When tide turns, central banks are caught swimming naked?

I have blogged here and here trying to put central banking in perspective. This is one more in that line. 

The world economy has experienced nearly four decades of extraordinary macroeconomic stability. Inflation has remained low and stable, except for the global financial crisis the financial markets have largely been benign, and the geo-political environment has been conducive. The global economic output and trade has expanded, asset markets have boomed and there has been massive wealth creation, and more people have been lifted out of poverty as never before. 

There have been several contributing secular trends. They range from advances in information and communications technology to massive container shipping carriers, from the spectacular growth of China to the only less impressive growth of India and other emerging economies, from trade liberalisation to globalised supply chains, from globally integrated markets in goods and services to skilled labour, from the savings glut in Asian economies to cross-border capital flows, and so on. The net result of all this has been sharply lower communication and transportation costs, numerous positive supply shocks, an abundance of cheap capital, and a global market for goods, services, skilled labour, and capital. 

Besides all these universal trends, some others have claimed credit for this period of remarkable stability and unprecedented economic growth. The loudest claimants have been central banks and their supporters. Researchers and commentators have marshalled impressive evidence and eloquently extolled the proficiency of independent technocrats pursuing policies grounded on orthodox economic models. This resonates with the dominant narrative of the wisdom of experts and the incompetence of politicians and bureaucrats, both in equal measure in opposite directions. The whimsical actions of leaders like Donald Trump and Recep Erdogan only reinforced these perceptions. Central bankers from Alan Greenspan to Raghuram Rajan have emerged as superstars, acclaimed for their expertise and calming presence. 

It has been argued that the long-period of macroeconomic stability was an outcome of the confidence among market participants in the central banks and their technical toolkits. It's claimed that the markets have confidence in the ability of central bankers to use inflation targeting framework to keep inflation under control. Similarly markets have confidence in central bank tools like quantitative targeting, forward guidance to maintain financial market stability. In fact, this argument has been taken to its logical conclusion - all good things that happen are the outcome of central bank policies, and all bad ones are due to politicians and bureaucrats interfering with the functioning of central banks. 

Sanna Marin, the prime minister of Finland, is only the latest non-expert to question central banks and their ideologues, 

There is something seriously wrong with the prevailing ideas of monetary policy when central banks protect their credibility by driving economies into recession.

All these raise some questions. Two sets in particular stand out.

The first concern the claims of causality. How do we know whether there is a causality or it's only a coincidental correlation between the macroeconomic stability of the last four decades and central bank policies? Is central bank actions the primary driver of macroeconomic stability, or are central banks  claiming a vastly disproportionate credit for outcomes determined by a rare confluence of factors? Or have central banks only contributed at the margins by not messing it up, just as politicians have allowed central banks their operational autonomy?

It's often said of many things that the good times exaggerate their relevance just as bad times expose their limitations. When the tide is high, we don't know who are swimming naked. There is a strong case that the same applies to central banks and their role in macroeconomic stabilisation, especially of the kind we have seen over the past four decades. 

Consider inflation targeting. For nearly a decade, central banks have failed on the downside in raising inflation to the 2% target. Now central banks are struggling on the upside of getting soaring inflation back to the target. In other words, central bankers have continuously got it badly wrong in their own inflation targeting for more than a decade!

In their pursuit of inflation, they kept interest rates too low for too long, thereby distorting incentives and spawning excesses. Even as its consequences have become all too apparent, nobody has had the intellectual honesty to acknowledge the failure of central banks to realise inflation despite extraordinary accommodation and their singular role in distorting the markets by inflating asset bubbles and unhealthy financial arbitrage practices.  

Now in their efforts to control galloping inflation, itself a consequence of the nearly a decade of monetary accommodation which has generated perverse incentives and entrenched distorted expectations among market participants, they are left with throwing everything at the problem. Economic growth and public suffering be damned, if theory tells that anchoring inflation expectations require raising rates steeply and quickly. Talk about getting it wrong twice in a row, and still claiming superior wisdom!

The second set of questions concern the so-called superiority of experts. How does technical expertise in macroeconomics endow anyone with the worldly wisdom to judge whether the market can be calmed with a 50 or 75 basis points cut, or two or three cuts in a row? In fact, how does mere technical expertise with limited or no practical market experience allow for judgements on interest rate decisions that seeks to control inflation without killing economic growth? It's almost like expecting Roger Federer's coach to replicate Federer's backhands in match play!

I'm inclined to argue that the market participants belief in central bank expertise is less about their actual confidence in the central banker's abilities or their belief in some technical models and more about their fear of politicians allowing political considerations to take supremacy in monetary policy decisions. It's more that the former would do less damage than the latter could potentially do. And the antics of politicians like Donald Trump and Recep Erdogan have done as much as could have to reinforce these fears. 

  

However, as inflation rears its ugly head, financial markets are roiled, and a set of geo-political dangers threaten to become the norm, the long period of Great Moderation may be in the rear-view mirror.  This does not mean a period of recession and stagnation beckons, but more likely a period of normal growth. One where all the fortuitously congruent powerful one-off drivers of growth of the last four decades have receded and the normal course of economic growth takes over. That should be a welcome development.