The Federal Reserve’s Jackson Hole conclave may be dominated by technical discussions of abstruse concepts such as the non-accelerating inflation rate of unemployment, but one also detects an undercurrent of nostalgia. Central bankers are wistful for a past when monetary policy was conventional and its makers could focus on adjusting interest rates.
Specifically, the assembled are eager to end the extended period of zero interest rates. They want to wind down their purchases of mortgage-backed securities and asset-backed commercial paper. These programmes involve interventions in financial markets. They may have undesirable side effects, encouraging investors to over-reach in the search for yield. Their benefits can be questioned. Policy makers are anxious to bring them to an end.
This instinct has led to calls, not least in the Federal Open Market Committee, for the US central bank to raise interest rates. It has prompted a noisy minority within the Bank of England’s Monetary Policy Committee to do likewise. It has discouraged the European Central Bank from pursuing unconventional policies of its own.
It is a dangerous sentiment, this yearning for an idealised past in which central bankers could focus on moving rates by a notch or two, this way or that – much as a physician adjusts the drugs administered to a patient with high blood pressure. For as long as they have existed, central banks have been in the business of buying and selling not just Treasury bonds but also commercial paper and sundry other corporate obligations.
Making monetary policy has always been a complicated craft. Whenever there was an effort to reduce the art of central banking to a simple formula, be it an exchange rate target under the gold standard or an inflation target more recently, other problems – such as threats to financial stability – have had an awkward tendency to intrude. They will undoubtedly do so again. That should be a caution to those seeking to tie the Fed to algorithms such as the Taylor rule, a simple formula that purports to say how interest rates should respond to changes in inflation and output.
Why then did modern central bankers embrace the mistaken notion of mechanistic monetary policy? Part of the explanation is serial malpractice by central banks in the 1970s and 1980s. If policy makers could not be trusted to exercise discretion wisely, better to bind them to a simple rule.
Another factor was the increased sophistication of analytical models and methods. Fed staff first undertook a project using mathematical techniques adapted from engineering science to guide policy in the 1970s. Others quickly followed, believing that if the structure of the economy could be represented as a set of fixed mathematical relationships, interest rates could easily be fine-tuned.
Milton Friedman was among the sage observers who were careful not to take the models too literally. As early as the 1940s, he understood that uncertainty about the structure of the economy was too great. But the spurious precision of these techniques, and the false scientism to which they gave rise, encouraged central bankers to believe that their job was to implement an optimal feedback rule, barely more complex than the one that switches on the compressor before the contents of the icebox begin to melt.
Such an idealised world never existed and never will. Financial innovation marches onwards. The more financially sophisticated the world, the more difficult it is for policy makers to draw the line between money and credit. Threats to financial stability are like a jack-in-the-box. You can close the lid, but you cannot keep the jester down.
It is fanciful to suppose that central banks can regulate the economy while responsibility for financial stability is hived off to some entirely separate government agency. Nothing better demonstrates this than the UK’s experience with the Financial Services Authority, the regulator whose disastrous 12-year tenure culminated in the run on Northern Rock.
The question is where to draw the line. If it is appropriate for central bankers to warn against excessive risk taking and dubious financial practices, should they also weigh in on fiscal policies? On structural reform? On income inequality?
The temptations are great. Before weighing in on an issue, central bankers should apply three tests.
First, do they have special expertise? The BoE was put in charge of rationalising the British textile industry in the 1920s, and the results were not great. The central bank, as a bank, has special expertise on issues of money and credit, but not obviously elsewhere. It should mind the gap.
Second, the issue in question should have big implications for the conduct of monetary policy. For instance, given the high level of public debts in Europe, failure to reduce them could place intense pressure on the ECB to inflate. The ECB could reasonably weigh in on the fiscal problems of Europe’s heavily indebted governments. This, however, is not a licence to pontificate on fiscal policy generally.
Third, is the issue one the central bank can address without losing sight of its fundamental responsibility for price and financial stability? The ECB has resisted loosening monetary policy for fear that such a stimulus would reduce the perceived urgency of reforms. This misguided priority has thrust Europe to the verge of deflation. It is a prime example of what a central bank should not do.
Knowing where to draw the line is difficult. Like it or not, central banking is still more art than science.
Barry Eichengreen is author of ‘Hall of Mirrors: The Great Depression, the Great Recession, and the Uses – and Misuses – of History’
It is a dangerous sentiment, this yearning for an idealised past in which central bankers could focus on moving rates by a notch or two, this way or that – much as a physician adjusts the drugs administered to a patient with high blood pressure. For as long as they have existed, central banks have been in the business of buying and selling not just Treasury bonds but also commercial paper and sundry other corporate obligations.
Making monetary policy has always been a complicated craft. Whenever there was an effort to reduce the art of central banking to a simple formula, be it an exchange rate target under the gold standard or an inflation target more recently, other problems – such as threats to financial stability – have had an awkward tendency to intrude. They will undoubtedly do so again. That should be a caution to those seeking to tie the Fed to algorithms such as the Taylor rule, a simple formula that purports to say how interest rates should respond to changes in inflation and output.
Why then did modern central bankers embrace the mistaken notion of mechanistic monetary policy? Part of the explanation is serial malpractice by central banks in the 1970s and 1980s. If policy makers could not be trusted to exercise discretion wisely, better to bind them to a simple rule.
Another factor was the increased sophistication of analytical models and methods. Fed staff first undertook a project using mathematical techniques adapted from engineering science to guide policy in the 1970s. Others quickly followed, believing that if the structure of the economy could be represented as a set of fixed mathematical relationships, interest rates could easily be fine-tuned.
Milton Friedman was among the sage observers who were careful not to take the models too literally. As early as the 1940s, he understood that uncertainty about the structure of the economy was too great. But the spurious precision of these techniques, and the false scientism to which they gave rise, encouraged central bankers to believe that their job was to implement an optimal feedback rule, barely more complex than the one that switches on the compressor before the contents of the icebox begin to melt.
Such an idealised world never existed and never will. Financial innovation marches onwards. The more financially sophisticated the world, the more difficult it is for policy makers to draw the line between money and credit. Threats to financial stability are like a jack-in-the-box. You can close the lid, but you cannot keep the jester down.
It is fanciful to suppose that central banks can regulate the economy while responsibility for financial stability is hived off to some entirely separate government agency. Nothing better demonstrates this than the UK’s experience with the Financial Services Authority, the regulator whose disastrous 12-year tenure culminated in the run on Northern Rock.
The question is where to draw the line. If it is appropriate for central bankers to warn against excessive risk taking and dubious financial practices, should they also weigh in on fiscal policies? On structural reform? On income inequality?
The temptations are great. Before weighing in on an issue, central bankers should apply three tests.
First, do they have special expertise? The BoE was put in charge of rationalising the British textile industry in the 1920s, and the results were not great. The central bank, as a bank, has special expertise on issues of money and credit, but not obviously elsewhere. It should mind the gap.
Second, the issue in question should have big implications for the conduct of monetary policy. For instance, given the high level of public debts in Europe, failure to reduce them could place intense pressure on the ECB to inflate. The ECB could reasonably weigh in on the fiscal problems of Europe’s heavily indebted governments. This, however, is not a licence to pontificate on fiscal policy generally.
Third, is the issue one the central bank can address without losing sight of its fundamental responsibility for price and financial stability? The ECB has resisted loosening monetary policy for fear that such a stimulus would reduce the perceived urgency of reforms. This misguided priority has thrust Europe to the verge of deflation. It is a prime example of what a central bank should not do.
Knowing where to draw the line is difficult. Like it or not, central banking is still more art than science.
Barry Eichengreen is author of ‘Hall of Mirrors: The Great Depression, the Great Recession, and the Uses – and Misuses – of History’
