Central banks are getting ready to end the unconventional policies that they developed in response to the credit crunch and Great Recession ten years ago. Interest rate setting committees are looking at how their expanded balance sheets can be contracted and how rates can be increased. This is now clearly the agenda of the Federal Reserve Board, the ECB, and the Bank of England.
Monetary policy challenges that go beyond managing the economic cycle
The challenge the central banks face is much more complicated than making judgements about monetary policy in relation to the economic cycle, inflation, and unemployment. After a hesitant, and in some cases tardy start, central banks did a good job in using monetary policy to stabilise the fall in output and to stimulate a sustained recovery in economic activity following the Great Recession.
Yet their very success may have aggravated and amplified longer-term structural changes in the character of financial institutions and the structure of financial markets — changes that could generate financial shocks, which could destabilise the wider economy. There appears to be a tension between policy measures that may be sensible in macroeconomic terms — with microeconomic effects that distort decisions about credit allocation, the appetite for risk, and have wider implications for market liquidity — and the efficient operation of banking and securities markets, which is at the heart of what a central bank does.
Tension between macroeconomic policy and its microeconomic consequences
Very low interest rates, forward guidance about policy rates, and quantitative and credit easing programmes have interacted with new prudential regulations requiring banks to hold more capital in a complex and awkward manner. Banking supervision — intended to make banks less risky and to reduce leverage — has constrained the capacity of the banking system to lend, limiting economic growth. In order to raise rates of GDP growth, very low rates of interest were supplemented by forward guidance that interest rates would remain low for an extended period of time. The policies did not have much effect in increasing the pace of GDP growth, yet they further amplified the complex interactions between macroeconomic policy and the microeconomics of resource allocation.
As central banks, led by the Federal Reserve, begin to brace themselves to tackle these issues, the tension between the macro and microeconomic policy imperative in monetary policy is as acute as ever. On most metrics, security prices, and both government bonds and equities are elevated. A central banker paying any attention to the strictures of the Bank for International Settlements would recognise the emergence of asset price bubbles. Yet inflation remains low, at below the target the Fed sets for itself — a PCE of no more than 2 per cent. The other part of the Fed’s policy mandate, maintaining high levels of employment, appears to be more easily accomplished for now at least. Non-farm payrolls rose by 220,000 in June, above consensus expectations; the average work week rose to 34.5 hours; and the unemployment rate ticked up to 4.4 per cent, from 4.3 per cent rate. Yet even this strong employment report contains details that illustrate the Fed’s challenge. Wage growth was weak; despite strong jobs growth, earnings only rose 0.2 percent in June and 2.5 per cent on the previous year; the labour market participation rate remains low; and although the share of people of working age in the labour force increased to 62 .8 per cent, this is still one of the lowest participation rates in three decades. We must ask to what extent monetary policy can influence the participation rate and the level of wages. The big questions involved may well go far beyond those related to monetary policy and where the economy is in relation to the economic cycle.
The challenge of much less liquid financial markets
As the Fed starts to unwind its balance sheet, it is not at all clear how far it will be able to go. Markets are less liquid, securities are more difficult to value, financial institutions are more concentrated, and regulators demand more capital. Private sector entities are generally prone to hoarding cash and liquid assets. When there is a hint of trouble, in practice, they have to turn to the monetary authorities for help. This may mean that the Fed and other central banks end up having to have much bigger balance sheets than they did before 2007.
In the nineteenth century, central banks, led by the Bank of England, developed their function to stabilise liquidity in the banking system, and to keep flows of credit working even when institutions or groups of institutions got into trouble. This function was famously catalogued by the then editor of The Economist, Walter Bagehot, in his 1873 book Lombard Street: A Description of the Money Market. Ensuring the smooth functioning of financial markets in good times and bad was the function of the central bank for years, before the development of active monetary policies that dominated central bank activities from the second half of the twentieth century.
Central banks became distracted from their original function
The issues that confront the Fed today are comparable to the questions that informed the debates that led to the passage of the Federal Reserve Act in 1913. Those debates arose from the practical concerns that practical bankers and businessmen had had for many years in the US, which without a functioning central bank, had experienced a succession of interest rate spikes and financial crises. Matters came to a head in 1907, with a crisis ultimately resolved by John Pier Point Morgan, by locking bankers in a room until they had agreed some form of clumsy resolution. Over the years, the attention of central banks increasingly turned to macroeconomic management, and the central liquidity function was increasingly taken for granted if not overlooked. In fairness to the Federal Reserve system, its governors and reserve bank presidents continued to take more interest in these core functions — not least the operation of the Fed wire payments system — than other central banks did, including the Bank of England, the institution that perfected the original role.
A viva for Dr Yellen?
This week, Dr Janet Yellen will deliver her semi-annual Humphrey Hawkins report on monetary policy, to both houses of Congress. It will be interesting to see how explicitly she exemplifies the policy challenge of her institution. Among the questions that it would be interesting for legislators to receive guidance about, are: how effective forward guidance can be, given the limitations of forecasting models dependent on inevitably defective historical data; how accommodating policies to support economic growth can avoid asset price bubbles and appetites for risk, which undermine financial market stability; how low interest rates have contributed to zombie lending and the slowing of productivity growth; to what extent prudential banking regulations and capital adequacy rules have undermined market liquidity, and increased the need for public sector assistance to financial institutions when there is trouble; and to what extent the banking system is constrained in a way that it cannot support credit growth consistent with the trend rate of growth of the economy. These questions are difficult. One further matter is, too: Dr Yellen has suggested that, following the regulatory changes made since 2008 to increase banking supervision, a major systemic crisis is unlikely. In the event of a major crisis at a systemically important bank — deemed too big to fail within what is an even more concentrated banking industry than 2007 — how well placed is the Fed to mange a fast moving financial crisis, following the legislation passed after 2008 to constrain its discretion?