Prepare for central bank regime change

  • Inflation-targeting independent central banks have a longer history than most CB regimes
  • Market complacency that current regimes will remain is probably too optimistic
  • Most new regimes mooted mean higher, more volatile inflation and thus lower growth

Central bank and monetary policy regimes last longer than expected, but also change faster than expected. The current paradigm – independent inflation-targeting central banks – began when the Reserve Bank of New Zealand was granted independence and set an inflation target in 1989. By now, most of the world’s central banks have either followed suit or have an exchange rate target. (A notable exception is the Central Bank of China in Taipei, which seems to have much greater freedom of action and primarily has a broad money growth target.)

After 30 years, the length of this regime compares favourably with its predecessors. While the Gold Standard operated for longer in Britain prior to World War I, this was not the case everywhere. Broadly speaking, pre-World War I regimes – Gold Standard, Silver Standard, occasionally in the context of currency unions – were in place from the mid-1860s or early 1870s (in some cases even later) until 1914. However, since then, monetary policy regimes have succeeded one another with – by macroeconomic standards – bewildering speed. Most countries suspended the Gold Standard during World War I but attempted to return to it after that war. This lasted until the early to mid-1930s (depending on the country). There were then various experiments – including price-level targeting in Sweden – although most countries attempted to peg their exchange rates, while others engaged in competitive devaluations or capital controls.

After World War II, we have the Bretton Woods Gold Exchange Standard, lasting from 1944 to 1971, with attempts to keep it going afterwards; and other attempts, mainly concentrating on fixed-but-variable exchange rates, globally (through formal or informal cooperation, e.g., the Louvre and Plaza Agreements) or regionally (notably in Europe, but also, e.g., the CFA franc in Africa). Some countries eventually floated their exchange rates, while others tied themselves more firmly to pegs, in the European Union eventually culminating with EMU and the introduction of the single currency. But, notably none of the post-World War I regimes lasted as long as the current system. This in itself should bring a warning that it may be coming to an end.

Moreover, inflation targeting was introduced when inflation was excessive. This is no longer the case; on the contrary, as everyone knows, central banks in most countries have for years struggled to bring inflation up to target, not down. As long as the institutional memory of the 1970s and 1980s inflation remains, there will still be a constituency in favour of inflation-targeting. But those who experienced this, get fewer as time goes by.

In fact, we are already seeing talk of broadening central bank mandates. In one sense, this is already happening. Central banks everywhere are now having to shoulder more responsibility for financial stability. This was usually an implicit mandate, certainly so before the Great Moderation. But now it is becoming explicit, with new tools (or old ones being resurrected) deployed under the broad heading of macro-prudential policies. There is of course also talk of changing inflation targets (something we covered in our series on Central Banking in August 2017, notably here). But there is also more formal talk of broadening central bank targets. Perhaps significantly, when the latest New Zealand government was formed, there were discussions about including employment and exchange rate targets in the RBNZ mandate (something we covered here). Ultimately, this came to nothing; but it was perhaps a straw in the wind.

Independent inflation-targeting central banks are not the perfect monetary policy regime. But, low and stable inflation is a good per se and more conducive to economic growth than high and/or varying inflation. Hence, almost all the arguments for changing the regime, are ones in favour of higher inflation and/or would lead to more instability and, over the medium and longer term, lower output growth.

Even so, there are a number of reasons why governments – who at the end of the day are the ones who set central bank regimes – might want to move away from pure inflation targeting.

One is of course the desire for financial stability. However, it should be noted that whether financial stability in itself is a Good Thing, is not entirely clear. For instance. Frank Westermann of Osnabrück University has shown that countries without systemic crises over time grow more slowly than those who do experience such events.[1] This is primarily because in financially liberated economies, risk-taking is encouraged. This increases investment and ultimately output growth, but also systemic risk and leads to more frequent crises.

But, while low inflation is intrinsically good, it is not clear that monetary stability (i.e., low inflation) is either necessary or sufficient for financial stability.  Indeed, there is considerable evidence that long periods of monetary stability – such as in the 19th century, or indeed the period of the Great Moderation to 2007 – lead to a greater risk of financial instability, as risk takers become overconfident that current benign conditions will continue and take on extra risk. (This was of course the basis for much of Hyman Minsky’s teaching.) In a real sense, therefore, the more that central banks add a focus on financial stability to their list of objectives and desired outcomes, the more they will be tempted to ease back on inflation-fighting, which also adds weight to the view that the era of the single-issue monetary hawk central banker may be passing.

A second cause is the high public debt that governments have amassed during and after the Great Recession. A few years of high inflation – say, 5% – would do wonders in terms of eroding the real value of this debt. But, in order for this to work, bond markets have to be controlled so that bond yields don’t shoot up and cause trouble when debt refinancing comes around. Hence the case for the central bank targeting (low) long-term interest rates as well.

This ties in with two further (and interconnected) points. One is weak demographics in almost all developed and many important emerging markets. As dependency ratios rise and ever larger cohorts demand to receive the usually generous pensions they have been promised, governments will find it difficult to fulfil their pledges without needing to either raise taxes sharply or take on more debt – meaning that the case for real debt erosion becomes even more relevant.

The other is weaker trend growth. We have seen trend growth rates ease in almost all developed economies (and in many emerging ones) in the wake of the Great Recession. In addition, lower population growth or even contracting populations, will, all things being equal, exercise further downward pressure on trend growth.

Both factors will push governments to come up with some way of boosting productivity and trend growth, preferably rapidly. Again, this is likely to at least initially prove inflationary if governments engineer pro-cyclical policies in the hope of accelerating growth. The Trump Administration’s 2018 fiscal stimulus is perhaps a good case in point. Unless there is a sustained rise in trend growth, temporarily faster growth will be inflationary. But, having achieved faster growth once (assuming they do), governments will want to see this sustained. Here is an argument for central banks to have a growth target as well, or perhaps a generous nominal GDP target.

A further current factor that may push a move away from pure inflation targeting is the possible return to protectionism. We are perhaps currently seeing the start of a new trade war. But, even if not, it is clear that the global commitment to and belief in free trade is being eroded. If protectionism returns with a vengeance, there would be a temptation for governments to put a greater emphasis on the exchange rate as a policy tool, not so much to stabilise the currency, as in order to keep it weak. Of course, this would almost certainly also prove to be inflationary.

Although governments may pursue policies that are inflationary, higher inflation, if achieved, is likely to be resented very quickly, not least by the large and growing retired cohorts who are unlikely to be fooled for long by money illusion (more nominal income, less real purchasing power). A further consequence of such policies could therefore be a return to shorter and more violent inflation – and thus business – cycles.

All of these are risks. Moreover, in spite of the opening sentence, they won’t happen overnight. However, they are sufficiently important risks to be taken into consideration. And there are two further factors that make changes in central bank regimes likely. One is the current populist climate, with its mistrust of ‘experts’ and dislike of allowing non-elected technocrats a decisive say over any aspect of society.

The second is the wide-spread complacency displayed by financial markets that changes in central bank behaviour and circumstances during the Great Recession are temporary and that a ‘return to normalcy’ (to quote Warren G Harding’s 1920 campaign slogan) is around the corner. That may be true; but it is important to keep in mind that independent inflation-targeting central banks came about in response to a particular set of circumstances (persistent high inflation and politicians incapable and/or unwilling to bring it down). Moreover, the new framework was introduced by governments; and what governments give, governments can take away. Circumstances have now changed. We should not assume that central banks will be able (and not necessarily willing either) to defend their independence and single-target regime in the face of governments determined to change them. As outlined above, the temptation to dilute central bank targets is certainly there

[1] Frank Westermann et al, Systemic Crises and Growth, Quarterly Journal of Economics, 2007