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82 Deleveraging, What Deleveraging<br />
In contrast with this view, the exceptional weakness of the recovery – as<br />
revealed, for example, by the persistence of low labour market participation rates<br />
in the US and underemployment in the UK – suggests that an accommodative<br />
monetary stance may be necessary for an extended period (International<br />
Monetary Fund 2014b). The weakness of the recovery calls for policies aiming<br />
at supporting aggregate demand and delaying exit (Summers, 2013; Krugman,<br />
2014). In this report, we have argued that potential output growth in advanced<br />
economies has been on a declining trend for decades, accelerating after the crisis,<br />
with structural forces putting downward pressure on the natural rate of interest.<br />
In such a context, and with leverage still very high, allowing the real rate to rise<br />
above its natural level would risk killing the recovery, pushing the economy into<br />
a prolonged period of stagnation while putting at risk the already challenging<br />
deleveraging process. Although there is a lot of uncertainty over these quantities,<br />
our call is for caution. The case for caution in pre-emptively raising interest rates<br />
is reinforced by the weakness of inflationary pressures.<br />
The policy question is whether monetary policy can remain accommodative<br />
while at the same time acting to prevent the rise of new bubbles via<br />
macroprudential tools. Since central banks have developed a new set of tools<br />
aimed at multiple targets, this should in principle be possible. However, we are in<br />
uncharted territory and vigilance is required in the monitoring of the observed<br />
growth in asset prices in various market segments and regions.<br />
Beside this tension between monetary policy and financial stability objectives,<br />
whatever the interest rate path judged appropriate, it will be difficult for the<br />
Federal Reserve to delink market interest rate dynamics from the path of exit<br />
from quantitative easing and instability in financial markets. When the Fed raises<br />
rates, it will likely have a balance sheet of around $4.5 trillion, or a quarter the<br />
size of nominal GDP. It will accomplish policy firming by increasing the interest<br />
rates it pays on excess reserves and at its fixed-rate allotment facility. That is,<br />
the Fed will run a massive rolling book of reverse repo transactions and term<br />
deposits.<br />
More generally, the reality is that the events of the past few years have redefined<br />
the term ‘unusual’. The Fed will be expected to do more in the future than was<br />
expected under the settled notion of appropriate central banking before the crisis.<br />
Because it acted in extreme ways during the period of duress, it will be expected<br />
to step up at the next time of stress. With its balance sheet large and complicated,<br />
central bank officials might consider expanding the range of policy instruments.<br />
Federal Reserve officials will have to take account of the net consequences of the<br />
functioning of the market and the precedents they are setting.<br />
The response to the last crisis illustrates that the dividing line between<br />
monetary and fiscal policy becomes very thin in exceptional circumstances.<br />
To an important degree, the Federal Reserve’s quantitative easing should be<br />
viewed as a second-best attempt to deal with collateral troubles associated with<br />
borrowers with debt greater than the value of their homes. Now that US home<br />
values at the national level have expanded at a double-digit pace but headwinds<br />
still seem evident, a more direct approach that is closer to the first-best solution<br />
of mortgage relief for still-stressed households might be in order.