Non-Conventional Monetary Policy Recent Economic

Non-Conventional Monetary Policy

Recent economic performance of the United States provides some lessons that we can learn about monetary policy. In particular, we have seen the Federal Reserve not only utilize conventional monetary policy but unconventional policy as well. Conventional monetary policy tools are open market transactions, changing the discount rate and changing the reserve requirements. Normally, these are the only forms of monetary policy that are utilized, and but in a time of crisis they can be used up quickly. In 2008, interest rates dropped to the zero bound and open market transactions were insufficient to prop up an economy in a freefall. With conventional monetary policy options already in use, the Federal Reserve turned to unconventional monetary policy.

The primary type of unconventional monetary policy has been what has been known as "quantitative easing." This is essentially a form of open market transaction that focuses on longer-term Treasuries. When this technique is used, the objective is not to pump more money into the economy -- enough money is already out there -- but to flatten the yield curve in order to spur more short-term spending. The results should be, if the tactic works, to a) adjust market expectations for economic growth and B) spur business investment, and with that GDP growth.

3. There are many criticisms, however, of unconventional monetary policy. One such criticism holds that policy that is aggressively expansionary will create inflationary pressure. Another criticism is that this approach expands the Fed's balance sheet too much, which is risky. A third criticism is that this approach is not likely to be effective, since the economy already has sufficient capital -- that unconventional monetary policy does not address the issue of demand, and certainly not in relation to the increase in risk that accrued.

4. Of the criticisms, some are valid and some are not. Clearly, nobody who has looked at the evidence will think that unconventional monetary policy is inflationary. Inflation is low, and interest rates are rock bottom. Under normal conditions, this policy would be inflationary, but it is likely only going to be used in crisis times, when the normal predicative conditions do not hold. However, expansion of the Fed's balance sheet is risky. Certainly, if it needs to shrink its balance sheet this could prove contractionary -- timing of such moves needs to be spot on. The last complaint -- that unconventional monetary policy is not particularly effective -- is a legitimate criticism. Despite the massive efforts we have seen in the past several years, economic growth in the U.S. remains muted and unemployment stubbornly high. If a central bank is going to take these sorts of risks, it should be successful.