«These unconventional policies created discomfort in many circles, not least among central bankers themselves.»
In 2007-8 central banks, in response to the global financial crisis, entered uncharted terrain, where they have remained ever since. Interest rates were cut to zero and, in some cases like Switzerland, below, something that many supposedly astute monetary experts did not think possible. Balance sheets expanded enormously, as the Swiss National Bank among others went to great lengths to remind us. Monetary authorities intervened in mortgage markets, foreign exchange markets and other dysfunctional post-crisis financial markets. Our central bankers, to paraphrase the prologue to Star Trek, «went where no central bankers had gone before.»
These unconventional policies created discomfort in many circles, not least among central bankers themselves. Central bankers are nothing if not conventional – some would say deeply conservative – people. This has created an instinctual desire on their part to resume business as usual. But that desire in turn raises the danger that they will revert to normal policies before there is again anything resembling a normal economy.
Such warnings are familiar. Not infrequently those sounding them point to 1937-8, when the U.S. Federal Reserve, anxious to resume business as usual, tightened monetary policy prematurely and plunged the economy, just beginning to recover from the Great Depression, into a double-dip recession.
Lots of patience this time – for good reasons
In the face of this dangerous instinct, central banks have by and large shown admirable restraint. The Fed has resisted the temptation to raise interest rates and made clear that its decision will be data driven. When and how fast it normalizes interest rates, it has made clear, will depend on the strength of the economy, which has been uneven of late, to put it mildly, and on the development of wage inflation, prospects for which are hazy.
This stance is appropriate given the unprecedented fall in U.S. labor force participation and consequent uncertainty about how close the country is to full employment. The Bank of England has similarly resisted the temptation to tighten, appropriately given uncertainty, in its case, about the evolution of labor productivity – not to mention about the political composition and policies of the next government. Two exceptions to this generalized display of restraint are the Swedish Riksbank, which raised interest rates in 2010-11 with disastrous consequences, and the Swiss National Bank, which lost patience with its ballooning balance sheet four months ago and abandoned its exchange-rate peg.
This patience displayed by the Fed, the Bank of England and other central banks is all the more striking given how they have come under pressure from politicians to begin raising rates. That these central banks are independent by law is what allows them to resist. Discomfort with the results in turn leads politicians question the desirability of central bank independence, as in the case of the «Audit the Fed» movement in the United States. But what is central bank independence for, one might ask, if not to allow monetary policy makers to displease the politicians?
Irresponsible behavior is the only responsible policy
There is a second question here worth pondering. Why is it that when interest rates are high central banks feel pressure from politicians to bring them down, but when rates are low central banks come under pressure from those same politicians to raise them? One answer is that it is not the same politicians in both cases. There is always a segment of society that is hurt by fluctuations in interest rates – borrowers when rates are high, savers when they are low – and it is their respective representatives, who are not one and the same, who criticize central bank policy at these different junctures.
A second answer is that what we are now seeing in fact is just another illustration of how the financial world has been turned upside down. Students of economics are taught that politicians can’t be trusted to refrain from the trick of cutting interest rates to goose the economy. This is why we delegate monetary policy to an independent central bank immune from this temptation and why we should expect politicians to regularly complain that interest rates are too high.
But the problem at the moment is not the typical one of too much inflation but, rather, too little. And the only way to get more inflation is for the central bank to commit to being «irresponsible» by keeping interest rates low for long, even if the result is that the monetary authorities overshoot their 2 per cent inflation target. Irresponsible behavior, it is said with a tinge of irony, is the only responsible policy under the circumstances.
Macroprudential tasks make independence even more difficult
Politicians do not appreciate irony. They are perturbed by this evidence of central bank irresponsibility, prompting their criticisms of monetary policy. But the fact is that, in our topsy-turvy world of «lowflation,» the central bank is doing the right thing, given the circumstances. Again, this is precisely why it pays to have an independent central bank.
Independence can be even more problematic when the central bank is responsible for macroprudential policy. A lesson of the crisis is that central banks can’t neglect risks to financial stability and simply fall back on their ability to clean up after the fact. Instead they should lean against financial market excesses before they develop and a crisis results, lowering the ceiling on permissible loan-to-value ratios for home purchases when the property market overheats, and cracking down on margin trading when the stock market rises to dangerous heights.
Such measures have pronounced impacts on particular sectors of the economy, which makes delegating them to independent technocrats uncomfortable, in the same way that voters in a democracy would be uncomfortable about delegating to an independent agency the decision of who to tax and how much revenue to allocate to different public spending programs – these being profoundly political decisions. As a result, the more central banks become involved with macroprudential policy, there more arguments we are likely to hear for strengthening political control of their actions and limiting their independence.
Clear mandate – clear words
There is no easy resolution of this dilemma. Some countries like the UK have tried to create a macroprudential regulator with a well-defined mandate separate from the central bank, in its case the Financial Services Agency. But, in the British case, lack of coordination and information sharing with the central bank had disastrous consequences. Can you say «Northern Rock?» Other countries like New Zealand have swallowed their qualms and made both the pursuit of price stability, to be achieved through interest rate policy, and financial stability, to be achieved through macroprudential tools, part of the central bank’s mandate.
How does New Zealand make this politically palatable? The answer, in part, is that it holds the central bank to exceptionally high transparency standards. The Reserve Bank of New Zealand is unusually forthright in communicating exactly what it is doing, how it is doing it, and why it is doing it, all in laborious detail. This allows parliamentarians and commentators to hold the country’s central bankers accountable for their actions in both the political arena and the court of public opinion.
To paraphrase Winston Churchill on democracy, independence for the central bank is the worst possible arrangement except for all the alternatives. But for independence to be politically acceptable, the central bank’s objectives must be well defined. The more numerous those objectives – the broader the mandate – the further the technocrats pursuing it must go in explaining exactly what they are doing and why. The resulting combination of independence and transparency may not satisfy the critics. But, then, nothing will.