17th February 2014
The recent fuss over the Fed’s tapering strategy, Janet Yellen’s ambiguous testimony to Congress about forward guidance, Mark Carney’s reboot of forward guidance in the UK after just six months, and the German Constitutional Court’s judgement on the ECB’s Outright Monetary Transaction (OMT) initiative have all served as timely reminders that there are no constants in central banking, and never have been. The conduct of monetary policy has gone through many iterations over the last 50-60 years, changing with economic and political circumstances. The most recent shift, of course, occurred as a consequence of the financial crisis, elevating central banks onto a pedestal. Central bankers may have had mixed views about this, but as a result, we have been unnaturally, and dangerously obsessed with central banks.
We have come to see them as pivotal to economic conditions and prospects but these expectations cannot possibly be fulfilled. We analyse and dissect everything leading central bankers say as though the world’s turning depended on it. By placing central banks and monetary policy at the centre of our economic universe, we have let governments off the hook from taking responsibility for sensible fiscal and debt management strategies, and from steering the economy gradually back towards sustainable growth and high levels of employment. In other words, we have ended up with a chronically unbalanced policy infrastructure, which, if unaddressed, is going to compromise severely our ability to cope with the next economic downturn or crisis, and or drive us into even more unusual and unpredictable policy responses.
So I like the idea that central banks are retreating a little. It’s better they should be reassuringly vague than act or be perceived as economic know-it-alls with monetary policy answers to many complex problems they are ill-equipped to address. Hopefully, this will also make more obvious why governments need to be (a very important) part of the policy process too. I’ll come back to this. First though, let’s just consider three recent examples of how and why the policy frameworks central banks have been articulating look rather suspect, or unbelievable.
The problem with tapering has taken two forms. The first is the judgement as to whether it’s appropriate given the state of the economy. The second is whether the Fed should or shouldn’t take into account the international consequences of its actions. Self-evidently, the Fed feels the economy can wear the gradual normalisation of monetary policy, starting with tapering. At least until the next FOMC meeting in February. Since tapering started, streams of high frequency economic data have suggested that the economy has lost momentum. The ‘street’ has taken about 0.5% off the initial, inventory-heavy 3.2% estimate for Q4 2013 GDP, and slashed Q1 2014 estimates from 3% or more to about 1.5-2%. So far, rest of year quarterly numbers haven’t been cut back as economists reckon, all things considered, that the weather has had a lot to do with that loss of momentum. There’s more to it than bad weather, though. Car sales and housing indicators started to weaken before the inclement weather set in. The household savings rate probably won’t fall further than it did at the end of 2013. And the labour market has many warts, as we know, in spite of the sharp drop in the unemployment rate. All of that said, it’s unlikely that the economy has lost as much as high frequency commentators fear. If the Fed’s judgement is that the economy’s underlying rate of growth is still 2-2.5%, the tapering will most likely stick.
The outburst that tapering was undermining stability in emerging markets was stupid, and wrong. With US 10 year Treasury yields around 2.75%, down from where they were at the start of the year, and back to where they were for much of the second half of last year, tapering has hardly tightened global monetary conditions. If capital has flowed back to the US from emerging markets, then other factors must have been at work too. In any case, weaning the economy off QE is fundamentally a good thing for the US economy, and therefore for financial stability over the medium term. There is more than a suspicion that the bleating about the Fed was a smokescreen to hide political weaknesses and or policy failures in the most affected emerging markets – not the least of which was the fragile state of investor confidence in the economic performance and economic models of many emerging countries.
That said, there’s no question that the Fed’s monetary policy sends waves around global capital markets, to which emerging markets are highly sensitive. This doesn’t or shouldn’t mean that the Fed has to stop, or reverse the taper, and it doesn’t mean that emerging markets are ‘victims’ of the Fed at all. But as the world’s de facto central bank, the Fed could have shown a greater sensitivity by saying that it was ready to support its emerging market peers with swap lines if they encountered undue financial turbulence.
Lesson 1: Domestic monetary policies, especially in the US, have important global spillover implications, operating via currency and bond markets, capital flows, and of course, with feedback effects amplified via policy responses. This puts the spotlight firmly on G20 governments and the IMF to strengthen a global monetary system that lacks structure and discipline
Forward guidance RIP?
Janet Yellen kicked off the latest debate about forward guidance by acknowledging to Congress that the Fed was looking at indicators in addition to the unemployment rate, which the Fed had previously said would have to fall ‘well through’ 6.5% to be seen as a trigger for a change in policy rates. If that obfuscated further what forward guidance was supposed to convey, Mark Carney pretty much buried it as a concept. Carney’s abandonment of the 7% unemployment threshold for forward guidance was embarrassing, perhaps, but wholly justified. From the very beginning, the strategy warranted the quip of ‘forward misguidance’, since it was by no means clear how or why the Bank of England could base its policy for nominal policy rates on a real variable, which was a) outside the Bank’s direct control and b) structurally in transition. The same goes for the Bernanke/Yellen focus too, by the way. By this I mean that labour market statistics, post the financial crisis, are simply not the same any more. Labour force participation rates, unemployment and under-employment indicators, wage trends in the aggregate and by income cohort, and working hours are being influenced strongly by the lingering consequences of the financial crisis; demographic trends, especially rapid societal ageing, social and leisure trends, and the impact of modern and robotic technologies.
So it’s not as clear as it used to be what traditional labour market measures actually mean, or if they should be used at all in a ‘scientific’ way to guide monetary policy. Mark Carney’s citing of spare capacity – which he estimated at 1-1.5% of GDP – as a new lodestone for policy rate guidance kind of says it all, given what we (don’t ) know about spare capacity. But at least now we have a range of indicators which we know the Bank of England is looking at, and that in the end, its judgement will be what determines policy. No lasting harm has been done to either the Bank or the Fed, and on balance, it looks as though policy rates might rise rather earlier than they are still suggesting. If we had to watch one indicator above most others, it might be the pace of wage and salary increases.
Lesson 2: Important structural changes are going on in the economy, especially in the labour market, some predating the financial crisis, some illuminated and exacerbated by it, and some as a consequence of it. Central banks are also hostage to the uncertainties generated by these changes, and will have to use their best judgement to understand feedback mechanisms, and new metrics guiding the appropriate level for policy rates.
ECB: when politics get in the way
The German Constitutional Court’s referral of the ECB’s OMT programme to the European Court of Justice for clarification under European law got most of the headlines. But the really important thing was the ruling that the programme is unconstitutional under German law, and goes beyond the capacity accorded to the Bundesbank. It’s going to take some time before this is all cleared up satisfactorily, but we can surmise that for the time being, a) the OMT programme could not be used, even if it had to be, and b) if and when it can be used, it’ll be a far cry from what markets expected from Draghi’s original ‘whatever it takes’. Draghi, himself, actually modified that phrase later by adding ‘within our mandate’, and the endgame of the latest legal twist is likely to circumscribe the capacity of the OMT programme.
In a way, perhaps it matters less than people say. Spreads have been falling in the Eurozone as capital has flowed back to the periphery, and while the OMTs were the confidence-inducing catalyst at the outset, the most recent compression of spreads looks to have more to do with economic confidence, for what it is worth. Moving on, it seems that OMTs will matter less and less (i) if their capacity becomes more limited (ii) as the ECB’s pan-Eurozone banking supervisory role is compromised by national bank resolution arrangements, and limited resources, and (iii) as the need for QE becomes greater. Anaemic cyclical growth in the Eurozone, accompanied by a general decline in CPI measures – rather than lower in the periphery and higher in the core – is the principal reason QE might be needed. From a legal standpoint, QE should be a shoo-in because, unlike OMTs, it isn’t a rescue programme for a specific government. But one imagines lawyers could still have a field-day arguing over the ECB’s mandate for price stability, monetary financing, bond purchase discrimination, and ultimate fiscal risk in the event of loss.
Lesson 3: The best laid plans of mice, men and central bankers, often go astray. The ECB, unlike the Fed and the Bank of England, or the Bank of Japan, for that matter, has a relatively limited (inflation) mandate which precludes it from copying its peers. It is a lender of last resort to banks, but it’s initiative to take on the same function for sovereigns is now (politically) in doubt again. It does take measures to improve the transmission mechanisms of its monetary policies, but politics again restrict its capacity to supplement the impact of zero rates through policies such as QE, let alone to work with official bodies to support growth and employment.
Looking beyond central banks
How did we become in awe of central banks, and, five years on from the financial crisis, should they now be behaving differently in changing economic conditions?
One strong proponent of this view is Bill White, former head of research at the BIS and now consultant to the OECD, who wrote a paper in 2012, called Ultra Easy Monetary Policy and the Law of Unintended Consequences. Here’s the url, as it’s definitely worth a read: http://www.dallasfed.org/assets/documents/institute/wpapers/2012/0126.pdf.
The paper threw a hand grenade into the monetary policy consensus of the time, warning that over-reliance on zero rate policies and QE was leading us down a dangerous path, and reminding central bank-focused financial markets, among others, that central banks were not and should not be the only game in town when it came to policy-making. Remember that at the time, Long Term Repurchase Operations (LTROs) were expanding the ECB’s balance sheet, Mario Draghi had recently uttered his ‘whatever it takes’ commitment, the Bank of England had announced an additional £50 billion of QE and launched its Funding for Lending scheme, and the Federal Reserve was just about to announce the third bout of QE.
White weighed up the balance of favourable short-run versus unfavourable long-run effects of unorthodox monetary policies. His trenchant conclusions were that
- we had to be cognisant of the limits of what central banks could realistically achieve (check that box)
- the flow effects of monetary stimulus might have a diminishing impact on demand (check that box)
- the stock effects might actually weaken both supply and demand over the medium-term (check)
- excessively easy monetary policy could impair the health of financial institutions, the independence of central banks, and the prudent behaviour of governments (check all three), and importantly,
- governments must, therefore, use the policy levers that they do control much more vigorously to support stronger, sustainable and balanced growth (my emphasis).
This last point is key, and at the heart of the whole debate about central banks, their capacity, and what we should expect of them. Whatever else happens, we should not expect monetary policy to be able to be a cure-all for any, or even many of the problems that define our post-crisis economic and financial condition. And we should not rely on monetary policy to an excessive degree. There never has been, nor is there anything permanent about monetary policy philosophy and techniques, and the ways in which we have embraced monetary policy have varied with economic circumstance and with the prevailing political ideology. There’s a great follow-up paper by Bill White that illuminates this and is worth a read. Called ‘Is Monetary Policy a Science? The Interaction of Theory and Practice Over the last 50 Years’, it’s at http://www.williamwhite.ca/content/monetary-policy-science-interaction-theory-and-practice-over-last-50-years-1
There is no question that circumstance lead us into unorthodox monetary policies, notably QE. But we need to recognise now that the blind pursuit of those policies are leading us down the wrong path. This isn’t to say that central banks shouldn’t give us their best guesses about growth forecasts, intermediate operating targets, and when they think interest rates might start to rise. But let them be reassuringly vague, and let them guide policy rates back to somewhere that we might call normal, given prevailing economic conditions. To compensate and restore balance to the mix of policy-making, we need to look to governments to play their proper part in deploying policy tools designed to lead to economic stability and steady growth in incomes and employment. That’ll make the job of central banks easier and more plausible.
In 2007-08, I wheeled out the work and teachings of Hyman Minsky to demonstrate how and why I thought we were headed for a systemic meltdown. I ventured timidly at the time – Rogoff and Reinhart have expressed it more eloquently and empirically since – that it might take a decade to get over the crisis. And, that we shouldn’t be surprised if government played a much bigger role in managing the economy, given that the religious belief in its self-correcting capacity during the Great Moderation had proved to be little more than…religious belief.
Until now, this judgement has looked rather poor. If anything, the politics of austerity and structural reform in Europe, and a blatant anti-Federal government movement in the US have taken us in the opposite direction. Partly as a result, central banks have moved centre-stage. But with recent developments in Washington, London and Karlsruhe, perhaps now is a good time to call time. Monetary policy isn’t going to help us with rebalancing and structural reforms, and without these, ultra-easy money is just going to lead down a path to asset bubbles and new financial instability. Central banks need to do what they can to normalise monetary policy but only when they judge it appropriate. In the meantime, it is becoming a matter of growing urgency that governments pick up the reins of policy in the budgetary, infrastructure and corporate and fiscal governance arenas to prioritise high levels of employment and training, and income formation and fairness. And that’s for starters.
1 The phrase, reassuringly vague, jumped out at me when reading a blog on Mark Carney’s forward guidance shift by Ed Conway, Economics Ed at Sky News at http://www.edmundconway.com/2014/02/mark-carneys-dangerous-new-forward-guidance/