Monetary policy as improv
Should central bankers be more like Miles Davis — experimental, improvisational, and out in front — or a Dixieland band — traditional, predictable, and in the background?
That question was the theme of a discussion at the Council on Foreign Relations in New York yesterday morning that featured Arminio Fraga, a former governor of the Central Bank of Brazil; Kevin Warsh, a former governor of the Federal Reserve Board; and Adam Posen, an American economist who currently sits on Bank of England’s Monetary Policy Committee (and who coined the Davis/Dixieland dichotomy). Within the panel, which was entitled “Central Banking in an Age of Improvisation,” there was discord about how activist monetary policy should be when interest rates are already at the zero bound and when the economy was not undergoing a financial crisis.
For Posen, the big fear is that in fifty years the current period will be remembered as a “major deflationary mistake.” In a series of op-eds and speeches this year, Posen has consistently called for more stimulative monetary policy, urging central banks to undertake unconventional maneuvers like purchasing long-term government bonds or even backing new public institutions that would lend directly to small- and medium-sized enterprises or securitize illiquid SME loans. He is not wide-eyed enough to believe that further easing will be a panacea, but does maintain that “irresponsible monetary tightening will make your problems insoluble.”
Pushing back against that idea was Kevin Warsh, who argued that since the acuteness of the financial crisis had passed — in the United States, at least — central bankers should be wary of adopting novel policies that may frighten market participants:
[T]o continue to improvise policy strikes me as quite counterproductive. The crisis response is one thing and requires some degree of improvisation. A recession response or a response to weaker economic conditions, I think, to me, suggests that you go back to a view of rules, a view of understanding between markets and central bankers so they’re not surprised, so they are not finding themselves waiting breathlessly on what central bankers announce on Sunday nights to get markets to move up on Monday morning, with press releases in hand.
In an environment where fiscal, trade, and regulatory policy have room to provide further jolts of stimulus, Warsh thinks the Fed will face higher risks and more uncertain rewards if it chooses to expand its balance sheet or engage in more unconventional measures of the variety that Posen suggested. Moreover, Warsh would not like to see the Fed get into the habit of absolving elected officials of their responsibilities to promote economic growth, saying central banks are “terrible repair shops for broken fiscal policy.”
Posen disagreed sharply with Warsh’s assessment. He pointed out inflationary risks were practically non-existent, noting that “every gilt currently in issuance is trading above par” — a first in the the history of British financial markets — and that “if you look at any possible way of trying to extract inflation expectations… all you have priced in as far as the eye can see are very low interest rates.” Furthermore, Posen said that the situation in Europe illustrates how central banks’ avoidance of cooperating with governments is merely feeding the continent’s panic. The Bank of Japan and Japan’s Ministry of Finance were locked in a similar standoff in the late 1990s, Posen observed, and its economy sank into an abyss while policymakers played chicken.
Of the three panelists, Fraga was the most orthodox. He espoused policies the IMF has historically prescribed for crisis-stricken countries: fiscal responsibility and low inflation. Fraga, who now runs his own investment fund in Brazil, likened the current era of deleveraging to a hangover following a drinking binge and invoked a medical analogy to caution against loose monetary policy:
For now, I find that money is on a lot of steroids — I come from a family of doctors — but that doesn’t cure everything. Sometimes even if you keep pumping steroids, your patient blows up and it doesn’t quite do it.
For a first-rate overview of the policy dilemmas the current crop of central bankers face, check out “The Central Banking Revolution,” a Reuters Special Report from earlier this year by MacroScope contributors Paul Carrel, Pedro da Costa, Mark Felsenthal, David Milliken, and Alan Wheatley.