Limits to Global Monetary Policy and Their Effect on Financial Institutions in 2018 and Beyond

Following the sluggish economic activity experienced after the 2008 Global Financial Crisis, international analysts and politicians fear that 2018 will be similar to 2017. Global financial firms are developing “tighter monetary policies” and “commodity rebound reverses,” which seem to be having a negative impact on global financial stability markets. The European markets witnessed a “taper tantrum” in early October 2017, a situation close to what happened in the United States in mid-2013. The surge in treasury yields is an indication that banks are slowly reducing the amount of funds that are circulating in the economy without recognizing the effect on overall economic performance. It is becomes necessary for governments and global financial institutions to establish policies that will ensure movement from global crises to global convergence. The first step involves establishing appropriate economic models that can be used to predict the changes in financial capabilities and the second step involves identifying and eliminating fixed financial policies established by domestic banks. Maintaining an inflation rate below 2.5% would mean recognizing the huge potentials flexible universal monetary policies.

I. Introduction

International economists and policymakers fear that the year 2018 might not be different from 2017 following the lethargic economic activities that have been witnessed since the 2008 Global Financial Crisis. Plenty of risks such as changes in geopolitics and countries’ economic instabilities are among the issues addressed in most economic journals. Moreover, researchers have made significant efforts to investigate the economic effects of “tighter fiscal policies,” and “commodity recovery reverses,” as well as the relationship between a protectionist head of state and economic growth. However, not a single study has been conducted as a scientific inquiry to the economic challenges of the global monetary policy reaching its limits.

Arguably, the economic impact of monetary policy is one of the most recent phenomenon attracting debates. According to the 2017 report on macro-prudential policies and interaction with monetary policies (Gambacorta & Murcia, 2017), central banks have already reached the limits of expansionary and contractionary monetary policies and must now explore other alternatives that can be used as disposable tools for financial control. Further research shows that there has been a significant increase in the balance sheets of some of the world’s biggest central banks from 6 trillion dollars to an average value of close to 8 trillion dollars following the eight years of subsequent quantitative easing. However, a greater percentage of the banks’ balance sheets consist of respective government bonds.

Although central banks have succeeded in using quantitative easing (EQ) to maintain short term liquidity, the EQ’s diminishing returns and consistent negative growth rates registered over the past years could mean the end of global financial markets. Furthermore, it is now speculated that because of fear of another global financial crisis, giant financial institutions including the European Central Bank (ECB) and Bank of England (BOE) are currently preparing to operate under tighter monetary policies. This research investigates whether global monetary policy has reached its limits and the effects on financial institutions in 2018 and beyond.

II. Previous Research

The European markets in earlier October 2017 experienced a “taper tantrum,” a similar condition that occurred in the U.S. in mid-2013. Taper tantrum is a serious surge in treasury yields, and occurs when banks use tapering technique to slowly reduce the amount of funds that are circulating in the economy. As far as treasury yields issuance is concerned, there is fear that any decision by the central banks to reduce the amount of money circulating in the economy might lead to a serious market failure. Despite these early warnings, big financial institutions including the ECB and BOE have shown interest in using quantitative easing in order to take advantage of the current market condition and financial security market. Similarly, the decisions by the Japan’s central bank (JCB) to venture into negative rates treasury bills have also raised concerns regarding the future of quantitative easing policies. The JCB is receiving pressure from international lending institution to pull back government bond buying activities and also develop policies that are in line with global financing needs.

Gills (2017) in his research demonstrates the need for governments and global financial institutions to establish policies that will ensure movement from global crises to global convergence. According to the research, financial institutions can only make the year 2018 and beyond different if they recognize the huge potentials flexible universal monetary policies. The author, however, makes it clear that the main challenge countries face in their bid to establish more flexible monetary policies include the legacies of the past financial crises. Following the 2008 global financial crisis, it has become difficult for governments and financial institutions to realize positive potentialities available today. Such conditions have reversed present financial developments to “worldwide dystopia” with very few successful milestones (Gills, 2017).

In a study dubbed “US Monetary Policy and Global Financial Stability,” Tong (2017) found out that financial institutions can use capital controls in the management of domestic macroeconomic conditions. In a panel study of 257 financial institutions across 26 nations, (Tong, 2017) determined that the U.S. monetary policy has significant influence on the risks-taking attitudes of financial institutions across the world. The researcher indicated that due to the development of QE in U.S. monetary policy, there has been unprecedented growth in banks’ default rates around the world. The challenge of financial default and inapplicable monetary policies are channeled through changes in capital flows, which tend to render banks with capital control less susceptible to monetary policy influences. Therefore, a comparison has to be made between QE controls and capital mobility failures when it comes to the management of domestic macroeconomic policies. Apart from capital mobility, (Tong, 2017) suggests the use of contractionary monetary policy as opposed to capital controls as an appropriate way of curbing future global credit bubbles.

The limits of global monetary policy is also demonstrated by the challenges of social democracy and market liberalism. Although economists recognize the two models as effective methods that can be used to solve monetary problems, Offer (2017) contends that the challenge of life-cycle dependency will continue to exist as long as there is transfer of financial entitlement. Social democracy according to Offer (2017) means lateral transfer of entitlement from producers to dependents through progressive taxation. While social democracy advocate for individuals’ protections against the limits of public expenditure, market liberalism permits overtime transfer of entitlements using financial assets. Such conditions have led to the recent “market turns,” a repeat of what happened in 1980s when there was an attempt to ease credit by shifting from social democracy to market liberalism.

III. Model

The “Norwegian Economic Model” or NEMO is a macro-level model that was developed by the Norges Bank for analysis and monetary policy forecast. Although the model has several characteristics in common with some of the models developed in the past, it has become an important tool of analysis given the current challenges faced by most financial institutions. The model’s short-term forecast revolves around several statistical and econometric predictions including the changes in rates of borrowing and lending, the role of banks when it comes to the establishment of economic policies, and the effect of negative financial growth on lending institutions.

The model is based on the assumption that countries with their national currencies can use monetary policies to regulate inflation rates over time rather than depending on global monetary policy. The underlying principle behind the application of the model is that each country’s monetary policy in affected by inflation expectations and aims at restoring inflation back to its target. The model further assumes that economic participants when making decisions regarding investment, household consumption, wage rates, and commodity prices must take into consideration the impacts of both expansionary and contractionary monetary policies.

The NEMO model is appropriate for this research because it combined the Keynesian features of short to medium economic policies with the classical features of long-term economic policies to determine the effects of financial institutions on security markets. According to the model, any optimal interest rate developed for the purposes of financial forecast raises a number of concerns that can be summarized using a “loss functions.” For the loss function to be used in demonstrating the relationship between a monetary policy and economic growth, it must show the characteristics of both Keynesian and Classical models. The model is, however, not welfare-based nor does it give the true representation of bank functions. Similarly, the NEMO’s loss function is known to be consistent with the target of many monetary policies which is a reduction and establishment of a stable rate of inflation. Achieving a low and stable consumer price inflation of about 2.5% overtime can be the one of the greatest achievement for both local and internal banks. The model also advocates for other considerations including the establishment and stabilization of real economy based in interest rate smoothing. The model’s loss function is given as:

Lt = (πt – π*)2 + ƛ(yt – yt*)2 + ƴ(it – it-1)2 + ¥(it – it*)2. With the monetary model, it becomes easy for banks to stabilize inflation given as πt (first term of the equation). The second variable (yt) defines the trade-off between stable inflation and stable economy while the third term is argumentative in nature. According to the third term, it is usually robust for a financial institution to change its interest rates gradually so that there is no deviation between interest rates it and previous period’s interest rate it-1. Any slight deviation between current interest rate and previous interest rate must be immediately corrected to avoid plunging in economic crisis.

IV. Data Presentation and Analysis

Overtime, banks seek to maintain an inflation rate that is equal or less than 2.5% (Norgers Bank Report, 2012). This means that any interest rate established by such banks should ensure that the inflation mark is attained and that the financial institution has a robust monetary policy. Moreover, the interest rate path must be based on a reasonable path so as to create a balance between capacity utilization and economic inflation.

The NEMO’s equation identifies three criteria that can be used in financial analysis and shown below.

The first criterion states for the inflation rate to be achieve, the loss function Lt must be greater than 0.5% (Norgers Bank Report, 2012). This means that the actual inflation πt will be significantly different from the target inflation π*. The second criterion states that for an inflation target to be flexible, the value of Lt must show fluctuations based on economic activities or other indicators. Such changes are mostly caused by variations between actual output yt and normal output yt* (Norgers Bank Report, 2012). The final assumption made is that for a robust monetary policy, all the three segments of the NEMO equation must show financial imbalance that result from high capability utilization. From the analysis of the graphs presented in the section of the appendix (ƛ=0,5, γ=0,25 and ¥=0.25) (Norgers Bank Report, 2012), it is clear that global financial institutions are developing monetary policies that cause financial imbalance hence the growing economic crises.

V. Conclusion

Just like previous years, the 2018 economic period might not show any significant improvements following the lethargic economic activities that are characterized by extreme changes in geopolitics and countries’ economic instabilities. There is no doubt that the current economic climate is characterized by “tighter fiscal policies,” “commodity recovery reverses,” and highly stretched global monetary policies. The 2017 report on macro-prudential policies and interaction with monetary policies demonstrates that central banks have already reached the limits of expansionary and contractionary monetary policies and are currently exploring new options that can be used to provide effective financial controls. Recent trends indicate an increase in the application of quantitative easing techniques to the maintenance of both short term and long-term liquidities. However, banks have consistently registered diminishing returns and negative growth rates. These conditions may persist or become even worst if financial institutions do not establish appropriate monetary policy or financial models.

At macro-level, banks now find the “Norwegian Economic Model” a more realistic approach for monetary policy forecast and analysis. One fundamental reason behind the application of NEMO model is that it has several characteristics in common with some of the methods developed in the past. The model has become an important tool of analysis given the current challenges faced by most financial institutions. Through the NEMO’s formula, financial institutions can determine whether the inflation mark has been attained, financial policy is robust, or if the inflation levelling system is flexible based on the changes in economic conditions.

References

Gambacorta, L., & Murcia, A. (2017). The impact of macroprudential policies and their interaction with monetary policy: an empirical analysis using credit registry data.

Gills, B. (2017, January). The future of development from global crises to global convergence. In Forum for Development Studies (Vol. 44, No. 1, pp. 155-161). Routledge.

Norgers Bank Report. (2012). Monetary Policy Report. http://www.norges-bank.no/contentassets/93604a21e5b54bba8e11007367845b13/mpr_312_k.pdf

Offer, A. (2017). The market turn: from social democracy to market liberalism. The Economic History Review.

Tong, E. (2017). US monetary policy and global financial stability. Research in International Business and Finance, 39, 466-485.

Appendices