These are uneasy times in central banking. The big beasts of the profession who met this month in Jackson Hole, Wyoming, were once the ultimate masters of the universe. Now they are nagged by self-doubt.
Four years on from the worst moment in the financial crisis, unemployment remains high across the developed world and the global economy is losing momentum. Risks from the eurozone and US fiscal policy loom large.
After the European Central Bank's decision to counter speculation of a euro break-up by proposing to buy short-dated government bonds in peripheral European countries, the US Federal Reserve must this week decide how best to help an economy its chairman described as "far from satisfactory”.
Yet the deeper central bankers delve to solve the developed economies’ woes, the more some in the profession fret.
"I am a little – maybe more than a little bit – worried about the future of central banking,” James Bullard, president of the Federal Reserve Bank of St Louis, said in a Financial Times interview at Jackson Hole. "We’ve constantly felt that there would be light at the end of the tunnel and there’d be an opportunity to normalise but it’s not really happening so far.”
"What I’m worried about is this creeping politicisation,” Bullard said. Pressure from politicians is often for central bankers to do more.
The biggest worry on display at Jackson Hole was whether these bureaucrats, sitting at the heart of every mature economy, still have the power to influence demand now that interest rates cannot fall much further. Lurking behind many debates was this question: if central bank policies are so effective, why is the global economy not growing faster?
For an answer, many reach for the insights of Carmen Reinhart and Kenneth Rogoff, who described how recoveries after a financial crisis tend to be painful and slow in their book This Time is Different .
Yet all of the central banking activism of the past four years is based on the belief that while this crisis may be similar to those of the past, there must be a cocktail of policies that will make the recovery different this time.
That faith is coming into question, however.
"I’ll confess that when that book came out I was a little sceptical about whether this was going to happen in the United States but they were right and I was wrong,” said Alan Blinder, a Princeton economics professor and former vice-chair of the Fed, from the platform at Jackson Hole. "We haven’t deviated that much from the pattern of a Reinhart-Rogoff recession.”
There are a few possible reasons why repeated rounds of central bank communication and quantitative easing, as the policy of buying long-dated assets in an effort to drive down long-term interest rates is known, have not brought about a strong recovery.
One is that something structural has changed to hold back growth. Speaking from the floor in Wyoming, Donald Kohn, another former Fed vice-chair now at the Brookings Institution, raised the possibility of "something deeper going on”, perhaps related to savings behaviour or the changed distribution of income between labour and capital.
Another is that the tools work, even if current conditions blunt their effect. If there are new headwinds, then the answer is to use them more aggressively. That is the mainstream view among central bankers.
"A balanced reading of the evidence supports the conclusion that central bank securities purchases have provided meaningful support to the economic recovery while mitigating deflationary risks,” Ben Bernanke, the Fed chairman, said in his remarks at Jackson Hole.
A third possibility is perhaps the most alarming for central bankers such as Bernanke, who have staked their reputations on successive rounds of quantitative easing: that it simply does not work.
In his presentation at Jackson Hole, Columbia University professor Michael Woodford presented evidence that, to the extent asset purchases have lowered long-term interest rates in the US, their effect was indirect. People saw the purchases as a signal that short-term interest rates will stay lower for longer, he argued.
That paper gave the assembled central bankers some food for thought, but will have little bearing on their immediate policy choices.
After August payroll growth came in at 96,000 jobs – below estimates and scarcely enough to allay Bernanke’s "grave concern” about the stagnation of the labour market – the Fed has three options to consider when it holds its two-day meeting this week.
It could buy more assets in another round of QE. It could extend its forecast of low interest rates beyond the current date of late-2014. Or it could cut the 25 basis points of interest that it pays to banks on their excess reserves.
Bernanke spent most of his speech on the pros and cons of more asset purchases, and QE3 remains the Fed’s main option for a substantial stimulus. One idea that has gained a lot of ground on the rate-setting Federal Open Market Committee is open-ended action: buying a certain amount a month or meeting with no fixed target.
The difficulty is how to define a goal. More hawkish members of the FOMC want discretion to stop buying assets at any meeting. Doves want a pledge to keep buying until a condition for improvement in the economy has been met. They would want that condition, most likely in words and not numbers, to imply a substantial QE3 unless the economy picks up.
A similar issue applies to the alternative of extending the Fed’s forecast of low interest rates into 2015. Doves would not want it interpreted simply as a prediction that the economy will stay weak. Instead, they would want to signal a change in the Fed’s behaviour, and that it plans to keep rates low even as the economy picks up.
What the Fed does will depend on whether the committee can agree on such a condition for improvement in the economy. If it cannot, then a straightforward chunk of asset purchases is more probable.
The last option, of cutting interest on reserves, has become somewhat more likely since the ECB cut its overnight deposit rate to zero without causing an apocalypse in the financial system. Few Fed officials think it would make much difference, however, and some continue to see modest risks. Certainly, it is unlikely except in conjunction with other actions.
But it is not just the Fed that is grappling with difficult policy issues. The ECB is faced with the threat of the disintegration of the single currency and a painfully slow international political process.
Its latest response has been to promise to buy bonds of European countries that have accepted potentially sweeping conditions of a program of fiscal consolidation and economic reform – potentially in unlimited quantities. Buying only securities with short maturities, the ECB sees this as a monetary policy operation designed to bring short-term interest rates back into harmony across the eurozone. It wants to remove the devaluation risk premium in certain countries’ government bonds.
But the agreed operation – outright monetary transactions – is extremely controversial, with the Bundesbank, Germany’s ultraconservative central bank, viewing them "as being tantamount to financing governments by printing banknotes”. In addition, it sees the danger that if things go wrong, the potentially unlimited bond purchases "may ultimately redistribute considerable risks among various countries’ taxpayers” in the eurozone.
In Britain, too, the Bank of England, has moved away from buying government bonds in the hope of reducing long-term interest rates to seeking to intervene more directly to bring down the borrowing costs of households and companies.
Like the Fed, it insists QE is working. But the BoE is placing a lot of faith in the idea that by providing cheap funding for banks on the condition that they step up lending to the real economy, it will boost demand.
But there are other suggestions out there, some getting rather close to an arbitrary line across which central bankers fear to tread: the one that divides monetary from fiscal policy.
Some see value in pre-commitment to policy stimulus until it works. Woodford argues for commitment to keeping interest rates low for a period that is linked to the performance of the economy. By holding rates down, even as inflation rises somewhat above a target such as the Fed’s 2 per cent, a central bank could make up for the period when the ideal interest rate would have been lower than zero.
And a rising number of voices, often those not so close to policy making circles but privately including some within the club, suggest central bankers could become more radical still. Central banks are being urged to buy assets other than government bonds, breaking a taboo that they should not accept credit risk on to their balance sheet.
While none of this is palatable, it is better than the really radical ideas that may gain traction if economic malaise lingers, such as the infamous "helicopter drop”. A central bank could simply credit the bank accounts of the citizens in a country, directly boosting incomes for a period and encouraging them to spend.
A variant of this proposal is to finance the spending of government temporarily, allowing it to cut taxes for a period. This monetary financing of government is outlawed in Europe for the good reason that when it has previously been tried direct money-printing has ended in hyperinflation. An economy cannot provide sufficient goods and services to match all the newly minted cash at prevailing prices, and inflation takes hold.
Being conservative by nature, no central banker wants to consider ideas that have been off limits for decades. But there are rumblings afoot.
The textbook is not providing the answers. When that happens more radical options come to the surface.
Copyright the Financial Times 2012.