What is the benchmark used to measure the effectiveness of monetary policy?

My answer on Quora:

There are different indicators one can look at to help assess if the monetary policy of a central bank is effective or not, but such assessments have been getting harder to make.

On the surface

On the surface, a central bank can be viewed as effective in its monetary policy if that central bank has a successful track record in meeting its objectives. These objectives vary across central banks.

In the US, the Federal Reserve has an explicit mandate to pursue price stability (stable and low inflation) and full employment. If its actions are consistent with its objectives — like raising interest rates to bring inflation down when it is too high, or lowering interest rates to help encourage investment, growth, and thereby employment — and if its objectives are broadly on target, then there is a case to be made that its monetary policy is effective. Of course, other things can be going on in the economy, so one has to be careful in her assessment.

In countries with fixed exchange rates, monetary policy can be broadly assessed by the central bank’s ability to keep its exchange rate pegged at the rate it wants. That rate, however, needs to be a “reasonable” one that doesn’t throw the rest of the economy off. If it is overvalued for too long, then an inevitable correction will put the central bank in a squeeze and could force it to remove the peg, which has consequences on inflation, debt servicing, and could bring the economy to recession. Again, other things can be going on in the economy (and global financial markets), so one has to be careful in his assessment.

Beneath the surface

Beneath the surface, judging the effectiveness of monetary policy can be a complicated exercise. After a whole decade of loose and unconventional monetary policy from the world’s major central banks (Fed, ECB, BOJ, BOE), the exercise has become more complicated. Adding to that, the development of financial technologies (fintech) and the advent of digital currencies have the potential to challenge existing approaches to central banking and monetary policy.

First, judging the effectiveness of monetary policy is difficult because it is not always easy to isolate all the other happenings in the economy (fiscal policy, external shocks, market idiosyncrasies) in order to come up with a causal relationship between a monetary policy instrument and an objective.

Sometimes it can be quite clear, like when Paul Volcker raised the Fed’s key rate from about 10 percent to over 20 percent to tame high inflation, but those are relatively unique episodes.

There is also a timing issue. Monetary policy operates with a lag. It takes time for a rate reduction, for example, to encourage spending. This also gives time for various judgements on the effectiveness of a given policy stance to be made.

Second, nearly a decade of zero or near-zero interest rates by the Fed and direct asset purchases by the Fed, European Central Bank and Bank of Japan have made their mark on the global monetary system and the global economy.

Was QE an effective policy? Many attribute the Fed’s monetary policy response to the crisis as effective in averting a Great Depression. Others say QE has only resulted in a build-up of financial imbalances. After all, inflation had remained extra low for an extended period and many were concerned about deflation. The effectiveness of these extraordinary policies is debated among macroeconomists (see herehere, and here too for a broader topic)

For the rest of the world, many central banks have done a decent job in handling larger capital flows and greater exchange rate pressures. But, the even stronger role of the Fed in driving global monetary conditions has raised questions on how effective central banks of smaller countries can be when tightly integrated into the global monetary system.

Finally, fintech and digital currencies are stirring up new questions around the role of monetary policy and central banking in a financial system that may increasingly bypass the banking system or traditional payments system where banks clear checks to pay for your transactions. For more on that, see “How will FinTech and digital currencies transform central banking”.

 

 

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