Speaking in Jackson Hole, the temporary Mecca of central bankers, Mario Draghi observed that monetary policy alone cannot fight deflation. This may have come as a shock to people who were told that inflation rates are determined by money growth. Yet, he was right. But this is just the tip of the iceberg. We see the Fed struggling to decide when and how to stop pouring liquidity in the economy, the Bank of England meeting the subtleties of «forward guidance», the Bank of Japan facing skepticism about its attempts to bring two decades of zero growth-zero inflation to an end. At home, the National Bank of Switzerland is still struggling to keep the franc above 1.20, three years after having adopted a policy that was meant to be temporary. What is going on?
Central banks have been the heroes of the Global Financial Crisis. With little or no hesitation, they have swung into action promptly and moved into unchartered territories, including multiplying several time over the size of their balance sheets or setting negative interest rates. While governments held magnificently choreographed summits that resulted into vibrant declarations and no or little actions, central banks quietly prevented the financial crisis from turning into another Great Depression. They now bake in glory but, deep down, they are worried. And they have every reason to.
To start with, the financial crisis was the result of poor bank regulation and supervision. Back then, few central banks were regulators or supervisors, but they could have sounded alarm bells. Former Fed President, Alan Greenspan, famously encouraged self-regulation and dismissed central bank intervention to cool off markets. Just before the crisis, central bankers celebrated their achievement, the Great Moderation, the many years of sustained growth and low inflation in the 2000s. It is now understood that this is when the forces that led to Global Financial Crisis built up. The lesson is that it is always too early to declare victory.
Money growth can be a misleading compass
Much of the transformation of central banking over the last two decades is rooted in new theories developed in the 1970s and 1980s. These theories put a nail in the coffin of the mechanical link between money growth and inflation and in the culture of central bank secrecy. It was recognized that demand for money by the private sector, including by banks, can be highly volatile, which means that money growth can be a very misleading compass. This is indeed what we see since 2007 and it explains why massive increases in central bank balance sheets have not provoked inflation. It also predicts that escaping deflation can be very difficult: creating liquidity does not mean that it will result into increased spending if banks, firms and households want to hold money because they are worried about the economic and financial situation. Wages do not rise when unemployment is high and firms do not raise prices when customers are timid.
Once low (or negative) inflation becomes entrenched, it tends to stay there. And once the interest rate is zero, not much can be done. Negative interest rates are now hotly discussed but what can they achieve? Making it expensive to hold money does not mean that people will rather spend than hold it if they remain concerned about their future economic well being. In fact negative interest rates hurt lenders without really encouraging borrowers, which may worsen the situation.
This calls into question the Holly Grail of low inflation that central banks worked so hard to reach. Now that we are there, doubts are surfacing. Low inflation means low nominal interest rates and the result is that the zero lower bound is never far. Central bankers still react with outrage to the suggestion that 2% is too low a target. They used to be proud to have reached it and they are naturally loath to abandon this achievement. But they have not yet told us how they plan to avoid periodical returns to treacherous zero interest rates. They claim that the current situation is special. Maybe, but this amounts to wishing away the problem.
Tricky communication with the markets
Then there is the opposite challenge. When exiting the zero lower bound, rising interest rates increase debt service costs of governments. Central banks will have to fear destabilizing government budgets. Calling for fiscal discipline is appropriate but not enough. They will need the cooperation of the fiscal authorities, which may, or may not, be forthcoming.
Another theoretical progress has been the realization that monetary policy works largely through its impact on financial market expectations. Shaping these expectations, therefore, is central to bank actions. This is why today’s central bankers develop considerable efforts to inform and prepare markets. Communication has been extensively developed and has led to the publication of forecasts, explicit statements of once secret intentions, publication of minutes and, more recently, the adoption of forward guidance. This is undeniably a progress but once the lid is taken off the box, the appetite for more information appears unbounded.
The problem here is that markets want to know what the central bank intends to do. Some central bankers have resisted this trend by arguing that they do not want to tie their hands with commitments that they can come to regret. No one asks them to make commitments but the fact is that often central banks do not know yet what they want to do. This has been illustrated by the taper tantrum. In June 20113, the Fed warned markets that the era of massive liquidity injections would not last forever. Markets reacted strongly and, when the Fed did not act soon, they complained that this had been a false alarm. The Fed was only worried at the time that markets were not factoring in the certainty that monetary policy would change. The markets wanted more certainty about when tapering would start and how. The Fed just did not know. The answer has been to explain under which conditions taper would start, that is the logic behind the central bank reasoning. Even that turned out to be a source of frustration because central banks do not, and should not, react mechanically. There currently is no answer to this difficulty.
So, we want our central banks to keep inflation at about 2% while ensuring financial stability, to act decisively but not to shake public budgets, to explain their intentions with a high degree of precision when they need to keep their options open. They have saved the world from a Great Depression but they are not superhuman. Maybe we are asking too much and maybe they are trying too hard to please us.