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The Financial Crisis Life Was Simple For Central Bankers

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EFORE the financial crisis life was simple for central bankers. They had a clear mission: temper booms and busts to maintain low and stable inflation. And they had a seemingly effective means to achieve that: nudge a key short-term interest rate up to discourage borrowing (and thus check inflation), or down to foster looser credit (and thus spur growth and employment). Deft use of this technique had kept the world humming along so smoothly in the decades before the crash that economists had declared a “Great Moderation” in the economic cycle. As it turned out, however, the moderation was transitory—and the crash that ended it undermined not only the central bankers’ record but also the method they relied on to prop up growth. Monetary…show more content…
Central banks were not entirely unprepared for this challenge. In the 1990s the Japanese economy had slumped following an asset-price crash. Facing weak growth and deflation the Bank of Japan had slashed rates to near-zero before embarking on a series of experiments with unconventional monetary tools. Although the Bank of Japan’s performance was widely considered disappointing, if not an outright failure, the rich world’s central banks began by drawing upon its playbook. image: http://cdn.static-economist.com/sites/default/files/imagecache/290-width/images/print-edition/20130921_SBC415.png Unconventional policy falls into two broad categories: asset purchases and “forward guidance”. Asset purchases are a natural extension of central banks’ more typical activities. America’s Federal Reserve, for instance, has long bought Treasury bills and other bonds with short maturities to increase the money supply and reduce short-term interest rates. After its benchmark rate fell close to zero the Fed began buying longer-term securities, including ten-year Treasury bonds and mortgage-backed securities, to bring down long-run borrowing costs (see chart 1). Printing money to buy assets is known as “quantitative easing” (QE) because central banks often announce purchase plans in terms of a desired increase in the quantity of bank reserves. The Bank of Japan first attempted QE in 2001 when it promised to buy {Yen}400
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