MacroScope

From one central banking era to another: beware the consequences

April 8, 2013

Paul Volcker’s inflation-fighting era as chairman of the Federal Reserve is quite the opposite of today’s U.S. central bank, which is battling to kick start growth and even stave off deflation with trillions in bond purchases. And it is polar opposite of where the Bank of Japan finds itself today, doubling down on easing to lift inflation expectations after two decades of Japanese stagnation. After all, Volcker ratcheted up interest rates in 1979 and the early 1980s to tame the inflation that had been choking the United States.

So it may come as no real surprise that, talking to students and faculty at New York University on Monday, he had a few concerns about where the world’s ultra accommodative central banks are headed.

“There are going to be big losses at central banks at someplace along the line,” he said. “You do all this support of buying longer term securities at very low interest rates; long term interest rates aren’t going to stay where they are forever; at some point losses are going to be taken.”

For the Fed, the BoJ, the European Central Bank and the Bank of England, he said, the money-printing will inevitably raise questions about limiting activities of central banks. “These central banks are no longer central banks. The Federal Reserve is the world’s biggest financial intermediary, it is dominating the long term credit market in the United States, and it is dominant in the residential mortgage market…” he said.

Volcker had particular words for the BoJ, which aims to raise inflation expectations to 2 percent within 2 years. It might be an “illusion” that inflation targets can be lowered again once the economy looks better, he said. “Once that feeling gets in there that a level of inflation is a good idea for the economy, it is very hard to get rid of.”

To be sure, the former Fed Chairman added, there is a “straight forward argument” to be made for the BoJ’s plan. “Let’s try it. (It’s) pretty sluggish out there. Let’s put some more money out there…” It just might not be one he would make.

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