Until a year ago, central bankers could boast with satisfaction that monetary policy had become boring. A widely shared “best practice” was followed by almost all central banks. Any controversies concerned technical nuances that were really only relevant to professionals in the field. Then came the credit crisis – and all certainties went out the window. Now new dilemmas are emerging, and many central banks have embarked on different routes. Within a few years, we will know who was right and who wasn’t.
Fighting inflation or avoiding recession?
A first question: what’s the primary objective – inflation or growth? The American Federal Reserve has chosen growth. For fear of recession, it lowered the interest rate to 2% - two points below the rate of inflation. The gamble is that the cyclical slowdown will still put the brakes on price increases, despite the energy shock and agricultural prices, and even though inflation forecasts have reared their heads – above all (but not only) in the short term. Paul Volcker, the architect of disinflation in the 80s, has said that recent months remind him of the early 70s. Even then the oil shock was accompanied by a rise in agricultural prices, a weakening of the dollar, and an expansive monetary policy to counteract recession. The result was a decade of inflation.
The Bank of England made the opposite choice – it’s keeping interest rates at 5% (2 points above the inflation rate), because it wants inflation to fall towards the target of 2%, while recognising that the English economy risks winding up in recession, driven by tight credit, the drop in house prices, and the oil shock. The economic situation in England still isn’t as serious as that in America, yet the orientations of the two central banks are very different. Mervyn King, governor of the Bank of England, has emphasised that the Bank “did not fall prey to the sirens who were pressing us to cut interest rates as rapidly as some other central banks have done”.
The European Central Bank is going even further, surprising everyone with a warning that a hike in interest rates is imminent, despite the global slowdown and the ongoing credit crunch. This is remarkable, because the source of higher inflation is clearly exogenous to the Euro area and not due to domestic overheating or wage increases. By implication, the ECB welcomes a slowdown of the European economy to make sure that external inflationary pressures do not ignite a domestic wage-price spiral. The contrast with the Fed approach could not be more striking; one of the two central banks must be making a mistake.
Monetary policy indicators
A second question concerns monetary policy indicators. The monetarist doctrine suggested keeping an eye on monetary aggregates in order to prevent their excessive growth from overheating the economy. This vision was then substituted by a new orthodoxy – that the quantity of money has no stable relationship with economic activity, so central banks need to set interest rates with an eye on inflation forecasts and growth, ignoring what happens to the quantity of money. The financial crisis revalued old monetarist ideas – not in the sense of keeping the quantity of money under control, but rather of counteracting too rapid growth of credit aggregates. The credit crisis of recent months was fed by excessive growth of financial leverage – that is to say, credit. If the central banks had paid attention, we might not be in the mess that we are in today. The ECB has scored a point in its favour, here, as it has always said that it was paying attention to monetary aggregates. While economists have derided it in the past for being too faithful to monetarist hang-ups, it now appears that the ECB has been wiser than other central banks.
Bursting asset bubbles
This brings up the next question. What should monetary policy do about speculative bubbles in asset markets? The response of the central banks has always been to react to the macro effects of the bubble (on inflation and growth) without trying to burst the bubble pre-emptively. Critics say that’s too condescending an attitude. If you really think market prices are distorted by a bubble, why limit yourself to picking up the pieces? Wouldn’t it be better to act before disaster arrives and force the bubble to burst? Central bankers give two answers. First, it’s hard to identify bubbles and second, we don’t want to destabilise the aggregate economy just to make them go away. But the damage done by the bubble on the housing market is causing a rethink. Above all, the instruments available to monetary authorities aren’t only interest rates. Even the Federal Reserve now admits it should have fought speculation with stricter regulation.
A fourth problem is how far authorities should go in offering liquidity to the markets. Some central banks were initially too reluctant, precipitating the crisis. Now there’s the opposite fear – that central bank portfolios are chock full of assets of dubious quality. It’s difficult to find the right balance between sustaining liquidity and avoiding an indiscriminate rescue of those who erred at the expense of taxpayers.
Central bank autonomy
There’s also a political side to these questions. Delegating monetary policy to an independent bureaucracy requires that policy decisions be guided by technical criteria and a solid knowledge of the subject matter. If instead, larger and more uncertain questions open up, politicians will be tempted to break central bank independence and take back decision-making. Note what happened after Bear Stearns was rescued. Some Congressmen asked the Fed to give favourable treatment to student loans, allowing banks to go to the central bank and swap them for the safer T-Bills. And the Fed promptly obeyed. The next step, where the central bank will be asked to help companies or sectors close to the heart or pockets of politicians, is not far off.