So far in this series of articles, we have considered the immediate challenges in front of central banks, which in a nutshell revolve around the normalisation of monetary policy and the re‑establishment of a more orthodox relationship with markets. In this final article we consider the longer term outlook, once the normalisation has occurred. It is a subject that central bankers themselves are increasingly turning to – and it is not without controversy.
At the moment, the debate in central banking circles revolves around the three tasks that central bankers face. These are:
1) The immediate task that central banks know they have, which is managing the great normalisation – a process which as we have seen involves both the shrinking of their balance sheets and the raising of official interest rates;
2) The longer term task that central banks would like to have, which is managing inflation – this would be a return to what many consider the “real” or core function of central banks, and were this to be back at the top of the central banks’ collective to-do list it would signify that their world was back in order again;
3) The task that central banks fear they actually have, or rather have had thrust upon them, which is managing financial stability.
Each of these three tasks poses their own challenges. On the first one, there is as we have observed in our earlier articles no road map, no precedent to guide the authorities, and every reason for them therefore to proceed cautiously. It could be damaging for the global economy, and would certainly be very damaging for central banks’ reputations, if the process of normalisation had to be put quickly into reverse to avoid unwanted or unexpected adverse consequences.
Note though that the fact that unwinding the unorthodox policies of the last 10 years is taking place at a very deliberate pace is in no way in conflict with the determination with which central bankers want the job done. No central banker wants to prolong any longer than is necessary the current position where the central bank and its balance sheet looms over markets, dominating and – some would say – distorting their operation. And all central bankers would like to be able to say that the long recovery from the Financial Crisis and rebuilding of the financial system was complete and, to (mis-) quote President George W Bush, it is “Mission accomplished”.
But the capacity for misjudgment is large, and (unlike when the policies were introduced, when the fires needed fighting urgently) there is no imperative to act now, today. And in the inner sanctums of central bank policy-making it is always easy to be sympathetic to a call for a delay for reflection and further analysis.
On the second task, that of managing inflation, the challenge is different. It is not that there are no rules, but that the rules seem to have changed. In most of the developed world, there is no inflation – not even in the UK, a notoriously inflation-prone economy but where the CPI remains stubbornly under 3% despite a 15% devaluation of sterling, a growing economy and a tight labour market with record high employment figures. Standard theories of the trade-off between economic activity, employment levels and inflation – summarised for economists in the theory of the Phillips curve – seem to have broken down and the usual central bank recipe for addressing inflation which is away from the desired levels (viz, altering official interest rates) appears to be ineffective.
That the Phillips curve was different during the height of the crisis did not surprise anyone; the global economy was under extreme stress and many other economic relationships were also affected and functioning differently from normal. But the continuing disconnect between monetary policy, economic activity and inflation even after several years of recovery and growth is more concerning and suggests that more fundamental changes have occurred. Central banks may need to appraise from first principles how the modern, more global economy works, what the impact of countries like China is on developed economies and how the “gig economy” has changed the dynamics of the labour market and the interaction between employment levels and salary growth.
Central banks are conscious that while inflation that is stubbornly below their targets may not seem much of a problem to the man in the street, over time it undermines their credibility as controllers of the economy, a credibility that will be important if in the future they once again face the need to rein back inflation that is rising above their desired levels. If the thought grows that it unclear how much the inflation rates of the past were actually under central bank control, even perhaps during the period of the “Great Moderation” before 2007, it will become increasingly hard to persuade people that the inflation rates of the future will be.
And on the final task, that of maintaining financial stability, central banks are painfully aware that there are only two rules – first, there will inevitably be banking failures and market crashes in the future (nobody seriously believes they have been abolished), and second, central banks will be unable to prevent them but also unable to avoid the blame for them.
Indeed, it is more complex than that, because the very act of making the financial system more and more robust will encourage the various private sector financial actors in the markets to take more and more risk. The more central banks are seen to be credible guardians of financial stability – and for understandable reasons central banks do want to be seen to be credible, do want to be seen to have mended the macro-prudential weaknesses that made the Financial Crisis possible – the more markets will come to rely on that credibility and feel able to push at the margins of financial prudence. This is a devastating feedback loop for those charged with maintaining financial stability. As the American economist Hyman Minsky observed, “Stability breeds instability”.
As an example of this, it is an interesting exercise to ask whether the authorities will ever allow a bank failure again. For all the discussion about the issue of “Too big to fail” – the fact that once a bank reaches a certain size, its failure would be so damaging to the economy that the authorities are compelled to rescue it – that dominated central bank discourse in the immediate aftermath of the crisis, it may now be more important to address the issue of whether any bank at all is “small enough to let fail”. If every bank knows that despite all the strong rhetoric, bail-in provisions and strict rules against the use of state finance, in the last resort no government will allow a bank to go under, what incentive remains for them to exercise restraint?
This is the very definition of moral hazard, and it is one of the unfortunate ironies of the authorities’ post-crisis activity that, despite their concerns and despite their best endeavours, the main result of their focus on financial stability after the crisis may have been to make moral hazard even more of a danger for the financial system.
Moreover, the very act of stabilising the financial system by circumscribing banks’ risky actions will undermine it. This is because ‘macro-prudential stability’, however defined or shaped, ultimately boils down to one thing and one thing only: for any given size of the banking system balance sheet, the stock of credit to the non-bank private sector will be smaller. But that will automatically create a demand for funds from borrowers unable to borrow from the banks, and a corresponding supply of funds from lenders prepared to meet that demand. In other words, the rise (more correctly, since it already exists, the expansion) of a shadow banking system. But the shadow banking system is by its very nature less regulated and controlled and thus more unstable. So by, as it were, putting a finger in the dam of “excessive” or “irresponsible” bank lending, central bankers and regulators simply open the gates for even riskier non-bank lending.
Thus in looking at the future, central bankers observe one task, the great normalisation, where they have little guide as to what to expect; a second, the control of inflation, where they are no longer totally sure they quite understand how economies work; and a third, financial stability, where they appear to have been set up to fail.
The common theme for all three of these is that central banks are not totally in control of events; in short, that they find themselves facing Responsibility without Power. This is not a good position for them to be in, especially as the public currently have high confidence in their competence and high expectations for their ability to manage the continuing emergence from the financial crisis.
If that public confidence and those public expectations are disappointed, there is a considerable risk to central bank reputations and possibly even their current independence. Governments may find any falling short by central banks a convenient moment to bring them back under closer oversight and control. And with the medium to longer term outlook for almost all developed economies being for more pressure on state finances as populations age, this opens the possibility of more active state direction of central banks – ordering them, for example, to be more concerned with growth than inflation. It might be very tempting for indebted governments to ask their central banks to “tolerate” higher inflation as state debt levels pass the point of no return and general inflation and financial repression becomes the easy way out for the over-indebted western economic model.
Central banks face an uncertain future as they re-establish what their role is in the post-crisis world, and the central bankers of the 2020s and 2030s may well look back with envy at the life of their predecessors in the “Golden Age of Central Banking” before the 2007-09 Financial Crisis.
 The quote is attributed to a speech Bush gave on 1 May 2003 on the US aircraft carrier Abraham Lincoln, at the conclusion of active hostilities in Iraq. In fact he never used these words – he was careful to say “Our mission continues” and “We have difficult work to do in Iraq”. But the huge banner behind him proclaimed the two words, and they have become inextricably linked to him ever since.
 See our previous article “Inequality, and the Licence Economy”, 11.12.16, for an assessment of the effect of the gig economy on society. In that article we observed that people working for “disruptor companies” such as Uber do not fit neatly into the standard division between employment and self-employed, and that society has yet to work out how to react socially, eg in taxation policy and employment protection legislation. The issue of what such employment means for economic management by central banks is another aspect of how radically they are changing the economy.
 Minsky’s main work was his “Financial Instability Hypothesis”, well summarised by Laurence Meyer, another US economist, as the theory that “a period of stability induces behavioural responses that erode margins of safety, reduce liquidity, raise cash flow commitments relative to income and profits, and raise the price of risky relative to safe assets – all combining to weaken the ability of the economy to withstand even modest adverse shocks”. The moment that stability is overcome by the forces for instability it has itself created has been christened the “Minsky Moment” in his honour.
 See for example the extreme lengths the Italian authorities have gone to – with the very grudging agreement of the ECB – to keep banks like Monti dei Paschi di Siena from collapsing and causing losses to the general public.