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Taming the Monetary Beast

Federal Reserve’s Unwinding and Global Monetary Governance

Kanad Bagchi ( is at the Max Planck Institute for Comparative Public Law and International Law, Heidelberg, Germany.

As the momentous monetary policy measures by the United States Federal Reserve—the decade-long quantitative easing and balance sheet expansion programme—inch closer to an end, this article captures some of the lessons learnt and, more particularly, the ones unlearnt in the last decade. The pivotal role of central bank communication, the impact of monetary policy spillovers, and the changing nature of central bank mandates are perhaps the most important takeaways from a decade of financial turmoil and monetary policy interventions.

On 20 September 2017, the United States (US) Federal Reserve announced the gradual unwinding of perhaps its biggest monetary experiment in history—the decade-long quantitative easing and balance sheet expansion programme. Adopted against the backdrop of the global financial crisis in 2008, and with an objective to revive aggregate demand and economic growth, the Federal Reserve embarked upon a hitherto unprecedented and practically unlimited purchase of long-term US treasury debt obligations and private asset-backed securities. The result—a bloated $4.5 trillion central bank balance sheet representing roughly 24% of the US’s gross domestic product (GDP), a possibility of looming losses for the Federal Reserve, and a fear of the private sector being crowded out.

Notably, the Federal Reserve was not alone in this endeavour. Central banks in other systemic countries(United Kingdom, Eurozone, and Japan) closely followed suit and launched their own versions of quantitative easing so as to influence long-term interest rates in their respective economies (Borio and Zabai 2017). With growth, investment, and employment levels slacking through consecutive quarters, and with no immediate indications of a course reversal, quantitative easing and unconventional monetary policies had come to acquire the status of the new “normal” in monetary policy parlance. Thus, after almost a decade of unusually low interest rates and ultra-cheap money, the Federal Reserve’s U-turn with respect to unconventional monetary policies and its balance sheet normalisation agenda, is indicative of several positive milestones: the revival of growth and investment in the US and the world economy, confidence with respect to an upsurge in inflation and employment, and a restoration of monetary policy transmission channels. It also perhaps signals the growing unease within the Federal Reserve and other policymakers about the potentially counterproductive impact of sustained “accommodative monetary policy” in augmenting asset price mismatches and financial market distortions.

As the “great monetary experiment” is inching closer to an end, this article captures some of the lessons learnt and more particularly, the ones unlearnt in the last decade. The pivotal role of central bank communications, the impact of monetary policy spillovers, and the changing nature of central bank mandates are perhaps the most important takeaways from the last decade of financial turmoil and monetary policy interventions.

Governing through Communication

While conventional wisdom has invariably assigned considerable importance to central bank communications in squaring out monetary policy decisions, the global financial crisis elevated the role of communication as an additional tool of monetary policy. As short term, key interest rates were brought down to the zero lower bound level in the aftermath of the global financial crisis, central banks increasingly struggled to transmit monetary policy measures through interest rates alone. Central bank communication through forward guidance was adopted as an explicit monetary policy tool, as against earlier practices of reporting primarily on the economic outlook. Policy guidance on the likely path of future interest rates presented the theoretical possibility of bridging the gap between current policy orientation and short-term policy preferences. Relevant studies have shown that, despite the inherent limitations of forward guidance as an instrument of monetary policy, it has been generally found to be effective, at least with respect to reducing volatility in short-term expectations and in improving the predictability of short-term yields (Charbonneau and Rennison 2015).

The central role of communication was also largely evident in 2013, when the Federal Reserve catalysed a “taper tantrum” in global financial markets, by indicating, rather unexpectedly, an imminent demise of its quantitative easing programme. Market participants and financial investors reacted decisively, pulling out from emerging economies, nudging local currencies and stock markets towards a tailspin, and significantly hiking US treasury yields. In contrast, the Federal Reserve’s latest taper announcement has barely caused a flutter in the global financial markets. What explains the shift in market perceptions from then and now? How can one account for the change from tethering tantrums to relative calm? Much of the qualitative difference can be demonstrated through the Federal Reserve’s renewed focus on its communication strategies and attuning them towards a better management of market expectations.

Internally, the Federal Reserve adopted several changes to its information-gathering operations, broadened its surveys of both primary market dealers and other market participants, and disseminated more frequently its summary of economic projections. Externally, by infusing more clarity, coherence, and predictability through press releases and public engagements, the Federal Reserve did not leave much room for either speculation or conjecture. Both the certainty of balance sheet normalisation, and its eventual modus operandi, has surfaced in several Federal Reserve briefings since early 2014. The Federal Reserve’s September communication on balance-sheet unwinding is similarly circumspect, and is neither overly aggressive nor meekly submissive. As opposed to “actively” and directly selling securities in the market, the Federal Reserve indicated a “passive” balance sheet rundown, by abstaining from reinvesting the proceeds of the maturing securities to buy newer ones. Accordingly, “predictability and certainty” underpinning the Federal Reserve’s communication strategies predisposed market participants towards a more considered response as opposed to a hurried and frantic reaction in 2013.

In the Federal Reserve’s own words expressed in a 2014 statement,

The Committee intends to reduce the Federal Reserve’s securities holdings in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities. (Federal Reserve 2014)

Several policymakers, including Ben Bernanke, have held similar views regarding the pace and content of the unwinding. Writing for Brookings, he expressed the view that an “active” approach to unwinding could likely cause disruptions in the financial markets and may not allow for a more considered response by market players, both inside the US and abroad (Bernanke 2017). Decidedly, Federal Reserve communications assumed significant importance as an additional governance mechanism, in defining an observable course of action, with minimum disruptions.

Negative Externalities

In an attempt to conceptualise this new age of central banking and what that means for the international monetary system, a plethora of new economic research on quantitative easing, unconventional monetary policies, and their effects on the broader economy has emerged in recent years (Bagchi 2017).While studies have been less conclusive on the causal relationship between quantitative easing on the one hand and economic growth on the other, the cross-border effects of quantitative easing policies on exchange rates and stock markets have been more forthcoming and definitive. Empirical studies have documented that historically low interest rates in the US and other advanced economies led to market participants and investors flooding emerging market stocks and bonds, in search of higher yields, thereby pushing up exchange rates and strengthening local currencies. Emerging markets shot back with accusations of “currency wars” and “competitive devaluations” while threatening to bring claims before the World Trade Organization (WTO).

Inversely, the Federal Reserve’s revelation to scale back its quantitative easing programme in 2013 caused an exact reversal of capital flows from emerging markets to advanced economies, stoking excessive exchange rate volatility and threatening financial stability in the region. Such cross-border spillovers and sudden “stops” and “reversals” of capital flows to and from emerging economies as a result of quantitative easing policies have renewed the debate on monetary policy coordination as a means to internalise the externalities arising out of domestically inward-looking policies. While much of the international community has acknowledged the menacing problem of negative externalities, policy coordination so as to alleviate such concerns has not acquired a definitive agenda. Correspondingly, emerging economies, in addition to augmenting their presence at global coordinating forums such as G20 and the Bank for International Settlements (BIS), have shown that capital controls and macro-prudential policies at the domestic level, if implemented succinctly, can be instrumental in insulating the economy from the vagaries of capital flows and exchange rate swings. Interestingly, both the IMF and the BIS have grudgingly recognised the utility of capital controls in their most recent communications (IMF 2012), representing a clear break from their erstwhile liberalisation agenda.

Monetary vs Financial Stability

Pre-crisis theoretical frameworks advocated a separation of monetary policy from other aspects of the economy, most notably financial supervision and regulation. While independent central banks were tasked with the objective of pursuing monetary stability, institutionally separate supervisory bodies were created for the purposes of ensuring financial stability. As risks arising out of financial stability were considered too remote for considerations of monetary policy and vice versa, the trade-offs between the two were never seriously analysed. The global financial crisis, however, exposed the fallacies of the separation model and underscored the intricacies and interlinkages between the conduct of monetary policy and the build-up of systemic risk. Monetary policy affects activity both in the financial market and in the real economy, especially through the asset price channel and thus has implications for financial stability. On the other hand, prudent financial supervision and regulation reduces financial distortions, thus improving monetary policy transmission. Also it cannot be sidestepped that the largely unexplored implications of quantitative easing and unconventional monetary policies on the financial system confounds policymakers with newer risks, formerly unobserved.

In recent years, therefore, an increasing number of policymakers and central bankers have sought to integrate parts of the two, by either incorporating financial stability concerns into central banking mandates, or through improving coordination between monetary and financial authorities. While debunking the traditional dichotomies in monetary and financial stability, the last decade of financial and monetary interventions have brought into focus the expanding role and mandate of central banks within the larger economy, compelling them towards a more systematic and holistic consideration of the two, during periods of normalcy and financial turmoil, both.


Bagchi, Kanad (2017): “Revisiting the Taper Tantrum: A Case for International Monetary Policy Coordination,” Journal of Financial Regulation, Vol 3, No 2, pp 280–89.

Bernanke, Ben (2017): “Shrinking the Fed’s Balance Sheet,” 26 January, Brookings,

Borio, Claudio and Anna Zabai (2016): “Unconventional Monetary Policies: An Appraisal,” BIS Working Paper No 570, Bank for International Settlements, ttp://

Charbonneau, Karyne and Lori Rennison (2015): “Forward Guidance at the Effective Lower Bound: International Experience,” Bank of Canada Staff Discussion Paper No 15,

Federal Reserve (2014): “Federal Reserve Issues Statement on FOMC Statement on Policy Normalization Principles and Plans,” 17 September,

IMF (2012): “The Liberalization and Management of Capital Flows: An Institutional View,” Policy Paper, 14 November, International Monetary Fund,

Updated On : 16th Feb, 2018


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