A Critique Of Modern Central Banking

Manoj Pradhan of Morgan Stanley muses over monetary policy strategy in the developed world (excerpt):

Is Modern Central Banking Ancient History?
By Manoj Pradhan | London

Two of the three principles of modern central banking were designed for a regime that developed economies will not see for the foreseeable future. The principles - (i) inflation targeting improves growth prospects in the medium run; (ii) inflation targeting effectively means inflation forecast targeting; and (iii) a ‘conservative' central banker (i.e., one who dislikes inflation more than the average economic agent) can deliver lower and less volatile inflation - are almost unquestioned among the central banking orthodoxy. However, these principles were espoused in an era of low debt when monetary policy was the dominant force. In the era we now live in, where debt, deficits and deleveraging (a DDD regime) are the dominant drivers of the economy and policy - an era of so-called ‘fiscal dominance' - the first and the last tenets can cause more harm than good. Inflation targeting and an aggressive approach to taming inflation in such times can create more volatile inflation and higher sovereign risks.

G3 monetary policy is still ultra-expansionary and on its way to becoming even more so, given the current disinflationary risks. However, inflation clocking in at over 5% in the UK and over 3% in the US and euro area gives hawks and dissenters plenty of ammunition. There remains a risk that monetary policy could ignore the perils of trying to curb inflation in an era of fiscal dominance. Tellingly, Chairman Bernanke's speech yesterday, The Effects of the Great Recession on Central Bank Doctrine and Practice, contained not one mention of fiscal concerns, let alone fiscal dominance. That the single greatest peacetime build-up in debt burdens in our lifetimes should go unmentioned in such a speech is strange at the very least.

Fiscal dominance - what does it mean? In the simplest characterisation of fiscal dominance, the fiscal position of the economy effectively ‘sets' a target that monetary policy has to follow. Monetary policy plays a subordinate role, keeps interest rates low and allows inflation to erode the real value of government debt. By contrast, monetary dominance implies that fiscal policy plays a passive role while monetary policy goes about keeping inflation under control without a concern about the adverse effect of higher interest rates on the ability of governments to sustain the debt burden. Such a regime clearly existed before the onset of the Great Recession in the advanced economies (excluding Japan) and continues to exist in the emerging market economies even now. Since the Great Recession, however, things have changed...

…Why does disinflation perversely lead to more volatile inflation? If we now turn to Taylor Rules under a regime of fiscal dominance, we see that an aggressive pursuit of inflation targeting leads to undesirable volatility of inflation - a point made very convincingly by Kumhof et al (2008). Why? 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…

…Fiscal policy is the right way to tackle inflation: In both discussions, that of the Taylor Rule and the Latin American experience, the onus of dealing with inflation falls on fiscal and not monetary policy. Meaningful fiscal consolidation, as and when possible, eases out the regime of fiscal dominance, thereby allowing central banks to revert to aggressively dealing with inflation. In the period of transition between a realisation of the need for fiscal consolidation and its achievement, monetary policy serves its inflation-fighting credentials best by not fighting inflation aggressively…

…Considering the Bank of England, domestically generated inflation is very low while imported inflation accounts for the bulk of the UK's inflation problems. Could such an inflation profile also be applicable to the US and the euro area, where growth and pricing power remain weak? If so, central banks may be inclined to pay less attention to inflation, given that the bulk of it comes from outside national borders, while monetary policy would have the greatest impact within the economy…

..The added complication - the ‘conservative' central banker: Rogoff's seminal paper in 1985 drilled home the result that a person/body with a greater distaste for inflation than the ordinary economic agent could deliver both lower and less variable inflation. This important result was often used to pick ‘conservative' central bankers who would deal with inflation aggressively…The need to preserve the conservative credentials of the central bank was also the rationale for asking for independence from outside influence, including the government. Granting the monetary policy committee, a non-elected body, independence from the preferences of elected representatives does not sit well with the principles of democracy (Blinder, 1993), but the importance of acting decisively against inflation was deemed strong enough to bypass such concerns…

…Ironically, the fact that EM central banks were not quite as independent as their counterparts in the advanced economies actually helped during periods of fiscal dominance. EM central banks, with their famous preferences for growth relative to inflation, did little to upset the applecart during tenuous times, allowing fiscal policy-makers more legroom to reduce indebtedness. Once the regime of fiscal dominance had been eliminated, EM central banks quickly adopted inflation-targeting policies to further improve macroeconomic fundamentals. Of course, the fact that EM central banks are still only quasi-independent is part of the reason why EM inflation expectations and inflation itself have not moderated even lower…

…The ‘solution' to dealing with higher inflation is therefore better fiscal and not more aggressive monetary policy. Going by the experience of emerging markets, a successful fiscal consolidation wipes out the constraint of fiscal dominance and restores traditional monetary policy and inflation targeting. Until that happens, though, monetary policy can best burnish its inflation-fighting credentials by not fighting inflation aggressively.

It’s worth the read; I’ve cut maybe 2/3rds off the original article in the excerpt above. There’s a lot more, making some very good points (I think I made a similar point earlier this year).

With reference to Europe, and it’s a very obviously a critique of ECB policy, that means a much more aggressive loosening of monetary policy, if the fiscal austerity programs implemented are to work. That’s not going to sit well with the core countries of France and Germany, though growth has fallen off lately in both those countries. This goes back to the ECB’s mandate where it’s only required to ensure (relative) price stability, and not the dual mandate of growth and price stability more common in both the developed and the developing world. The dogged pursuit of the price stability mandate under the current circumstances would be ultimately self defeating.

There’s a growing chorus of opinion that inflation should be allowed to rise, with a broadening consensus across many different schools of thought – market monetarism for one, though its proponents aren’t alone by any means. The IMF for instance, has been wondering if inflation targets shouldn’t be set at 4% instead of the more common 2% as it is now.

Fighting inflation for the sake of price stability isn’t the point of monetary policy – inflation targeting was chosen as the orthodoxy because empirically it correlated with sustained economic growth. But if fighting inflation results in economic and market turmoil, debt defaults and long term high unemployment, then the whole exercise has missed the point. In the end, it’s still about people.