Central banks open Pandora’s Jar
In Greek mythology, when Pandora opened her jar the ills of the world sprang out, leaving only hope behind. Once out, the contents could not be captured and put back. Pandora could not undo what she had wrought.
In 2008-2009, central banks billed their strategy of ultra-low interest rates and quantitative easing as extraordinary and temporary measures — justified by the exceptional severity of the banking crisis and the danger to the global trade and payments systems.
But what was once unconventional and unorthodox is rapidly becoming the new normal and likely to be maintained for an extended period.
In theory, the main central banks are still committed to reverting to pre-crisis system of inflation targets and an orthodox monetary policy centered on short-term interest rates.
But it will not be easy to exit from the extraordinary interventions of the last two years or persuade investors, policymakers and the public that central banks should revert to a more limited role focused on core consumer prices and short-term rates, leaving broader trends in debt, equity and commodities to market forces.
TECHNICAL STEP, OR REVOLUTION?
Most central bankers and economists still characterize ultra-low rates and quantitative easing (QE) as a crisis response or an extreme version of traditional monetary policies.
QE is portrayed as a technical step, used when the orthodox Taylor Rule implies the need for deeply negative interest rates but central banks are prevented from achieving them by falling inflation and the zero interest rate bound (ZIRB).
Unorthodox monetary policies are not really unorthodox at all, in this view, more an extension of the norm, an extremum in the conventional spectrum, different in degree but not kind. Once the combination of low rates and QE has put the economy firmly on the road to recovery, unusual measures can be scaled back.
But the crisis has revealed limits in the theory of inflation targeting that will have to be answered. And it has involved central banks reacting to and trying to influence a far wider range of asset prices than just short-term money market instruments.
Investors cannot be made to forget that in a crisis the central bank will put a floor under prices for a broad range of assets along the whole spectrum of risk — from government bonds to equities and commodities. Once released, the Bernanke Put cannot be stuffed back in the bottle.
In future, every investment decision will have to include an assessment of the circumstances and extent to which buyers of an asset can rely on a central bank guarantee. The central bank’s reaction function will become a significant determinant, perhaps the single most important one, of asset prices.
There is nothing new in this. Bonds, equities and commodities have always been highly sensitive to expectations about how the central bank will adjust rates. But by intruding on market functions more than ever before, the Fed and other central banks have ensured reaction functions will be an even more dominant factor in asset pricing in future.
SETTING OUT INTO THE UNKNOWN
The crisis has shattered previous understandings about both the ends and means of monetary policy. In terms of ends, it has broken the three-decade old assumption that inflation control and price stability is both a necessary and a sufficient condition for promoting growth and employment. It has also strained the idea that the central bank should simply focus on keeping the inflation rate close to some arbitrarily low target rate.
In an article published in Tuesday’s Financial Times, Columbia University Professor Michael Woodford called for inflation targeting to be replaced by a form of price-level targeting.
Woodford argued the Fed should make clear it “has no plans to tighten policy through increases in the federal funds rate, even if inflation temporarily exceeds the rate regarded as consistent with the Fed’s mandate. In short, the Fed should permit a one-time-only inflation increase, with a plan to control it once the target level of prices has been reached”.
He goes on: “The Fed should commit to make up for current ‘inflation shortfalls’ due to its inability to cut interest rates … Catch up inflation would simply put prices back on the path they would have followed had the Fed been able to cut interest rates earlier”.
In this view, the Fed should define price stability not as an instant rate of growth (say 2 percent) but as a commitment to a whole future path for prices. Below-trend inflation in one period would be corrected by above-trend inflation in a subsequent one to return prices to their target trajectory.
Presumably the same would apply in reverse. Over-inflation in one period would need to be corrected by below trend rates subsequently to return prices to their target level.
Inflation is currently below target in the United States. But for most of the period between 2003 and 2008 it was substantially above target. So it is not clear whether the Fed should be trying to stoke more inflation, or welcoming the current disinflation as a corrective to the earlier over-inflation. It all depends whether the baseline for the “correct” price level is set at 2003/2004 or 2007/2008.
The problem of price level targeting is even more acute in Britain, where inflation has been above target for 42 of the last 51 months, and prices are now more than 3 percent higher than they should have been. Bank of England officials would strenuously dispute the idea they should deliberately engineer a period of slow growth and below target inflation in future to correct for the previous overshoots. Bygones should be bygones.
Price level targeting also raises in particularly acute form the question of which items should be included in the target and which should be excluded. Should the target include all prices or just some of them? Should certain commodities be excluded? Is the criterion for exclusion that commodities are volatile, or that they are subject to one-off supply shocks to which monetary policy should not react? What about one-off shocks to manufacturing and services?
If commodities should be excluded, should the exclusion be restricted to a narrow range of grains and fuels, or be expanded to cover freight, metals, meat and softs? What about near-commodities such as steel and chemical preparations? If too many items are excluded, does the target have any meaning?
Turning from ends to means, central banks increasingly justify QE in terms of asset prices. Speaking last week, New York Fed Executive Vice President Brian Sack admitted “balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise might be”. He might have added that QE has an impact on commodities.
But during the boom (2004-2008), the Fed and other central banks rejected the idea they should react to or try to influence changes in asset prices and commodities. The Fed specifically stated it should not try to prick bubbles and should not respond to escalating commodity costs unless they threatened to become entrenched in core consumer prices and expectations.
That position is no longer tenable. Sack has admitted the Fed is blowing a financial bubble by “keeping asset prices higher than they otherwise might be”. It will be impossible to argue (coherently) the Fed should not seek to damp future asset booms by reducing liquidity.
And if the Fed can push commodity prices up via QE, it could reduce them via reverse-QE. If commodities are influenced by monetary factors as well as physical demand and supply shocks, as is now clearly established, the Fed will come under pressure to limit future commodity booms like 2006-2008 by reducing liquidity.
For good or ill, QE and the manipulation of bond prices and other assets have been let out of the jar, and the Fed cannot stuff them back in again