Central banking and central bankers as we know them are out of touch with the modern world and ill-equipped to deal with the challenges set before them.
That is the view of Morgan Stanley’s Manoj Pradhan who argued that the current ‘DDD regime’, meaning debt, deficits and deleveraging, requires a different monetary policy strategy.
Indeed, modern central banking runs on three key principles:
i) inflation targeting improves growth prospects in the medium run
ii) inflation targeting effectively means inflation forecast targeting
iii) a ‘conservative’ central banker (i.e., one who dislikes inflation more than the average economic agent) can deliver lower and less volatile inflation
But two of these three tenants were designed for a regime of low debt when monetary policy was the dominant force, something developed economies will not see for the foreseeable future, Pradhan said.
In the DDD world, or era of so-called ‘fiscal dominance’ — defined as a period of time when the fiscal position of the economy effectively ‘sets’ a target that monetary policy has to follow — the first and the last tenets “can cause more harm than good”.
Here’s why: (emphasis ours)
The standard Taylor Rule would recommend, all else equal, that the central bank raises policy rates faster than inflation, thereby raising real interest rates in order to slow down the economy and reduce inflation. However, when there is a high level of indebtedness, higher real interest rates reduce the attractiveness of sovereign debt in two ways. First, the cost of servicing this debt rises. Second, higher real rates reduce output and production, which makes it tougher for economies to ‘grow’ their way out of debt. The result is a rise in risk premiums and a higher probability of default.
Eventually, monetary policy is forced to turn its strategy around because it has to ensure fiscal solvency to prevent a catastrophe. In order to do so, it is eventually forced to push up inflation even higher than it was before in order to generate seignorage revenues. Clearly, applying what is considered ‘normal’ monetary policy when there is a regime of fiscal dominance therefore risks aggravating not just the fiscal situation but inflation dynamics too.
And here’s more on the problem of being earnest conservative:
When inflation targeting arrived, the presence of a conservative central banker leading an independent central bank only served to bring inflation down faster. In a regime of monetary dominance, this combination worked very well. Under fiscal dominance, however, it will likely only make an aggressive pursuit of the inflation target more likely and therefore more disruptive.
Pradhan is not the only one to express concern about central bank strategy/competence in recent days. In a pithy editorial in Thursday’s FT, Gillian Tett raised the same issue:
The essential problem is that the crisis has tossed central banking into an intellectual limbo. Before 2007, their reputation appeared to be sky high, since central bankers appeared to have produced a Great Moderation of low inflation and growth (remember, those pieces lauding Alan Greenspan as the so-called “maestro”?). But these days, it is clear that many elements of that pre-2007 central bank intellectual model were flawed: central bankers were too obsessed with watching price stability, at the expense of monitoring financial stability; they overestimated the power of short-term interest rates in controlling the economy; and they thought – wrongly – they could shape monetary policy by watching national issues alone.
So far, so obvious. And Borio offers a sensible list of measures that might address these flaws: central banks need to adopt a wider sense of responsibility that combines an awareness of monetary trends and financial stability; they need to take an international, not national, view of the markets; they need better toolkits to monitor financial stability; they must take steps to protect themselves from political meddling. Last, but not least, he also thinks they need to wean themselves away from the idea that suppressing short term interest rates – via quantitative easing or anything else – will fix the current woes; while this might work during a normal business recession, it does not cure a balance sheet recession. Instead he – like many Japanese officials – argues that excessively cheap money tends merely to stave off the eventual adjustment, prolonging the woes. Call it a “time inconsistency” problem.
But while Borio’s proposed checklist of necessary reforms might sound obvious, the gloomy fact is that most of these are merely pipe dreams.
Unfortunately the criticisms are easier to come by than the solutions.
Related links:
Central bankers must update outdated analytical toolkit – FT
Fed urged to weigh new moves to boost economy – FT Alphaville
Bernanke hints at communication changes – FT Alphaville
Should the Fed target a nominal level of GDP? – FT Alphaville