It might be little known outside of monetary policy wonks, but both the US Fed and the ECB are undertaking reviews of their policy frameworks this year. The outcome could change how the two most important central banks in the world conduct monetary policy. Admittedly, the signs point more towards evolution rather than revolution. Yet many believe that some soul searching is in order as central bankers struggle to find the right response to the current environment of low growth, low inflation and low interest rates.
Like many central banks, the Fed and the ECB currently focus on inflation targeting: keep inflation below, but close to 2%. If inflation runs above the target, they tighten monetary conditions to cool down the economy and bring down inflation. If inflation is too far below the target, central banks lower interest rates to stimulate economic activity and produce on-target inflation.
Central banks as activists
To its credit, this approach appears to have done a remarkable job of taming inflation. The stagflation of the 70s is a thing of the past and independent central banks, supposedly free from the influence of myopic politicians, have arguably contributed to that. However, the past decade has called central bankers’ wisdom – and capabilities – into question. As policy makers have been desperately trying to deal with the challenges of the post-crisis era, they have become increasingly interventionist, with one ad-hoc measure after the other. As a result, the financial dictionary has grown to include terms such as Quantitative Easing, Forward Guidance, “Operation Twist” and “Targeted longer-term refinancing operations”.
This activism stands in stark contrast to the intellectual heritage of contemporary central banking, and its focus on fighting inflation while intervening as little as possible. Take (for example) the ideas of free-market advocate Milton Friedman. He argued that the best a central bank could do was to let the money supply grow at a constant rate. Friedman acknowledged that such a policy would be far from perfect; but considering the uncertainty and vagaries central bankers faced, he thought a predictable and rules-based approach was preferable to a more discretionary one.
When targeting the money supply turned out to be impractical, inflation-targeting instead became the norm. Sceptical of central banks’ recent history of exercising a high degree of discretion, some economists favour a return to a strictly rules-based approach. They may have a point: it is far from clear what the (potentially negative) side effects of quasi-permanent, ultra-loose monetary policy are. Tinkering with large, complex systems is risky and a prescriptive policy rule would rein in central bankers’ creativity.
Rules or radicalism?
Unfortunately, this doesn’t address key questions as to how central banks should act once interest rates are near their effective lower bound. Nor does it provide for how any target should be set. In fact, just as central banks are discovering the limitations of low interest rates, the voices arguing for more radical approaches to monetary policy are growing louder. Ideas such as helicopter money, “people’s QE” or any kind of central bank-financed government deficit spending are no longer confined to the fringes of economics.
Those worried that this would threaten central bank independence should be reminded that the line between fiscal and monetary policy is already extremely blurry. The ECB’s QE keeps over-indebted Eurozone members afloat, while low borrowing cost are meant to encourage countries running a surplus to cut taxes or invest in infrastructure. The Fed’s intervention in repo markets – dubbed QE4 by some – constitutes a covert financing of the US government’s large deficit.
There is plenty for policymakers to ponder on in the upcoming reviews of the Fed’s and ECB’s monetary frameworks. But a pivot to a strictly rules-based approach seems just as unlikely as an open endorsement of more radical monetary measures. It was stagflation that brought about the last revolution in central banking, but today’s challenges do not seem severe enough to warrant a complete overhaul. Some changes, however, may be coming – and even seemingly minor adjustments to policy frameworks could result in noticeable shifts in interest rates.
For more information, please contact Moritz Sterzinger, Director at Chatham, at firstname.lastname@example.org.