Central banks: A balancing act

One of the issues which central banks are going to have to face up to at some point in future is the question of whether and how to reduce their balance sheets, which have been swollen by the huge purchases of financial assets under the QE programme. The balance sheet of the US Federal Reserve, for example, now stands at $4.5 trillion, which is roughly 25% of GDP compared to a figure around 7% at the start of the financial crisis, with the expansion comprised primarily of Treasury and Mortgage Backed Securities (MBS).

From the outset, central banks were clear that it was the stock of assets held on the balance sheet which was important for the purpose of injecting additional liquidity, not the rate at which they were purchased. This was because the purchase of bonds has a counterpart on the liability side of the balance sheet in the form of a credit to the banking system (excess reserves), representing the transfer of funds from the central bank to the seller of the bond. To the extent that the banking system creates liquidity as a multiple of the deposits in the system, this rise in banking sector deposits held at the central bank is what ultimately determines the pace of liquidity creation in the wider economy. The Fed ceased buying assets in October 2014. But as existing bonds matured so they ceased to be an item on the asset side. In order to prevent an unintended decline in the balance sheet, it was forced to rollover maturing securities which means that it is still actively buying assets, albeit on a smaller scale than previously.

But the Fed has indicated that it will ultimately shrink its balance sheet, and thus impose an additional degree of monetary tightening, but not until “normalization of the level of the federal funds rate is well under way.” Whilst markets are concerned about when this is likely to happen, a more interesting question is how rapidly it is likely to proceed. It is widely anticipated that the Fed will allow its maturing bonds to simply disappear from the balance sheet – a form of passive (or less active) reduction compared to the alternative of actively selling bonds. Ben Bernanke (amongst others) has argued that the Fed should simply aim for a given size for the balance sheet and allow the maturing of existing bonds to continue until the desired level is reached.

It is pretty likely that wherever we do end up in the longer-term, the balance sheet will not go back to pre-2008 levels. With Fed estimates indicating that demand for currency is likely to reach $2.5 trillion over the next decade, compared to $1.5 trillion today (and $900bn before the crisis), it is evident that the absolute size of the balance sheet in the longer term will be far higher than it was 10 years ago. In one sense, this makes the Fed’s task easier because it will not have to run it down so far. Indeed, in a nice little blog piece in January, Ben Bernanke reckoned that the optimal size for the balance sheet over the next decade is likely to be in the region of $2.5 to $4 trillion. If indeed the optimal size is close to the upper end of the range, it implies that the degree of reduction will be very small indeed, and would have little impact on markets which fear that a rundown of the balance sheet will result in a sharp rise in interest rates.

This absence of a dramatic reduction would be in keeping with past historical evidence. Analysis by Ferguson, Schaab and Schularick which looks at central bank balance sheets over the twentieth century, argues that prior to the onset of the financial crisis balance sheets relative to GDP were very small relative to the size of the economy compared to longer-term historical experience. They also note that “outright nominal reductions of balance sheets are rare. Historically, reductions have typically been achieved by keeping the growth rate of assets below the growth rate of the economy.”

Perhaps what this all means is that we should stop worrying too much about the potential impact of big central bank balance sheet reductions. But it does mean that a more permanent change in the conduct of monetary policy is about to take hold. Prior to 2008, central banks controlled access to demand for banking sector liquidity by regulating its price via the overnight rate. Now that liquidity is plentiful, both the Fed and ECB operate a floor system by controlling the rate they pay banks on reserves held with the central bank. As recently as November 2016, the FOMC described the current floor system as “relatively simple and efficient to administer, relatively straightforward to communicate, and effective in enabling interest rate control across a wide range of circumstances.”

Such a policy requires the banking system to be saturated with reserves and implies that the balance sheet may be about to assume a more important role in the conduct of policy as it becomes the tool via which bank reserves are supplied. So maybe central bank watchers will spend less time worrying about the policy rate in future and we will go back to the old-fashioned job of trying to predict how much liquidity central banks are injecting into the market. Now that takes me back a bit …

Keep talking

Last week, Bank of England chief economist, Andy Haldane, gave one of his excellent speeches which on this occasion provided a tour-de-force on the topic of central bank communications (here). He pointed out that just over twenty years ago, central banks were still concerned to maintain their mystique. Indeed, I well remember from my student days that much of the contemporary economic literature was focused on the extent to which central banks could influence policy by withholding their reaction functions from public view. Today, however, central banks are much more open institutions. According to Haldane, the BoE’s communications last year amounted to 4.5 million words, which is pretty impressive even by the standards of the Twitter age.

But what is the point of all this communication? Central banks in democratic societies believe that they have a duty to get their message across to as many citizens as possible. There is a certain logic to this: After all, even though most central banks are independent – albeit to varying degrees – they still have a duty to explain their actions to the people in whose name they are acting. One of the pioneers of such communications was the Bank of Canada in the 1950s whose governor, James Coyne, viewed BoC speeches and other reports as devices to explain monetary policy to the public but also as a tool to underpin the central bank’s credibility and reputation. Karl Blessing, President of the Bundesbank from 1958 to 1969, similarly argued that: “A central bank which never fights, which at times of economic tension never raises its voice ... will be viewed with mistrust.”

Of course, much of this effort is wasted if those at whom the information is aimed do not understand the message being conveyed. The BoE is acutely aware of this problem and it was highlighted in a post by Jon Fullwood on the Bank Underground blog last October (here) which demonstrated that BoE texts generally have a Grade 14 reading level, which is equivalent to that required by a second year university student. In any case, even if the message is understood, it may not be accepted – particularly at a time when trust in institutions is low. This raises an important question of whether trust and understanding are inextricably linked. It is likely, as Haldane points out, that  “change in the nature of public language – shorter, simpler, shriller – puts an even greater premium on institutions making themselves understood … That means speaking in words and sentences that land rather than levitate with the public, that connect rather than divide public opinion, that illuminate rather than darken public debate.”

Some might say that this is akin to dumbing down the message. But there is nothing wrong with a little dumbing down if it gets the message across – after all, those with more interest in the subject matter can always engage at a higher level if they have the desire to do so. In any case, the actions of managing the economy do not have to change at all – merely the way in which they are communicated. Central bank communication can, of course, be taken to extremes as Richmond Fed President Jeff Lacker found out this week following the discovery that he had communicated sensitive market information to an analyst (prompting his immediate resignation). Sometimes the phrase “too much information” takes on a new meaning.

But despite central bank efforts to ensure that they communicate as effectively as possible, sometimes I wonder whether they overdo it. Should central banks worry overly much about whether their every last utterance is understood by the ordinary citizen? A certain degree of financial literacy amongst the general public is desirable but many citizens manage just fine without much knowledge about what central banks are up to.

As for a market perspective, it sometimes feels like Say’s Law is in operation, with supply creating its own demand. In other words, the more information central banks give out, the more markets seem to want. I would not be at all surprised if at some point in the near future there are calls for live broadcasts of central bank discussions, or at the least a live Twitter feed. That said markets are much more trusting of central banks today. Gone are the days when markets used to interpret central bank actions as being motivated by any informational advantage which they enjoyed. This is partly the result of greater central bank openness – after all, the Fed has gone out of its way to avoid a repeat of the actions which prompted the bond crash of 1994. But it is also to do with the communications revolution which means that markets and central banks operate with similar information sets.

Ironically, economists were originally employed in financial markets to interpret the actions of opaque central banks. I well remember a TV interview around 1990 in which Gavyn Davies was asked what the 1990s would hold for the City. His answer was something to the effect that he did not know but he ventured that by the end of the decade there would be fewer economists employed than there were at that time. He was wrong about that: But with central banks providing much more information and comment than they used to, it is possible that he will only be wrong about the timing.

Don't make it personal

Depending on your point of view, the decision by BoE Governor Carney to step down in June 2019 is either a one year extension of his term, having previously said he would leave in 2018, or he is leaving two years earlier than the mandated eight years. Either way, at least we have some clarity on where we stand ahead of the release of tomorrow's Inflation Report.

The whole affair does raise a number of issues regarding the role of central banks. For one thing, does it even matter whether Carney stays a year longer? His decision is based on the notion that the Brexit negotiations will be completed by that point and he will thus have steered the BoE through this critical period. That said, the hard work will only just be beginning. So whilst an extra year is welcome, in reality he probably only has a couple more years of any real authority. Once he enters the last year of his contract the markets will be less willing to hang onto his every word. Just ask Sir Alex Ferguson, who announced he would retire as Man United manager in 2002 but his team stopped listening to him and they underperformed as a result. And as we now know, Ferguson reversed his position and stayed for another 11 years.

Then there is the ongoing saga regarding the personification of central banking. Just over twenty years ago, central banks were secretive places where senior officials went out of their way to be anonymous. Alan Greenspan put a stop to that, of course. But the Fed has done just fine since he left. Indeed, Greenspan's reputation, which was such that Republican senator John McCain once remarked that he would like to  “prop him up and put a pair of dark glasses on him and keep him as long as we could," has since taken something of a beating.

Carney himself was hailed as the "rock star" central banker. But his decisions have been far from flawless and his forward guidance policy got off to a very shaky start, although he redeemed himself in many people's eyes with his conduct during the Brexit campaign. However, personification of policy issues is to miss the point. Central banks are not about one man (or woman). They are organisations with long institutional memories, staffed with competent people, and in theory it should be possible to find a few possible replacements from amongst the senior members of staff.

The media made a big thing of the extent to which Carney's reluctance to commit for the full eight years was the result of increasing conflict with the new administration. There may indeed be something to that. The Times reports today that he was "incensed by the criticism of the global elite ... because he saw it as an attack personally." There is no doubt that the government badly handled many economic issues at the Conservative Party conference last month. Thus Carney's extension, whilst not the full three years which the government undoubtedly wanted, represents a compromise which allows him to say he is not cutting and running during the worst of the Brexit negotiations. It also makes Carney look like a guy who hangs around when the going gets tough - no longer the unreliable boyfriend, as he was once memorably described - which is likely to serve him well in future.

Indeed, the small matter of his own personal ambitions may have played a role in all of this. A Canadian election is scheduled no later than October 2019 and Carney would then be well placed to return home to claim a senior political position, should he wish to pursue such a career as often claimed. He would also be well placed for a slot as head of the IMF once Christine Lagarde's term expires in 2021, with the horse trading likely to start well before that. These factors may have been the personal decisions which Carney was referring to when asked last week about his future as BoE Governor.

The big question is how crucial will Carney be to the UK's immediate economic future. There is no doubt that he is a big beast in the economic and political spheres in which he will have to operate. He is far from indispensable but for a government short of serious economic talent, he gives it some cover as it tries to figure out how to move forward on Brexit. Carney has demonstrated his willingness to stand up to preserve central bank independence. This may not be popular in certain sectors of government but it is what he is paid for. As it happens, I do believe that easy monetary policy is more of a hindrance than a help at this stage of the cycle. The difference between myself saying that, and Theresa May expressing the same sentiment, is that I am arguing for a change of the policy mix between fiscal and monetary. The PM made no such claims.

Whatever else Carney does over the next couple of years, the real fun will be watching him take on his Brexit critics. The likes of Jacob Rees-Mogg will undoubtedly be critical of Carney's decision to give the job another year but sniping is Rees-Mogg's default position. Ultimately Carney's position has become highly politicised thanks to the Brexit shenanigans and over the next couple of years that position is unlikely to change.

Is central bank independence all it is cracked up to be?

Regular readers will know that I am not a fan of combating the current economic ills purely via easier monetary policy and I do believe that both the Fed and BoE have been rather tardy in their monetary responses in recent years. Arguably, the Fed could have raised rates at a faster pace, and there was a window of opportunity for the BoE to have done so in 2014 as the unemployment rate breached the threshold levels which were seen as an obstacle to action. Indeed, a widespread belief is gaining ground that further monetary easing is likely to be counterproductive, given the distortionary effects this has on markets and the distributional impacts on savers. However, we have given central banks operational independence to focus on an inflation mandate and we have to leave them to get on with that job.

This makes the recent spat between UK politicians and the BoE Governor all the more remarkable. Prime Minister Theresa May noted a couple of weeks ago that, “there have been some bad side effects” from the current monetary policy “with super-low interest rates and quantitative easing” and that “a change has got to come.”  This prompted Governor Carney, who has already faced fierce criticism from pro-Brexit MPs regarding his impartiality during the referendum campaign, to respond that he would not “take instruction” from politicians about how to handle policy issues. Politicians have returned fire, and then some, with former Conservative leader William Hague writing yesterday that “eight years after the global financial crisis [central banks] are still pursuing emergency policies that are becoming steadily more unpopular and counterproductive. Unless they change course soon, they will find their independence increasingly under attack.” Whilst a good debate is healthy, that is tantamount to a threat. And one which most economists find unacceptable.

For one thing, central banks are not charged with distributional policy issues. That lies solely in the realm of government. If governments have not used the fiscal space created by the lowest interest rates in history, which after all were delivered by central banks, that is purely their own fault. Moreover, at a time when governments have been conducting an aggressively tight – and pretty regressive – fiscal stance it makes sense to keep monetary policy as lax as possible. It is called policy coordination and is what the Fed did during the first term of the Clinton Administration of 1992-96. We might not like the fact that interest rates remain at their emergency lows after eight years, but monetary policy prevented a much more dramatic collapse than might otherwise have occurred. With central banks having done the heavy lifting for all this time, what politicians should now be saying is, “thanks, we will take it from here."

Threats to central bank independence are not new, of course. The US Fed has been subject to Congressional badgering for years, as Alan Greenspan’s autobiography makes clear. The ECB’s unconventional policy measures have routinely been scrutinised by the German Constitutional Court, to ensure that they do not fall foul of the letter of the law. But is central bank independence all it is cracked up to be?

The independent central bank par excellence is the Bundesbank, which successfully delivered low inflation and stable growth for Germany for almost 50 years. Whilst the academic evidence suggests that they do deliver lower interest rates than non-independent central banks, this may be more to do with the trend towards more independence at a time of low inflation. Indeed, like many other aspects of monetary policy, they may simply be a fad which serves a purpose for a while but ultimately fall victim to a change in economic fashion, like monetary or exchange rate targeting. Indeed, there has been a tendency in the last 20 years to entrust the running of central banks to academic economists, not career bankers. Whilst they undoubtedly have a better understanding of monetary theory, which has allowed them to be more creative at finding solutions as interest rates hit the lower bound, I wonder whether the more restrained bankers of old would have been quite so tolerant of the liquidity build-up which contributed to the crash of 2008-09?

There is a school of thought which says that independent central banks were created to solve a problem which no longer exists – the reduction of inflation to tolerable levels – and that whilst they may be good at slowing the inflation process, they are not so good at reflating economies. There may be something in this, and we should not overlook the fact that the biggest financial crash in history took place on the watch of independent central banks. So there is nothing mystical or immutable about their independence. But the point of independence is to allow them to do things that politicians do not always like. Sometimes these things may be inconvenient, but if politicians want to change the landscape they need to have a grown-up discussion about the mandate, not issue threats.Political dialogue? There's a novelty!

Interest rates: Absolute zero

The Kansas City Fed’s Jackson Hole Symposium is closely scrutinised by market watchers for any indications of changes in the Fed’s policy stance, and sure enough, most of the headlines over the weekend focused on Janet Yellen’s comment that “the case for an increase in the federal funds rate has strengthened”. But this is to overlook a lot of other interesting material which comes out during the course of the two day session. This year’s symposium was entitled “Designing Resilient Monetary Policy Frameworks for the Future” and if there was any takeaway, it is that central bankers believe they still have sufficient ammunition to provide cover for the economic recovery. It was also evident that central bankers are aware of the impact of low interest rates on the structure of the global monetary system, and that we are not going back to a pre-2007 world anytime soon. 

Marvin Goodfriend’s paper was interesting and makes the point that we should ignore the zero bound constraint on interest rates altogether, primarily because “the effectiveness of evermore quantitative monetary stimulus is questionable.” He argues that one way to facilitate an end to the lower bound constraint would be to abolish paper money and replace it with electronic money. This is not a new idea, having been kicked around since the 1930s and gaining currency (if you’ll pardon the pun) in the wake of the financial crisis. Indeed, Goodfriend’s policy prescriptions echo those made by Andy Haldane a year ago. In brief, this policy relies on central banks making it unattractive to hold cash, thus raising the incentive to hold it in an electronic account overseen by the central bank. The downside, of course, is that this reduces the control which individuals have over their own cash balances: you no longer have the choice of the bank or the mattress – it’s the central bank or nothing, which may persuade many to shift into assets such as property or gold, thus creating bubbles elsewhere.

A bigger objection to removing the lower bound on interest rates is that it has a massive distortionary impact on expectations. Will investors be willing to fund projects if the rate of return is zero or negative? Will we be prepared to continue handing over 30-40% of our earnings in tax (more in continental Europe) when we simultaneously have to invest to provide a fund for our retirement? How does the banking sector cope in a world of increasingly negative rates? Will we eventually reach a situation where customers are charged for depositing funds (actually, yes, with corporate clients in some countries already facing this problem)? For all these reasons and more, it should be evident that a prolonged period of zero or negative interest rates may lead to consequences which we cannot yet foresee and could cause major long-term economic disruption. It is one thing to try the policy on a temporary basis but when it becomes the norm, something is wrong.


Whilst I agree with Goodfriend’s point that QE is at the limit, the notion that we should abolish the lower bound should be treated as an interesting thought experiment and nothing more. The idea that central banks can continue to operate an ever looser monetary policy, but still fail to achieve their economic objectives, should act as an indication that there are deeper seated economic problems which require alternative solutions. Indeed, former Fed governor Kroszner argues that “many central banks are being asked to do things they simply can’t do. Central banks can try to fight deflation. Central banks can’t simply create growth.” Indeed, the ECB has made the point since its inception in 1999 that it cannot create the conditions for a sustainable pickup in growth on its own. Governments need to play their part with structural policies designed to raise the economy’s speed limit.

A bigger problem is that in the wake of the financial crisis, many European economies have been trying to accelerate with the brakes on. In other words, they have operated a very loose monetary policy and a tight fiscal stance. This reflects a misunderstanding about the nature of the shock which hit in 2008. Whilst this may have been understandable in the immediate wake of the crisis, we have had long enough to review the evidence to realise that the current policy mix is not delivering. It is clearly not creating stable jobs in sufficient quantities to allow economies to generate escape velocity, and as a result lots of people are taking out their frustration by voting for populist politicians. This is not the whole story: it certainly does not explain the rise of Donald Trump, but it is part of a wider narrative. We have already seen in the UK how this has panned out, but it is still not too late for other European countries to learn from this mistake. Failure to do so will have major adverse consequences for the euro zone in the years to come.

The lowdown on interest rates

Over the course of the past seven years, monetary policy has been at its most expansionary setting in history, a point made by Andy Haldane in a speech last year. Indeed, we have become dangerously used to interest rates at near zero – and in some cases below.

It used to be thought that when interest rates get close to zero, there was very little else central banks could do. But in 2001, the Bank of Japan began the process of flooding financial markets with liquidity by buying huge quantities of financial assets in a bid to head off deflation (so-called quantitative easing). In 2002, Ben Bernanke argued, in what has gone down as one of the most influential speeches in modern central banking history, that a policy of central bank balance sheet expansion was guaranteed to reflate moribund economies and if it was failing in Japan, this was primarily a result of specific Japanese factors. Little did we know that western central banks would quickly exhaust all their conventional ammunition in the wake of the meltdown triggered by the Lehman’s bankruptcy, and that by 2009 the Fed and Bank of England would  be pumping huge amounts of liquidity into the financial system with the European Central Bank following suit in 2015.

We don’t have space to go into a detailed discussion of these unconventional monetary policies here, but suffice to say that although I was critical of the QE strategy in 2009, it did serve a purpose by preventing a market meltdown, and it probably did help to stabilise the real economy and set the stage for a recovery. The key point, however, is that it helped markets first and foremost. It did so by forcing investors to abandon the safe haven of government bonds, as central bank purchases drove down yields, and into riskier assets yielding higher returns. But with the ECB only starting to embrace QE last year, when global markets were a lot more stable than in 2009, this struck me as too little too late. It has had no discernible impact on generating a pickup in activity and although the ECB will doubtless argue that the situation would have been worse in its absence, that remains unproven.

What has become apparent is that central banks have become addicted to the provision of cheap liquidity. Indeed, in the euro zone the interest rate on cash deposits at the central bank is negative, as the ECB tries to force banks to lend rather than hold excess cash balances. There is little evidence that this policy is working.

In fact, lowering interest rates in the current environment is merely helping to magnify economic distortions. For one thing, they have forced investors to raise asset prices out of line with fundamentals by producing market bubbles which may well pop in future (at the very least, they raise market volatility by increasing the degree to which markets are dependent on central bank policy). For another, they distort the operation of the financial system, the main purpose of which is to match those with excess funds and those with insufficient funds. But in an environment of excess liquidity, banks are simply holding excess cash which – in the euro zone at least – is a drain on profitability because they have little option but to hold it at the central bank, which incurs a penal rate of interest. Then there is the problem of how savers can build up their balances in order to generate sufficient for their retirement. Today’s consumers may enjoy the dubious privilege of low rates today, but they will not thank central banks tomorrow when they see what their retirement funds are worth.

So it is against this backdrop that the BoE is widely expected to cut interest rates this week. But the truth is it will do little good. Whatever else the Brexit shock is, it is not a monetary shock to the system as we saw post-Lehmans when the global financial system seized up. At that point, radical monetary easing made sense. Lower interest rates today cannot compensate for any uncertainty shock which may cause companies to cut back on investment and employment. Nor is there any real need to expand QE – the BoE has already taken action to reduce banks’ countercyclical capital buffer which does much the same job.

The BoE will argue that the harm caused by inactivity outweighs the harm of further easing and the markets certainly will not take kindly to inaction. But the lesson of the past seven years is that once policy is eased, it has proven very difficult for central banks to consider unwinding it. We may not know the longer-term costs of cheap money for many years to come but it increasingly looks to me as though monetary policy is almost out of road and it is time for some heavy lifting from fiscal policy.