Michael Heise
Michael Heise is Chief Economist of Allianz SE and the author of Emerging From the Euro Debt Crisis: Making the Single Currency Work.
MUNICH
– How long will major central banks blindly rely on rigid rules to
control inflation and stimulate growth? Given the clear benefits of
nimble monetary policy, central bankers need to open their eyes to the
possibilities that flexibility affords.
The
rule of thumb for monetary policymakers has long been that if inflation
is below official target ranges, short-term interest rates should be
set at a level that spurs spending and investment. This approach has
meant that once interest rates reach or approach zero, central banks
have little choice but to activate large asset-purchase programs that
are supposed to stimulate demand. When circumstances call for it,
policymakers default to the predetermined scripts of neo-Keynesian
economic models.
But
in too many cases, those scripts have led us astray, because they
assume that monetary policy has a measurable and foreseeable impact on
demand and inflation. There is plenty of reason to question this
assumption.
For
starters, households have not responded to ultra-low interest rates by
saving less and spending more. If savings no longer yield a return,
people can’t afford big-ticket items or pay for retirement down the
road. Likewise, companies today are faced with so much uncertainty and
so many risks that ever-lower costs of capital have not enticed them to
invest more.
It’s
easy to see why, despite the data, predetermined formulas are
attractive to monetary policymakers. The prevailing wisdom holds that in
order to return the inflation rate to a preferred level, any slack in
the economy must be eliminated. This requires pushing interest rates as
low as possible, and when these policies have run their course (such as
when rates dip toward the negative), unconventional instruments like
“quantitative easing” must be deployed to revive growth and inflation.
The paradigm has become so universally accepted – and the model
simulations underpinning central banks’ decisions have become so complex
– that few are willing to question it. For individual central banks or
economists, to do so would be sacrilege.
Central
banks do not completely deny the economic costs that these policies
imply: exuberance in financial markets, financing gaps in funded pension
systems, and deeper wealth inequality, to name just a few. But these
costs are deemed an acceptable price to pay to reach the clearly defined
inflation level.
Yet
the policies pursued in recent years have given no room for the
intangibles – unstable political environments, geopolitical tremors, or
rising risks on financial markets – that can send models off course. As
the 2008 financial crisis illustrated, the normal distribution of risk
was useless for predictions.
Keynes
never tired of arguing that monetary policy becomes ineffective if
uncertainty is sufficient to destabilize the expectations of consumers
and investors. Unfortunately, many central banks have forgotten this.
The Bank of Japan, the Bank of England, and the European Central Bank
all hone to rather rigid policy rules. If expansionary policies fail to
have the desired effect of lifting inflation to the predefined level of
around 2%, they do not question their models; they simply increase the
policy dosage – which is just what markets expect.
For
now, the US Federal Reserve has the most flexible toolkit among the
major central banks. In addition to inflationary pressure, the Fed’s
monetary policy must also take into account employment statistics,
growth data, and the stability of financial markets. But even the Fed’s
flexibility is under siege. Republican lawmakers are discussing how to bind the Fed to more scripted policy rules to manage inflation (using a formula known as the Taylor rule,
which predetermines changes in the federal funds rate in relation to
inflation and an output gap). Needless to say, such a move would be a
mistake.
Central
banks (not to mention lawmakers), with their strong attachment to
neo-Keynesian theory, are ignoring a major lesson from decades of
monetary-policy experimentation: the impact of monetary policy cannot be
predicted with a high degree of certainty or accuracy. But the belief
that it can is essential to the credibility of the now-standard
inflation targets. If central banks keep missing these rather narrow
marks (“below, but close to 2%”),
they end up in an expectations trap, whereby markets expect them to
dispense ever higher doses of monetary medicine in a frantic attempt to
reach their target.
Clearly,
such monetary policies create soaring costs and risks for the economy.
And central banks themselves are coming dangerously close to looking
like fiscal agents, which could undermine their legitimacy.
A
new and more realistic monetary paradigm would discard overly rigid
rules that embody the fallacy that monetary policy is always effective.
It would give central banks more room to incorporate the risks and costs
of monetary policies. With such a paradigm, central banks could move
away from negative interest rates and large-scale asset purchases. They
would define their inflation targets more flexibly, to avoid being
forced into action whenever “uncertainties” such as declining oil prices
or required wage adjustments cause inflation to move above or below 2%.
Perhaps
most important, a new paradigm would acknowledge the limits of central
banks’ power and foresight. That would remove an alibi that governments
too often hide behind to avoid introducing the structural reforms that
really matter for long-term growth
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