Wednesday, February 23, 2011

The changing role of central banking

Standard economic models define the role of central bankers as managing price stability, as manifested by inflation rates, through the conventional interest rates-based monetary policy actions. Accordingly, inflation targeting has been the guiding monetary policy framework for a generation of central bankers.

The sub-prime crisis and the Great Recession has naturally raised questions about this strategy. On the one hand, it has brought to the fore the issue of financial stability, while on the other, it has also raised questions about the importance of economic growth itself. What can central banks do to promote these objectives?

Whatever the earlier reluctance, the dilemma about whether central banks should go beyond inflation targeting appears to have been settled. Some central banks, like the US Federal Reserve and the Reserve Bank of India, have always explicitly considered the promotion of economic growth as part of their objective (though others like the ECB have not been sure). However, the big change has been in the embrace of financial stability as an important objective of central banking policies.

Hitherto central banks have been concerned about the prices of goods and services. The prices of financial and other tradeable assets have remained outside their surveillance radar. The sub-prime mortgage bubble (and the financial market bubbles of the last two decades) with its several incentive distortions and its disastrous contagion effects on the real economy have highlighted the importance of monitoring the prices of financial assets. It is now clear that macroeconomic stability is a function of both price and financial stability.

This expansion in the scope of central banking has naturally raised questions about the instruments in their armoury to address the three-fold challenge of price stability, financial stability, and output stabilization. Financial stability is a much deeper issue than the other two, and requires that central banks go beyond their traditional micro-prudential regulation of individual banks. They have to assess the systemic risk impact of individual banks through macro-prudential regulation.

The current crisis has also seen central banks in the developed economies deploying a variety of often extraordinary measures to get their financial markets and economies back on the recovery path. The most important of these unconventional policies have been quantitative easing, which has been embraced by many central banks. Broadly, quantitative easing refers to the generic set of policies that involved direct credit injections, liberal credit access windows, near blanket credit guarantees, collateral standard expansions/dilutions, and outright asset purchases. The result of all this, coupled with the zero-bound in interest rates, has been dramatic credit expansions with explosive growth in the balance sheets of the central banks.

In the aftermath of the sub-prime meltdown, the US Federal Reserve and Treasury responded swiftly and pumped massive amounts to bailout Wall Street. Apart from lowering interest rates to the zero-bound, these measures also included credit guarantees and unconventional quantitative easing through direct credit injections and asset purchases. The Fed emerged as an effective lender, buyer and insurer of last resort.

It is difficult to estimate the exact impact of such policies. The counterfactual is one of the most difficult riddles. All the more so when the policy itself has not delivered its ultimate objective but merely prevented the situation from getting worse. How do we know what would have been the situation now without all these extraordinary policies? How do we know that these policies, tried out in desperation, have not prevented a repeat of the Great Depression? Or how do we know what could have been, as Paul Krugman and some others have claimed, with a stronger dose of quantitative easing?

There are other equally importat issues. For long time now, economic stability has meant targeting an inflation rate of around 2%. Accordingly, central banks across the developed world have successfully managed monetary policies over the past two decades and kept inflation expectations under control. In fact, it was even being suggested that central banking has slayed the inflation demon. All the major developed economies had low inflation rates and inflation expectations when the sub-prime bubble burst.

However, that in turn posed a problem of a different kind. The low inflation also mean that the interest rates were at already low levels. This also meant that the real interest rates were at ultra-low levels. Once the bubble burst and the Great Recession took hold, the central banks aggressively cut rates even further, and the interest rates touched the zero-bound. With inflation rates remaining low and even falling further, the real interest rates fell into the negative territory. All this meant that conventional monetary policy and its primary instrument, interest rate changes, had become blunt.

This naturally raised questions about the inflation and monetary policy decisions of the pre-crisis era. What is the optimal inflation rate? Should inflation rates be targeted a little higher, so as to enable governments and central banks to have some room to maneouvre with interest rates when downturns strike? What should be the ideal interest rates during the good times?

Almost exactly a year back, the IMF Chief Economist, Olivier Blanchard waded into this debate with a landmark paper. In a major U-turn from the standard IMF orthodoxy on inflation, he advocated a higher inflation target for economies during good times. He argued that economies should target a higher inflation rate, preferably 4% (against the standard 2%), so as to leave enough room for monetary policy actions to work when recessions and downturns strike.

At a 4% inflation rate, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.

However, the challenge with higher interest rates lies in balancing the central bank credibility associated with a rigid and well-communicated low inflation policy and the difficulty of anchoring inflationary expectations at a higher level of inflation. The Blanchard paper has several other important suggestions, some of which are of importance to central bankers. I have discussed them here.

More fundamentally, the recent crisis has certainly highlighted the importance of central banks, especially in crisis situations. The technical nature of their work and their ability to act immediately and without much lag, unlike their political counterparts, make them important institutions. In fact, given the centrality of the economy and the increasing importance of the central banks in macroeconomic management, it is important to re-assess the role of central banks.

Their over-sized role, even in developing economies, raises the inevitable questions about the type of over-sight that the political system should have on central banks. In the US itself there is a clear divide between those advocating much greater political control over the functioning of central banks and those demanding continuance of the central banks' autonomy.

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