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The Way Back for Monetary Policy

SEOUL – The central banks of major advanced economies have been navigating uncharted territory in recent years. While their use of a range of unconventional monetary-policy tools has had benefits, it has also generated significant uncertainty, without fully stabilizing the world economy. Now the time has come to head back toward more familiar policy terrain.

Following the 2008 financial meltdown, the US Federal Reserve cut the policy rate to almost zero and pursued so-called quantitative easing (QE), by purchasing long-term securities from the public and private sectors. The central banks of the European Union, Japan, and the United Kingdom soon launched similar unconventional programs. The result was a vast amount of cheap liquidity that helped to stabilize the financial sector, restore stock and real-estate prices, and increase domestic demand. All of this helped to limit the fallout of the financial crisis and push the global economy toward recovery.

But this aggressive approach has its limits. Indeed, as Reserve Bank of India Governor Raghuram Rajan has pointed out, after years of effort, the benefits of unconventional monetary policy are diminishing, while the costs are increasing. Recognizing this, the Fed ended QE at the end of last year and raised its policy rate by 25 basis points. The rate hikes will likely continue this year, though the speed and extent of the increases are uncertain.

Yet the European Central Bank and the Bank of Japan (BOJ) have decided to sustain their QE programs. Moreover, they have adopted a negative interest-rate policy – which amounts to charging a fee for bank reserves – to revitalize depressed demand. Unsurprisingly, the effects on inflation and real output have been limited.