In the good old days when economies were growing close to trend, monetary policy was about setting interest rates. Nowadays it is a complex mix of quantitative easing, credit easing, liquidity provision, prudential controls and debt management. With economies stagnant and interest rates near zero, central banks are trying other ways to induce banks to lend and companies to borrow. As a practical matter, promoting financial stability and restarting growth are the priorities, rather than inflation control. This creates two major problems.
First, economic theory is lacking. Compared to the vast literature on interest rates, little is known about the transmission channels, the lags and the ultimate economic and distributional effects of these unconventional tools. Some of them were standard fare for central banks in the 1950s and 1960s but the field of economic history has been sadly neglected and, in any case, the world has changed since then. Without a solid steer from empirical research, it is risky for policy makers to rely on economic models that predict the impact of different policy options. This is a classic case of “multiplicative uncertainty” for which the optimal response is to move very cautiously. As Alan Blinder once said, “estimate what you should do and then do less”. The problem with this advice is that the media clamour for policies to promote growth is unrelenting whereas few would argue publically for higher inflation. Central banks are in the spotlight because they have more freedom to act than politicians, especially in the eurozone where many parliaments are involved.
The second problem facing central banks is policy coordination. The eurozone has a classic chicken and egg problem over which comes first: governments’ budgetary progress or more support to banks from the European Central Bank and the European Stability Mechanism. In Britain, the latest minutes from the Monetary Policy Committee report that some members wanted to wait and see what effect the Treasury’s recent “funding for lending” initiatives and the looser liquidity advice from the Financial Policy Committee would have on bank lending before they could decide on more quantitative easing. This reveals the muddle at the heart of the current separation of the two committees, with their partial overlap in membership. Not only does this give too much power to the Bank of England governor and other BoE insiders at the expense of the external members on both committees, it also risks policy gaps and inconsistencies.
It is not too late to change because the legislation to establish the FPC has not yet gone to parliament. If, as the governor has suggested, we are less than half-way through this difficult post-crisis period, then the MPC will be using unconventional tools for some time to come. The best way to deal with the intrinsic connection between monetary and financial levers is a single, accountable Monetary and Financial Policy Committee, with a solid quotient of external members, published minutes, and a dual mandate for inflation control and financial stability.