Open-ended forward guidance gives no precise indication of timing or conditions under which monetary policy may be tightened in the future. Time-contingent forward guidance provides an explicit conditional commitment about the exact date when the monetary policy stance may change. Finally, state-contingent forward guidance formulates a threshold for certain economic indicators that should be met before policy rates may be changed.
During 2007-2018, seven out of the 14 central banks we analyse implemented forward guidance of some kind (see Figure 1). All of them included a price stability (inflation) goal in their forward guidance formulation. In this sense, forward guidance has solidified a commitment to a price stability objective, although the extent of the commitment varies across central banks. At the time of writing, four central banks were still using forward guidance, suggesting that this communication tool may become a permanent element of their monetary policy frameworks.
Figure 1 Forward guidance in 14 central banks during 2007-2018
Note: the graph displays the use of forward guidance, distinguished as open-ended (green), time-contingent (yellow), state-contingent (red), and a combination of time- and state-contingent forward guidance (blue). * Central banks in New Zealand, Norway, and Sweden use Delphic forward guidance by publishing projections of policy rates.
Monetary policy toolkit
To stimulate economic recovery and restore the functioning of financial intermediation after the crisis, central banks extensively used accommodative monetary policy measures. As a result, the monetary policy toolkit has been expanded.
The expansion of instrumental toolkits involved a broader use of refinancing operations at longer horizons, on a larger scale and higher frequency, with an expanded set of counterparties and eligible collateral. The goal of refinancing operations has changed, too. While in the past they were used primarily to ‘fill the asset side of the balance sheet’ and signal the policy stance, since the crisis the objective has shifted toward supporting sufficient bank funding conditions. Ten central banks also used dollar-liquidity swap lines with the Fed. In addition, eight central banks in small open economies conducted foreign exchange interventions to ease foreign currency liquidity tensions and weaken their domestic currencies.
Under the ELB on policy rates, seven central banks experimented with balance sheet policies to provide further monetary policy accommodation, including targeted liquidity provisions, negative deposit facility rates, asset purchase programmes (for private and public securities), and QQE with yield targeting (Bank of Japan).
The extensive use of monetary policy instruments has resulted in a substantial increase in the size of central bank balance sheets, from 16.3% of GDP in 2007 to 38.4% of GDP in 2018 on average for the 14 central banks we analyse. Most of extraordinary measures were considered as temporary solutions under extreme circumstances. It remains to be seen whether and to what extent they will be permanently incorporated into the monetary policy toolkit.
Several conclusions can be drawn about the evolution of monetary policy frameworks after the crisis. First, no central bank has formally abandoned its existing framework so far. However, the design of monetary policy strategy has been high on the central bank agenda in recent years. The Fed is about to conclude a review of its framework and the review of the ECB’s monetary policy strategy has been implicitly announced. The revision primarily concerns the formulation of the price stability objective, with some economists proposing alternative frameworks such as average inflation or price-level targeting.
Second, existing frameworks have not been sufficiently adjusted to address the problem of persistently low inflation. While some economists have advocated increasing the level of inflation targets, no central bank has opted for this solution. On the contrary, there have been cases of central banks lowering the target. This may reduce the room for manoeuvre by the central bank in the future, making it more difficult to stimulate the economy when inflation drops below the target.
Third, although some academics have proposed increasing flexibility as a way to adapt monetary policy frameworks to the post-crisis environment, this stands in contrast with the recent tendency of central banks to move towards tighter inflation targets and stronger commitments.
Finally, financial stability has not been formally added into the monetary policy mandate. However, central banks have a separate mandate for financial stability and use macroprudential tools to address financial stability concerns. Some unconventional monetary policy measures may have contributed to financial stability by restoring deficiencies in the monetary policy transmission mechanism and providing accommodation under the ELB on policy rates.
Blinder, A, M Ehrmann, J de Haan, and D-J Jansen (2017), “Necessity as the mother of invention: monetary policy after the crisis”, Economic Policy 32(92): 707-755.
Constâncio, V (2017), The future of monetary policy frameworks, Lecture at the Instituto Superior de Economia e Gestão, Lisbon, 25 May.
Hartmann, P and F Smets (2018), “The first twenty years of the European Central Bank: Monetary policy”, ECB working paper 2219.
Rostagno M, C Altavilla, G Carboni, W Lemke, R Motto, A Saint-Guilhem, J Yiangou (2019), “The ECB monetary policy strategy: past and future”, mimeo.
Samarina, A and N Apokoritis (2020), “Evolution of monetary policy frameworks in the post-crisis environment”, De Nederlandsche Bank working paper 664.
1 Based on central banks’ own characterisation of their frameworks as well as on taxonomy used in the literature, we identify ten central banks that implement full-fledged inflation targeting (in Australia, Canada, Czech Republic, Iceland, Israel, South Korea, New Zealand, Norway, Sweden, and the UK), and four that use an implicit price stability anchor (in the euro area, Japan, Switzerland, and the US). The latter do not identify themselves as inflation targeters, but formulate the price stability objective in terms of a clearly defined numerical target for inflation.
2 In September 2017, Sveriges Riksbank returned to a variation band of 1-3 percentage points around a 2% inflation target explaining that inflation may vary around the target in the short run.
3 Mario Draghi attempted to dissuade this perceived asymmetry by emphasising that the ECB remains “committed to return inflation to 2% without undue delay” and that “inflation aim doesn’t imply a ceiling at 2%” (ECB Press Conference, Introductory Statement, 10 April 2019). Monetary policy decisions in July 2019 also stated that “the Governing Council is determined to act, in line with its commitment to symmetry in the inflation aim.”
4 The ECB does not have a financial stability mandate but only contributes to the efforts of responsible authorities.
5 Three central banks (in New Zealand, Norway, and Sweden) use Delphic forward guidance by publishing projections of policy rates. Unlike Odyssean forward guidance, Delphic forward guidance excludes a commitment, as forecasts of interest rates are not considered as promises.