We need a root and branch review of the central bank’s policy toolkit
I’m sure that most of you will have heard of, even if not having read, the famed Millenium trilogy by the late Stieg Larson. They were The Girl with the Dragon Tattoo, The Girl Who Played with Fire and The Girl Who Kicked the Hornets’ Nest. I might not be a guy with the dragon tattoo, but I do feel ready to play with fire and to kick a hornets’ nest.
It began yesterday with an email I received from the established Australian financial journalist Michael Pascoe – I once referred to him as a “veteran” to which I recall him not having taken too kindly – in which he wrote, “Re the forecasting racket, my ex-RBA friend was bemused by this FT piece suggesting other central banks are moving away from relying on crystal balls just when the silly review of our central bank seems to nudge it closer to models – and none of them from Victoria’s Secret”.
To which I replied without having particularly considered my response, “I fear that central banks have become a little overawed by their own power. Is it not said that power corrupts, and absolute power corrupts absolutely? I think people have forgotten that economies rise and fall by the people who spit in their hands and create value added. Too much store is put in monetary policy. It should be an adjunct to a productive society, not its nub, its touchstone. I’d love to suggest we set short rates at 4% and leave them there. End of. That would also take a huge speculative element out of the system, and it is all the second-guessing that does much of the damage. Rates at 4% for a minimum of 5 years. That’d give business a lot more confidence in investing in plant and equipment. I simply can’t understand why, having seen all the damage done in the ultra-low interest rate environment, everybody seems too keen to go back there?”
This began to trigger more thinking on the subject and when I in the afternoon had a long talk with my chum Morris Sachs of the IBWOC podcast who has forgotten more about rates than most of us will ever know, I told him of my exchange with Michael. He quite readily agreed and by the time I went to bed, I had decided that a bit of playing with fire and kicking of hornets’ nests might be of the order. This morning this manifests itself with the question of whether, at the end of the first quarter of the 21st century, our central banks and their model of active interest rate policy is still fit for purpose?
We know what the objective is of active management of central bank reference rates, but do we know whether it actually works? The answer has to be an emphatic “No!”. The textbook tells us that monetary policy needs a period of time to take effect. How long is a piece of string? Does the effect kick in in six months, 12 months, two years, never? If the Fed, the Bank of England, or the ECB were to stick a pin in the diary at those given dates after a change in their respective rates – I am only talking rates here and not all monetary policy tools – and tried to measure the effect, would they get a discernible result? Of course they wouldn’t.
Where they do affect a clear and immediate response, however, is in markets to which the rather mindless stampede that we saw in the last two weeks of 2023 bears adequate witness. To what extent, one must therefore ask oneself and for a moment disregarding the slings and arrows of financial markets, is monetary policy the cause or the effect of expansion and contraction in the economy? Although not an economist by training, or maybe because of that, I have over many years lived with the belief that economies will go through the cycles and that monetary policy should restrict itself to assisting in constraining the size of the amplitudes both to the up, and to the downside.
I have over time seen the Federal Reserve step away from such basics. It has done so by redefining what it deems to be trend growth. If economic growth begins to overshoot what is supposed to be the long-term trend in the economy, then it should in theory begin to tighten monetary conditions in order to cool things down. That is what the late William McChesney Martin, Fed Chairman from 1951 to 1970, meant when he coined the phrase about the Fed having to remove the punchbowl before the party had begun. Martin, simply Bill to his friends, had once considered becoming a Methodist minister, hated excess and was once described by a journalist as “the happy Puritan”. Martin was well before my time – not even I am that old – but I think in his way. My correspondent to whom I occasionally refer to as “The Apocalypticist” is, however, old enough to remember Bill Martin at the Fed and his views would likely embrace the idea of setting one fixed money market rate and letting the Fed, along with its friends and relatives, manage money supply through other available tools such as draining or adding liquidity ether side of a fixed central reference rate.
Going back, we are consistently treated to rhetoric about today’s rates decisions having been taken with a view to their future impact. Meaning we do not know what that impact is and when it kicked in or whether whatever did happen might not have happened anyhow even without the monetary policy intervention. A couple of months ago I wrote a piece which mused upon the possibility of looking at the last great inflationary cycle from the late 1960s through to the early 1980s and wondered whether it had been Paul Volker’s epically ultra-aggressive monetary policy which had brought double-digit inflation back under control or whether the economy had over time organically recalibrated itself to an extent that the imbalances in demand and supply had been overcome. In other words, will an inflationary, disinflationary, or even deflationary economy over time self-right itself, and if so does flexible interest rate policy add meaningfully to the process?
It could be argued that the roots of the Global Financial Crisis are to be found in Alan Greenspan’s having pushed rates too low in the aftermath of the 9/11 attacks on New York and Washington. It can entirely sensibly be argued, so my belief, that Greenspan’s aggressive easing from late 2001 to mid-2003 were primarily political and never economically justifiable. No wonder asset prices went into overdrive and, once rates had been returned to more rational levels between June 2004 and June 2006, it all went to hell again. Whilst moaning and groaning about the current cycle and gagging for aggressive Fed easing, bear in mind that the 2004/2006 one included 17 consecutive 25 bps tightening moves. To what extent one might ask with some justification was interest rate policy not the response to inflating and deflating asset prices but the very cause of the stop/start rather than the intended and much-vaunted countermeasure?
Would the epic collapse of the likes of Silicon Valley Bank have occurred if the Fed had not left the banking system like a polar bear sitting on an ice floe heading south? Zero and negative interest rate policy – ZIRP and NIRP – never ever intuitively felt right and in retrospect most probably weren’t. We are sitting on asset markets, both financial and non-financial – which have become addicted to cheap money and an S&P which was at year-end flirting with a new record all-time high looked just like a junkie hanging around the Eccles Building, the Washington headquarters of the Federal Reserve, hoping to be able to quickly strap on the next fix.
Please don’t get me wrong. I do not have a boil-in-the-bag solution to hand. I am not postulating that we must introduce one fixed short-term money rate and leave it in perpetuity, but I am suggesting that the time might be right to open a debate on the possibility of rethinking not the role of the central banks but the toolkit they should be working with.
I well remember Ben Bernanke popping up in 2008 and introducing “unconventional policy tools”. With this he meant quantitative easing. Much work has been done around his assurance that QE works in practice but not in theory and the delicate matter of Wallace Neutrality which postulates that the size of the central bank’s balance sheet has no effect on either inflation or employment.
In the first quarter of this century, we have had two huge interest rate cycles, two substantial asset price bubbles and so far only one massive bust. There is little doubt that the central banks are perfectly cognisant of the missing second bust and that they are pedalling like fury to prevent it from occurring. So far public markets have been spared the ignominy of another bust although they might be benefiting from a reallocation of funds away from formerly sexy sectors such as commercial real estate and private equity which are currently back to the wall. When the tide went out, to borrow Warren Buffett’s analogy, they look to have been caught swimming with no shorts, or at best with transparent ones.
Central bank balance sheets have through QE become a sort of equalisation pond in money markets. If they can be used to manage money supply, do the monetary policy authorities also need to control reference rates to the same effect? Until QE, central banks could famously only control the front end of the yield curve and influence rates for up to 12 months. Anything longer lay totally in the hands of the markets. QE has enabled the authorities to intervene in the market and directly influence longer rates and the shape of the yield curve. With QE the cat is out of the bag, the genie is out of the bottle, and it is hard to believe that it will ever go away.
Do the monetary policy authorities need to be able to be everywhere all of the time? I do suspect – I’d never be mad enough to say that I’m certain – that the economy’s ability to self-right, to self-heal, is much stronger than for which we give it credit and that to be looking to the central banks as physician, surgeon and psychiatrist rolled into one is to some extent praying at the altar of a false god.
This is not to say that Milton Friedman and the other leading monetarists of half a century ago were wrong. It is simply, as expressed by Bill Bernanke, that practice had overtaken theory, and the time is right for theories to be meaningfully updated. When undertaking a root and branch review, the question must be raised whether quarter of a century of faffing around with reference rates has been part of the solution or whether, if looked at with enough distance, it has in effect been in some ways more the cause of the problem.
Handing the monetary authorities an arsenal containing too many weapons has in the past few years not led to a sustainable outcome but to a race to counteract an overuse of one with an overuse of the other and in consequence great volatility. Traders love volatility and they have made tidy fortunes from it. But how good has it all been for the economy as a whole? We are overindebted.
Has the time maybe come to give the central banks an either/or? You can manage short rates or, by way of QE, long rates but you can’t do both. And given the complexity of markets and of the economy, we might be better served by them working with the latter. I would love to see some serious work done along those lines. Will it happen?
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