Economists, irrespective of their scholarly persuasion, and policymakers alike became convinced of Milton Friedman’s famous dictum that “inflation is always and everywhere a monetary phenomenon”.This return to old wisdom helped to rebuild a consensus that central banks need to be granted sufficient independence to pursue monetary stability without political interference.
On the contrary, notions hardened that monetary policy was powerless and that macroeconomic stability needed to be safeguarded through other policies.
This shift in emphasis culminated in fiscal dominance, which contributed to the monetary mismanagement of the 1960s and 70s, paving the way for the “Great Inflation”.
But the crisis has upended traditional patterns in finance and economics, and monetary policy is no exception.
In its response to the crisis, the ECB has deployed a novel and complex range of instruments.
The deployment of the central bank balance sheet as a stabilising instrument was a novelty, and immediately met substantial scepticism.
First, there were concerns about moral hazard, given the unprecedented expansion of ECB credit to banks at a time when banks were under scrutiny for their mismanagement of risk in the pre-crisis period and for having precipitated the crisis in the first place.
To arrest and reverse this development, two policies were introduced.
First, to ensure banks could rely on longer-term funding, central bank liquidity was made available for up to three years, and the collateral that could be used to access central bank money was expanded.
This in turn resulted in financial fragmentation and a serious disruption of the monetary policy transmission mechanism.