The limits of central banking

Prior to the great crash of 2008, investment bankers were – at least in their own minds – regarded as masters of the universe. No more. As their fancy clothes, woven from cloth so fine that the eye could not see it, were revealed to be non-existent, they were usurped by central bankers who used the muscle of zero interest rates and the power of their balance sheets to rescue the global economy from meltdown. More than a decade later and questions are increasingly being raised as to whether the tools which were deployed in 2009, and which are still in use today, are fit for purpose. Worse still, central bankers can be forgiven for wondering whether they have been hung out to dry by politicians who seem increasingly unwilling to provide the necessary degree of support to allow them to do their job effectively.

The BoE: A relative oasis of calm

The BoE finds itself in a slightly easier position than either the Fed or ECB although it has been sucked into the political fallout from Brexit, and with a new Governor set to take over from Mark Carney in just over seven months’ time, his successor may face an unenviable task in steering a post-Brexit course. One criticism that can be levelled at the BoE is that its forward guidance policy, which has often hinted at rate hikes which never materialise, may be about to miss the mark again. Indeed, recent hints that the next rate move will be upwards flies in the face of economic data, which point at below-target inflation in H2, and trends in the global monetary cycle. In common with many central banks, it has failed to create space to ease policy in the event that the economy cools. Central bankers dismissed this line of reasoning when conditions were propitious for a rate hike in 2014, and whilst Brexit has complicated the picture, it is hard to avoid the feeling that the BoE will go into the next economic slowdown with precious little ammunition.

The ECB: Taking flak from all sides

Across the channel, the ECB’s situation is even more desperate. Despite having cut the main refinancing rate to zero and the deposit rate to -0.4% whilst boosting its balance sheet to almost 40% of GDP, a meaningful economic recovery in the euro zone remains elusive and inflation continues to undershoot the ECB’s target. There are now expectations that the ECB will counter current economic conditions with even more monetary easing – a view that Mario Draghi reinforced this morning. The ECB is all that has stood between the integrity of the euro zone and disaster: It has done all the policy easing whilst governments have stood idly by without deploying any of the fiscal ammunition at their disposal. Draghi, who will leave his post as ECB President in October, deserves great credit for doing “whatever it takes” to keep the show on the road. Those who have criticised Draghi, including Bundesbank President Weidmann and various northern European politicians, should take some time to reflect on what might have happened in 2012 had the ECB not opened the taps.

However, the criticisms levelled by Weidmann at least come from someone with skin in the game. Draghi’s hints of further easing were met today by a Twitter blast from the self-styled stable genius in the White House accusing the ECB of weakening the euro against the dollar “making it unfairly easier for them to compete against the USA. They have been getting away with this for years, along with China and others.” This sends two messages: (i) Trump is a lobster short of a clambake and more seriously (ii) he threatens to open a new front in the war of economic nationalism, dragging the euro zone into a conflict which has hitherto been confined to the US and China.

The Fed: Managing in the presence of a stable genius

Imagine, therefore, what it must be like to be in Jay Powell’s shoes. The Fed has done what the textbooks recommend by taking away some of the excessive stimulus as the economy recovered. Unfortunately, Trump has determined that the Fed is the main obstacle to the ongoing US upswing and has been excoriating the FOMC for not cutting rates. Worse still, a story surfaced today suggesting that in February the White House explored the possibility of stripping Powell of his chairmanship and leaving him as a Fed governor. This is an unprecedented attack on the independence of the central bank. Not that politicians have refrained from dictating to the Fed in the past. One story, recounted by Reuters journalist Andy Bruce, recalls instructions from the White House to former Fed Chairman Paul Volcker ordering him not to raise interest rates during an election campaign. “Volcker, knowing the command was illegal, left the room without saying anything.” But the attacks on Powell are far worse – and lest we forget, he was appointed by Trump in 2018 with the endorsement that “He’s strong, he’s committed, he’s smart.”

The FOMC has recently revised down its assessment of the need for future rate hikes and it is increasingly likely that the next move will be a cut. It is not clear whether this is a direct response to the President’s attacks or whether the Fed has misread the economic outlook so badly that it feels the need to ease policy rather than tighten, as it believed necessary at the start of the year. However, to the extent that the Fed may be trying to head off further attempts by Trump to impose his own candidates on the FOMC, following the failed attempts to appoint Stephen Moore and Herman Cain, it is likely that the Fed is acceding to the pressure. Perhaps the Fed’s view is that by throwing a few small scraps in Trump’s direction, it will be better placed to maintain its independence in the longer run. But whilst it has long been evident that the Fed is not as free from political influence as it portrays, selling out in such an obvious manner could have the reverse effect by undermining its perception of independence in the market.

Dealing with the lower bound

The common themes across the central banking universe are that they are running out of tools to deal with the low-inflation world which we inhabit today, whilst also coming under much greater pressure to deliver on politicians’ objectives. With regard to instruments at the central banks’ disposal once interest rates reach the lower bound, there are essentially just three: QE, forward guidance and driving interest rates into negative territory as the ECB has done. At a recent Fed monetary policy conference (a so-called “Fed Listens Event” which deserves more in-depth coverage another time), a paper by Sims and Wu highlighted that QE is the most useful tool of the three; forward guidance depends on a central bank’s credibility (cf. the Fed’s position) and that negative rates become less effective the larger is the balance sheet (cf. the ECB’s position).

With central banks having tried all of these instruments to a greater or lesser degree, it is difficult to avoid the conclusion that we are near the end of the road with regard to monetary policy. After all, central banks have largely failed to stimulate inflation and there are serious concerns that if the floodgates are opened even further, this will serve only to store up greater problems in the future. Indeed, I have long argued that we will only know the full impact of low interest rates in the very long term once we see what our pensions are worth. What this does suggest is that much more of the burden of managing the economy will have to fall on fiscal policy in future – an issue I will deal with in my next post. The good news is that this will at least take central bankers out of the firing line and make politicians take some responsibility for what they should have been doing all along.