A simple observation last week by the Bank of England’s Monetary Policy Committee speaks volumes to the historic evolution of modern central banking – a process that is consequential, unprecedented and inadequately covered in traditional “money and banking” texts.
In its February 7 statement, the MPC stated that, due to a sluggish UK economy facing fiscal contraction, it is “appropriate to look through the temporary, albeit protracted, period of above-target inflation”. And it sure has been “protracted”; and will remain so.
The last time UK inflation came in below target was November 2009. If official projections are accurate, inflation will stay above target until the third quarter of 2014 – or a divergence of more than 50 consecutive months. To quote Mike Amey, my Pimco colleague, the target has become a “loose reference tool”.
The BoE is not the only central bank coping with inconsistencies. The European Central Bank has repeatedly been forced to react in ways once deemed contrary to its philosophy and practices. Under pressure from the new government, the Bank of Japan is in the midst of a historical U-turn.
Emerging economies are also struggling to respond. Some subordinate domestic objectives to the unusual activism of western central banks. Others experiment with “heterodox” measures. And yet others flip-flop in their search for the right policy mix.
Then there is the global dimension, including the risk of a currency war that has less to do with trade tensions and more with unconventional monetary policy. Just last week, Felipe Larrain, Chile’s minister of finance, warned in the Financial Times that “by seeking relief at the expense of other economies, [quantitative easing] is, in its essence, a globally counterproductive policy”.
To many, including politicians itching to interfere, central banking is stuck between a conundrum and incoherence. So here are a few pointers on where the debate stands, and where it should go.
With many other policy makers essentially missing in action, central banks find themselves in leadership roles not out of choice but necessity. Given imperfect tools, their involvement entails, to use the US Federal Reserve chairman Ben Bernanke’s phrase, “benefits, costs and risks”. They believe that macroeconomic benefits will outweigh the collateral damage; and they hope that they will buy sufficient time for others to respond properly and for economies to heal endogenously.
The dilemma of modern central banking was captured well last week by incoming BoE governor Mark Carney in his testimony to the UK House of Commons Treasury committee. While recognising the risks of further QE, the current Bank of Canada chief argued that central banks should act to avoid sluggish growth raising the natural unemployment rate via hysteresis.
The fundamental problem is that central banks are pursuing too many objectives with too few instruments. That is why outcomes consistently fall short of their expectations; and also why talk of exit is repeatedly shelved.
Absent better support from other policy makers, central banks will be dragged deeper into policy experimentation. Meanwhile, with incentive structures failing to align properly, perverse reactions are clear – from persistent (and, in Europe’s case, increasing) policy complacency elsewhere to distorted market functioning leading to potentially harmful resource allocations.
Then there is the biggest issue of all: the effects of unconventional monetary measures are likely to become volatile and highly binary if a growing number of central banks around the world feel they have no choice but to join the current western policy stance.
A larger global shift to expansionary monetary policy would enhance the probability of triggering “wealth effects” and “animal spirits”: the two channels through which policy-bolstered asset prices translate into better economic fundamentals. With that, the greater the likelihood of a pivot from “supported growth” to “genuine growth”.
However, relative pricing channels, including currency relationship, would be crippled if too many central banks were to opt for the same policy. Harmful beggar-thy-neighbour effects would amplify damage from artificial surges in asset prices that encourage irresponsible risk taking, fuel “bad inflation” and worsen the risk of disorderly economic and financial deleveraging.
Neither historical experiences nor analytical studies point convincingly to how the systemic effects will ultimately tip. What is clear, however, is that the probability distribution could be significantly improved if central banks were to get stronger support from those who touch more directly productivity and demand, as well as from multilateral institutions mandated with global policy co-ordination. This is where both debate and advocacy should focus.
The writer is the chief executive and co-chief investment officer of Pimco