It’s a potential lose-lose: the risk of fuelling future inflation in order to avoid a recession induced by a market driven credit crunch, or maintaining low inflationary expectations at the risk of both depressed economic growth and serious financial market dislocations?
But as Ben Bernanke heads to Capitol Hill on Thursday that is the challenge facing him, and other central bankers around the globe, says Mohamed El-Erian in the FT.
The Fed chairman is expected to give the nod to a stimulus package in his testimony, such as tax cuts or spending measures, even if such a move would boost the deficit in the short-term – which rather suggests he is prepared to err towards the former of the lose scenarios.
But El-Erian is concerned with how far global financial transformations have eroded the potency of traditional central bank tools:
Central bankers now operate in a world where monetary policy influences only a small part of the fluctuations in overall liquidity in the economy. “Endogenous liquidity”, or the extent to which the market itself expands and contracts liquidity, has taken over as the main driver.
We are now seeing that interest rate cuts are having difficulty countering the forces of endogenous contraction – just as rises did little to contain liquidity in a phase “turbo-charged by financial innovation and alchemy.”
What can the bankers do? El-Erian has five suggestions:
- Improve their understanding of the new financial landscape, particularly the big investment banks.
- Revisit conventional wisdom calling for separation of monetary policy and bank supervision
- Improve scrutiny of financial activities that have migrated outside their formal jurisdiction
- A broader approach of monetary policy, with greater recourse to open market operations and further revamps to the discount window
- Work harder to manage policy expectations and improve communication
If they do not act, says El-Erian:…they will be condemned to walk behind the financial market parade. In the process, they will continue to be blamed for, and expected to clean up, the occasional large mess, but with declining effectiveness.