The Effects of Monetary Policy during Financial Crises: Initially Useful, but Subsequently Largely Ineffective
by Nils Jannsen, Galina Potjagailo, and Maik Wolters, researchers at the Kiel Institute for the World Economy
The effects of monetary policy during financial crises can dramatically differ from normal times. If central banks do not take this into consideration their policies may lead to huge welfare losses.
With the onset of the Financial Crisis 2008 many central banks worldwide considerably eased their monetary policies. Some central banks, like the Federal Reserve, the European Central Bank, and the Bank of England, quickly reached the zero lower bound on nominal interest rates; these central banks then started conducting unconventional measures like Quantitative Easing (QE) and forward guidance. There is some consensus that this massive monetary stimulus in the first, ‘acute’, phase of the crisis was largely appropriate, preventing a second Great Depression. However, since then, doubts about the effectiveness of expansionary monetary policy in the aftermath of banking crises have risen because the recoveries have been disappointingly sluggish and central banks continuously missed their targets.
New research shows that monetary policy loses much of its power in the aftermath of financial crises
In a comprehensive empirical study named ‘Monetary Policy during Financial Crises: Is the Transmission Mechanism Impaired?‘, which covers the period of the last 30 years for 20 advanced economies, we systematically compare the effects of monetary policy on output and inflation in normal times with the effects during financial crises. We show that the effects of monetary policy during the most acute phase of a financial crisis (e.g., in the years 2008 and 2009) are significantly stronger compared to normal times. The main reason is that monetary policy is able to mitigate uncertainty that is particularly high in such phases. However, in the aftermath of a financial crisis (e.g., since 2010) additional monetary policy measures basically do not have any significant impact on the economy. In such phases, uncertainty is already mitigated and other factors, such as the need for balance-sheet adjustments and deleveraging, may weigh on the effectiveness of monetary policy.
Lessons learned from the crisis and the post-crisis period
Our results show that central banks indeed have contributed significantly to stabilize the economy in the acute phase of the Global Financial Crisis in the years 2008 and 2009. However, since then the additional measures taken by the central banks from around 2010 onward, which include unconventional measures such as the current QE-Program from the ECB, have probably not been very effective. Monetary policy is not a silver bullet with the ability to control GDP growth and inflation at will. Even worse, given that monetary policy can have also unpleasant side effects there is a risk that such additional measures may lead to considerable welfare losses. We tend to believe that central banks should exercise caution around additional expansionary measures during an emerging post-crisis recovery because the cost/benefit evaluation of such measures seem to worsen dramatically compared to other phases. However, this question is far from being settled and currently there seems to be no consensus on how central banks should react when there policy measures apparently lose some of their effectiveness. The GES in the session ‘Monetary Policy – Lessons Learned from the Crisis and the Post-Crisis Period’ will address this and other related questions.