Central banks face crisis of confidence
Central banks around the world are facing the worst crisis of confidence since the 1930s, as investors, households and firms question their commitment and ability to deliver price stability.
Whether it is inflation or deflation, outsiders question whether the major central banks will be able to regulate prices in the next few years.
TOO HOT ….
Bank of England Chief Economist Spencer Dale last week lashed out at what he branded “dangerous talk” the Bank had gone soft on inflation and was choosing to ignore price increases persistently above the target.
Dale admitted “One of the most worrying comments I have heard in recent months came at a lunch of senior businessmen I attended. One of the diners suggested that the UK was returning to its old ways of “depreciating the exchange rate and inflating its way out of trouble.” Soon after, a City circular asked “is the MPC turning a blind eye to inflation.” This is dangerous talk. The evils of inflation are well known.”
He insisted the monetary policy committee (MPC) had only three main priorities — inflation, inflation, inflation — and was committed to meeting the target.
But the rest of the speech was a familiar justification of why inflation has been above target for 41 of the last 50 months (one off shocks to the price level, mothballed spare capacity, exchange rate depreciation and stronger retailers’ margins) and why the Bank had been right to refuse to respond and keep policy very stimulative.
In the end it was an unconvincing narrative that is unlikely to satisfy the Bank’s critics, or a public increasingly angry prices are rising while wages are not.
The Bank is trying to draw a sophisticated distinction between certain types of price rises to which it will respond (demand-driven, wage-driven) and those to which it will not (driven by global commodity prices, exchange rate shifts). While this is perfectly defensible in theory, it was not the remit the Bank was given when it was made independent in 1997, or how the public understands the Bank’s mandate.
The Bank of England Act 1998 states the objective is to maintain price stability (defined as an increase of 2 percent over 12 months in the consumer price index); and subject to that to support the government’s economic policies, including its objectives for growth and employment.
Nowhere does it say the Bank should target certain types of CPI but not others. Nor does it say the Bank is free to ignore price rises driven by exchange rate depreciation, or rising energy and food prices, or retailers’ pricing strategies. It simply says the Bank must set interest rates to achieve an overall increase in the price level of 2 percent.
If some components of the CPI are rising much faster than 2 percent, then, unfortunately, the Bank must ensure others are rising more slowly or even falling. That is what an inflation target of 2 percent means.
The Bank’s redefinitions have made the target as useful as corporate financial statements that focus on EBITDA (earnings before interest, taxes, depreciation and amortisation) — disparagingly known as earnings before the bad bits. On the Bank’s own definition it will never miss the target because deviations can always be explained as one-off, non-recurring adjustments in the price level.
Dale did nothing to dispel the suspicions the Bank’s real objectives are far from “inflation, inflation, inflation”, and now include resuscitating growth, boosting asset prices, avoiding widespread household default on excessive mortgage debts, and trying to prop up the value of the houses that serve as collateral for all those mortgage loans. These are all worthy goals — just not what the Bank is saying in public.
He gave the game away when he admitted “trying to use monetary policy to offset short-run movements in inflation is likely to have amplified output volatility.” The problem is that it is not clear when a short-run movement in inflation become a long-run one — presumably sometime after 50 months.
In the end, the frustrated speeches given by Dale and other senior officials at the Bank have made it look like a frustrated and ineffective bystander in its own play. Either officials have privately abandoned the target for the time being but do not want to admit it publicly, or they are impotent to achieve it. Neither is very flattering.
TOO COLD …
On the other side of the Atlantic, Fed Chairman Ben Bernanke appears to have the opposite problem. The Fed would rather like the Bank of England’s problem of too much inflation. At the Board of Governors in Washington DC, the chairman and senior policymakers are currently preoccupied by the potential of falling into a deflationary trap.
Almost two years of near-zero interest rates and a massive programme of quantitative easing have produced only a sputtering recovery and “measures of underlying inflation … at levels somewhat below those the Committee judges most consistent, over the long run, with its mandate to promote maximum employment and price stability”, according to a statement released by the Federal Open Market Committee on Sep 21.
Vast quantities of liquidity have been poured into the banking system, and asset markets have started to merrily bubble away again, but the extraordinary policy interventions of the past two years have produced disappointingly little in the way of a recovery in output or jobs.
WHERE DID GOLDILOCKS GO?
Despite the superficial differences, the Fed and the Bank of England face the same problem. Both have found they have less control over inflation (and jobs and growth) than policymakers previously believed.
The Fed cannot stimulate prices to rise fast enough. The Bank cannot get them to slow down. The monetary levers are broken. Both institutions find themselves in a stormy sea, subject to global forces over which they have little control.
Not since the hapless Arthur Burns was chairman of the Federal Reserve in the 1970s, and before that the disastrous performance of both the Fed and the Bank of England in the 1930s, have central banks seemed so unequal to the challenges facing them.
The era in which central bankers appeared to be Masters of the Universe (Alan Greenspan conducting the world economic orchestra as the Maestro) seems a distant memory. Instead there are doubts about whether the major central banks (Fed, Bank of England, European Central Bank, and the long-suffering Bank of Japan) can solve the problems confronting them.
The public and investors sense that ineffectiveness and crisis of confidence. Funds are pouring into gold, commodities and other “real assets” as investors worry about inflation, deflation and general instability. But whether investors fear inflation or deflation, they all express a lack of confidence in the monetary authorities’ ability to regulate prices.
Meanwhile corporations and households across the United States, Europe and Japan are resolutely pessimistic about the outlook. Unprecedented monetary stimulus has failed to convince them the central banks will succeed in reflating and refloating economies in the wake of the debt crisis. Confidence is broken.
With all the other levers seemingly not working, the major central banks have resorted to what Brazil’s Finance Minister Guido Mantega this week called an undeclared “international currency war, a general weakening of currency.” The United States, the United Kingdom, the euro area and Japan all want to depreciate and export their way out of recession, while emerging markets try to stem appreciation to protect market share.
The crisis has cruelly exposed the limitations of monetary policy. It cannot solve all the problems in the economy.
For that reason, another round of quantitative easing in the United States and the United Kingdom risks being ineffective at best and counterproductive at worst, as investors, households and firms question whether central banks have run out of ideas and are simply overwhelmed by the scale of the problem — like the generals of World War One who kept throwing more men and material into the trenches.
Rather than risk a further erosion of credibility, it is time to promote structural adjustments and leave the natural evolution of the economic cycle to work.