Podcast: Post-crisis monetary policy

US dollar

Central banks have stepped up their monitoring of money-like instruments in the wake of the 2008 crisis, but more work is needed on tools that can control these parts of the financial system, says Andrew Metrick.

The professor of finance at Yale University says groups at central banks now monitor short-term money markets closely. Such teams may not have existed before the financial crisis.

But while Metrick says there has been a “whole lot of thinking” about the need for new instruments to control these parts of the market, “we’re still a way away, certainly under the mandate of many central banks, from being able to manipulate those things in any effective way”.

One thing that might help, he suggests, is giving non-banks access to central bank facilities. Central banks could, for example, allow firms to access a discount window to draw on emergency liquidity at a penalty rate.

Metrick says the idea of liquidity facilities for banks has long been seen as a good idea. “But for some reason we limit that just to banks, and we limit it just to lending. Whereas what we know is that in a crisis a lot of other things become necessary.”

At the very least, such a facility should be ready to be “stood up really quickly”, he says, noting that Congress does not need to be consulted for the fire department to be dispatched.

To hear the full interview, listen in the player above, or download. CB On Air is also available via iTunes or podcast apps. All episodes in the series are available here.

Transcript

Hello, I’m Dan Hinge, news editor at Central Banking, and you’re listening to CB on Air.

We’re on episode three of our tour of post-crisis central banking, and this week we’re going to turn our attention to monetary policy. 

Yale’s Andrew Metrick joins us again to talk through the issues. Hello again, Andrew.

Andrew Metrick: Hello.

DH: One thing we learned from the crisis is that as you’ve said in previous episodes, more things than just cash can behave in a money-like way. So how are new forms of money and market-based finance impacting the way central banks go about setting monetary policy?

AM: Well I would say that it’s much more now of an intellectual effect in the way central bankers are thinking about it than it actually is an instrumental effect in the way they’re setting it yet, and in part it’s because the full range of thinking has not yet caught up to our intuition of what some of the problems are.

So for example, we’ve known for a long time that effectively monetary policy involves exchanging one form of safe asset for another. If what a central bank is doing is buying government securities, then what it can affect is the relative price of, for example, currency and government securities, since that’s what it’s buying, but it can’t affect the relative price of the full collection of safe assets, which includes both currency and government securities, as against everything else in the market. 

It is almost as though, if we were in the United States, exchanging dollar bills for hundred-dollar bills as part of our monetary policy, it’s not going to do all that much for the overall value of money, since they are substitutes for each other. And I think what we learned in the years leading up to the crisis is how in many, many applications, government securities, safe government securities can be even more money-like than money itself, since it is easier to use a large Treasury security, for example, as collateral for something than it is to move the cash around.

The intellectual understanding that now exists that we need some additional instruments, and that a lot of the things we see being created and traded challenge the typical way we do monetary policy – that’s led to a whole lot of thinking. You can see groups at central banks that are focused on short-term money markets, on money instruments, groups that perhaps didn’t even exist before, that are following very carefully things like the [general collateral, GC] repo rate or other forms of things we might call the ‘convenience yield’.

But we’re still a way away, certainly under the mandate of many central banks, from being able to manipulate those things in any effective way. So, again, like many of the things we have discussed in past episodes, this is a place where I’m very happy to see thinking having really advanced, and optimistic that the tools can eventually catch up with the thinking, but still sit here today thinking that the job is unfinished.

DH: Would it help central banks’ task in being able to influence those markets if non-banks were given access to central bank facilities?

AM: Well I have a somewhat radical view on a lot of these types of emergency facilities – things like having a discount window that was open to non-banks, or having some kind of standing guarantee authority – which is I think all of these things should be available and open all the time, just at a very high price.

We think that generally having something like a discount window at a central bank is a good thing, and that it should always be there, and there is just some penalty rate, and the central bank has a policy of fooling around with that penalty rate in an effort to keep things stable. And we think that’s a very good idea. But for some reason we limit that just to banks and we limit it just to lending. Whereas what we know is that in a crisis a lot of other things become necessary.

I think if you start with the recognition that the taxpayers, through the government, collectively own the tail risk of something very, very bad happening in the financial system, if you start with that assumption, and realise there is no way to run away from it, it seems to me we should be designing things and having those things at the very least able to be stood up really quickly, without the need to have a massive legislative round to go through to get it done. Those necessary steps are really a very big challenge in a crisis itself. And I think just like you really wouldn’t want some vote of the legislature to authorise the fire department to come to my house, even if I caused the fire to start in my house, somehow we think the fire department should be able to make those decisions on their own.

So in terms of having facilities for non-banks, I think it would be useful to have something that was a standing facility, perhaps with a very high penalty rate, and to give the central banks the ability to manipulate the size of that facility, the collateral it would take, and the size of the penalty, and to do that so as to be able to react quickly in an emergency.

DH: So, turning to another major monetary policy to come out of the crisis – quantitative easing – how does that impact domestic and global financial markets? A bit of a big question.

AM: Well I think we’ve taken a very big additional step towards both exchanging different types of safe assets for each other, and in some cases a willingness to exchange safe assets for things that are privately produced safe assets but perhaps are not in the full class of safe assets that the governments ordinarily provide.

So, broadly speaking, QE, and a lot of the thinking and the operational activity that have gone on around it, I think are very important additions to the toolkit of central banks, not just for dealing with the zero lower bound, but also for how just in regular times they might be able to play with more than just the shortest part of the yield curve, and more than just the trade-off between currency and government securities.

DH: Another issue that seems to be building up is the growing debt around the world. Do you see that as a problem for monetary policy-makers, as well as financial regulators?

AM: Certainly this is the number one issue that financial stability specialists within central banks need to be paying attention to. We don’t really know a whole lot about the precursors of financial crises, except that they are always preceded by build-ups of debt. To the best of our ability to tell it is often short-term debt and debt that is associated with housing.

So when you see those things happening, it is a major concern on the financial stability side. Not every time there’s a big build-up in debt does it end in a crisis, and that of course is the challenge – it is the same type of challenge central bankers face in any kind of credit boom in that not every credit boom leads to a crash – but it is certainly the most important thing for central banks to be paying attention to on the financial stability side and the current levels are of course worrying.

DH: And do you view debt as a constraint on monetary policy, in the sense it might be harder to raise interest rates if debts are very high?

AM: Well, to me the bigger concern is the constraint that it places on fiscal policy. So yes, we would have a concern that if interest rates go up, the overall interest burden on debtors goes up – standard ways of thinking say we would have a problem, and that would go through the macroeconomy. They’re standard because we understand them well and our models have a pretty good idea of what happens.

To me the larger concern, outside of just the instability it creates, is when it is government debt, when it is public debt, it provides us with a whole lot less room for fiscal activity, particularly if we need that fiscal activity either in a financial crisis or in a garden-variety recession.

DH: Lastly, it feels a little bit as though we have a better understanding of economics, we have a better understanding of what can go wrong and the challenges facing us, such as geopolitics – are central banks better able to deal with uncertainty, and how can they go about doing that?

AM: I think that what central banks have learned about dealing with uncertainty on the monetary policy side, it is very important to the credibility of a central bank that they not be seen as overreacting to things. That central banks develop credibility by, particularly today, signalling to the markets what they plan to do, giving the markets an idea of what kind of information they are looking for to drive some of their future decisions, and then not overreacting. An overreaction on the monetary policy side that needs to be reversed ends up really reducing confidence and the credibility of the central bank.

In that respect I think those have been important lessons, they’ve been hard-won lessons over time and central bankers are aware of them. A challenge, however, is that on the financial stability side, sometimes overreaction is necessary. Sometimes what you’re really trying to do is to stop a panic, a liquidity type of panic, before it overwhelms your ability to fight it. You need to do things that nip those types of activity in the bud, and it might require a little bit of an overreaction.

This is I think an organisational challenge for central banks who have correctly learned the lesson of dealing with uncertainty with slow and deliberate movements on the monetary policy side but might need to take stronger reactions on the financial stability side. So we’re, like many things in financial stability policy, still at the early stages of learning how to manage that.

DH: In a sense it feels like that might require another crisis for us to get some experience putting these tools into effect.

AM: I certainly hope it doesn’t take that!

DH: Andrew, thanks very much.

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