Central banks have run out of answers

Central banks are unfairly expected to save the globe's failing economies when monetary policy has already done all it can. The best strategy would be to focus on fiscal stimulus.

Lowy Interpreter

Central banks around the world had a couple of halcyon decades leading up to the global financial crisis, when growth was good and inflation was low. Since 2008 they have taken a lot of criticism. The Bank of England illustrates the fall from grace. So great are the bank's perceived failings that a foreigner has been chosen to be the next governor. 

The BoE may have copped more flack than most, but central banks in most advanced countries have lost their aura of omniscience. The BoE was one of the most enthusiastic inflation targeters, maintaining a laser-intensity focus on the single objective of low inflation. Some see this as the explanation for its lack of interest in the dull job of ensuring financial stability. After the global financial crisis, with high unemployment and the economy in the doldrums, the BoE was seen to be fighting the wrong war, against inflation rather than supporting the depressed economy.

Whatever mistakes were made, the current problem for the BoE (and for the US Fed and the Bank of Japan) is a legacy of the days when central banks seemed all-powerful: there is a public perception that if economic activity is limp, it must be because monetary policy is doing a poor job.

A valid defence would be that monetary policy has done all it can. Just because interest rates are at zero and can't go any lower, it doesn't mean monetary policy isn't working. In fact it is working 'flat to the floor', but it can't overcome the other constraints on growth: over-stretched balance sheets, excessive public and private debt, depressed confidence and, for Europe in particular, the whole gamut of structural problems.

Central banks have certainly been inventive, especially with quantitative easing. But there is little evidence that QE has had much effect via the usual channel of interest rates: if these policies are to work, it has to be via the boost to confidence that comes because central banks are seen to be working hard to foster growth. 

Central banks must always have another trick up their sleeves, such as the Fed's announcement of an unemployment target. This leaves them open to a raft of policy suggestions, of varying coherence.

One set of suggestions is designed to embolden central banks to be more accommodative. In Japan, this means the Bank of Japan should adopt a formal mandated inflation target, set this at some positive number such as 2 per cent and do whatever is necessary to achieve it. For others (the UK and US) the related idea is that the central bank should have a nominal income target, encouraging (or mandating) policy to be eased further until growth has revived.

But there's not much use giving central banks a more expansionary target if they have no way of achieving it. Japanese inflation is stuck around zero, whatever the Bank of Japan does. The UK could replace the inflation target with a nominal income target, but monetary policy is already doing all it can to boost growth.

Other, more eccentric, schemes have been put forward: central banks should buy debt in the market and then government should write this off. It is claimed that this fall in official debt would break the gloom caused by excessive debt. A related idea is that governments should run more expansionary fiscal policies (which may in itself be sensible) but avoid the debt implications by funding the extra budget expenditure through 'printing money'.

Any panacea relying on 'printing money' misunderstands the way monetary policy works. No, printing money would not unleash some Weimar-style hyper-inflation. It's just that it will have little or no impact. The public already has all the currency it wants to hold, so if the central bank tries to add more, the excess money gravitates to the commercial banks which, unwilling to expand their balance sheets further, just deposit it back with the central bank.

The net effect is that both sides of the central bank balance sheet expand, but not much else happens. If government debt were to be written off, it would leave a hole on the asset side of the central bank balance sheet, bankrupting it. This is unlikely to help confidence.

If monetary policy is already doing all it can, what about fiscal policy? Fiscal policy just about everywhere was relaxed in 2009 to boost recovery from the financial crash. But since then policies have been tightened, with fiscal policy in most advanced countries actually subtracting from growth:


The idea that tight fiscal policy would help confidence (the 'confidence fairy' argument) has lost favour, but there is still a widespread view that, for countries with heavy official debt, it is necessary to trim back budget deficits vigorously. A slow economy makes this painfully difficult.

Policy is in a serious bind, with no attractive options. There is a sharp policy imbalance between easy monetary policy and firming fiscal policy, causing increasing international unhappiness about 'currency wars' and beggar-thy-neighbour exchange-rate depreciation.

Whoever is to blame, we are where we are. We need to accept that monetary policy is doing all it can, and not waste too much time on harebrained 'print money' schemes. The focus should be on the opportunity for fiscal policy to maintain a stimulatory stance in those countries (such as the UK and the US) where historically low yields in bond markets demonstrate that there is room for more official debt.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.

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