Two decades ago, monetary policy seemed to have reached the 'end of history': it had evolved an optimal format from which no further refinement seemed necessary. The two key elements were a focus on low inflation and central bank independence as the means of separating monetary policy from political pressure.
Now both those characteristics are being questioned.
In the UK, the newly appointed head the Bank of England is a foreigner who is universally thought to be 'softer' than the current governor. He has also shown some interest in alternatives to inflation targeting. In Japan, the BoJ has responded to political pressure from the new government by raising its inflation objective and promising to embark on more concerted quantitative easing. A more dovish governor is in prospect when the current governor finishes his term in April.
In the US, Fed Chairman Bernanke has been innovative in loosening policy, with low interest rates and expansive QE. As well, he has now set an unemployment objective, as a commitment to maintaining an accommodative stance until there is demonstrable progress in restoring full employment.
All this has been widely reported as marking the end of the era when central banks stood tall and strong in resisting politicians' attempt to distort macro policy for short-term political gains. It is, however, a more complex story than that.
Central bank independence is important because of the perception that governments will always be in favour of accommodative monetary policy. But this concern has not been relevant in the period since the financial meltdown of 2008. Certainly, central banks have been very ready to put in place accommodative policies, but this was their own reaction to the parlous economic circumstances, not a response to governmental pressure.
Central banks in advanced countries were quick to lower interest rates to near-zero levels. Both the US Fed and the Bank of England have, on their own initiative, expanded their balance sheets hugely with QE operations. The Bank of Japan, for its part, has maintained its long-standing accommodative stance. If the Bank of Japan's efforts seem less active, this reflects its well-based scepticism that more QE or a higher inflation target will make much difference.
Thus nothing in the experience of the past five years would suggest that central banks have bowed to political pressure. Nor is the replacement of the governors in the UK and Japan with more dovish candidates a demonstration that the era of central bank independence has finished. Governments have always had the right to appoint central bank governors of their choice when the incumbent's term expires.
Routinely, the setting of the inflation target has been done either by the government or in concert with it. Shifting to a different target (for example, nominal GDP instead of a simple inflation number) is not a revolutionary idea; it was fully explored as an alternative when inflation targets were first devised. And while many would regard a GDP target as an inferior approach, it would formalise a message that central banks already accept: output is important as well as inflation.
More generally, the independence enjoyed in recent decades has always been conditional, not absolute. Absolute and irrevocable independence would be a serious 'democratic deficit'.
All that said, there is a potential issue here. There was a third key element in the 'end of history' framework: governments should not require central banks to finance budget deficits. Budget discipline requires that deficits should be funded by bond sales to the public.
This seemed straightforward enough until the 2008 financial crisis made QE a routine part of monetary policy. The key principle of budget funding has not been transgressed so far. After all, the QE operations in the UK and the US have been initiated by the central banks themselves. But if a central bank already voluntarily buys government bonds in the market to implement monetary policy objectives, it is only a small further step to asking the central bank to fund bigger budget deficits directly, taking the debt directly onto its balance sheet.
The proponents of this idea argue that this would allow more expansionary fiscal policy without the drawback of pushing up the interest rate on government debt or risking adverse market reaction to a higher government debt level. Others argue that QE has become so large that it is de facto part of the budget and this reality should be recognised by ending the fiction of independence.
It is premature to announce the death of the successful monetary policy framework of the past two decades. The huge challenge of the 2008 crisis pushed US and UK central banks to the edge of what they can and should do. These extraordinary circumstances justify the risks that the subtle balance between central banks and governments would be undermined.
The time will come for re-building the credibility of this framework. If central banks talk and act as if they are in the pocket of the current government; if the operational objective is set so loosely as to leave inflation expectations unanchored; or if central bank bond purchases are directed at funding the budget deficit rather than influencing market interest rates, then the framework which performed well for two decades will, indeed, have reached the end of its usefulness.
Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.
Has monetary policy been hijacked?
The monetary policy framework of the past two decades is not defunct. But if central banks act as if in the pocket of government, or direct bond purchases at budgets rather than market interest rates, it soon will be.
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