Is modern central banking ancient history?

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This post is a guest contribution by Manoj Pradhan of Morgan Stanley.

Two of the three principles of modern central banking were designed for a regime that developed economies will not see for the foreseeable future. The principles – (i) inflation targeting improves growth prospects in the medium run; (ii) inflation targeting effectively means inflation forecast targeting; and (iii) a ‘conservative’ central banker (i.e., one who dislikes inflation more than the average economic agent) can deliver lower and less volatile inflation – are almost unquestioned among the central banking orthodoxy. However, these principles were espoused in an era of low debt when monetary policy was the dominant force. In the era we now live in, where debt, deficits and deleveraging (a DDD regime) are the dominant drivers of the economy and policy – an era of so-called ‘fiscal dominance’ – the first and the last tenets can cause more harm than good. Inflation targeting and an aggressive approach to taming inflation in such times can create more volatile inflation and higher sovereign risks.

G3 monetary policy is still ultra-expansionary and on its way to becoming even more so, given the current disinflationary risks. However, inflation clocking in at over 5% in the UK and over 3% in the US and euro area gives hawks and dissenters plenty of ammunition. There remains a risk that monetary policy could ignore the perils of trying to curb inflation in an era of fiscal dominance. Tellingly, Chairman Bernanke’s speech yesterday, The Effects of the Great Recession on Central Bank Doctrine and Practice, contained not one mention of fiscal concerns, let alone fiscal dominance. That the single greatest peacetime build-up in debt burdens in our lifetimes should go unmentioned in such a speech is strange at the very least.

Fiscal dominance – what does it mean? In the simplest characterisation of fiscal dominance, the fiscal position of the economy effectively ‘sets’ a target that monetary policy has to follow. Monetary policy plays a subordinate role, keeps interest rates low and allows inflation to erode the real value of government debt. By contrast, monetary dominance implies that fiscal policy plays a passive role while monetary policy goes about keeping inflation under control without a concern about the adverse effect of higher interest rates on the ability of governments to sustain the debt burden. Such a regime clearly existed before the onset of the Great Recession in the advanced economies (excluding Japan) and continues to exist in the emerging market economies even now. Since the Great Recession, however, things have changed.

Fiscal dominance isn’t a new concept. In 1981, one of this year’s Nobel Laureates, Thomas Sargent, and co-author Neil Wallace argued that trying to achieve too little inflation in a debt-ridden economy only meant inflation had to be ramped up further down the road to reduce the real debt burden.

More recently, the fiscal theory of the price level has argued that monetary policy needs to accommodate fiscal dominance by providing lower real interest rates as inflation rises. These papers spurred great debate, but the practical contribution of that research is going to be evident only now given that much of the developed world is in the clutches of sovereign risk and there is a prospect of many years of deleveraging of public debt.

Taylor Rules missing the point: Perhaps the best way to highlight the stark contrast between the two regimes is to consider Taylor Rules. Used (and often abused) to assess where policy rates should be, given macro fundamentals, the underlying structure of the Taylor Rule is often ignored. In its construction, the microeconomic foundations of the Taylor Rule assume that the government sets policy in order to keep the budget balanced. This takes an awkward fiscal position of questionable sustainability out of the equation, quite literally.

Why does disinflation perversely lead to more volatile inflation? If we now turn to Taylor Rules under a regime of fiscal dominance, we see that an aggressive pursuit of inflation targeting leads to undesirable volatility of inflation – a point made very convincingly by Kumhof et al (2008). Why? The standard Taylor Rule would recommend, all else equal, that the central bank raises policy rates faster than inflation, thereby raising real interest rates in order to slow down the economy and reduce inflation. However, when there is a high level of indebtedness, higher real interest rates reduce the attractiveness of sovereign debt in two ways. First, the cost of servicing this debt rises. Second, higher real rates reduce output and production, which makes it tougher for economies to ‘grow’ their way out of debt. The result is a rise in risk premiums and a higher probability of default.

Eventually, monetary policy is forced to turn its strategy around because it has to ensure fiscal solvency to prevent a catastrophe. In order to do so, it is eventually forced to push up inflation even higher than it was before in order to generate seignorage revenues. Clearly, applying what is considered ‘normal’ monetary policy when there is a regime of fiscal dominance therefore risks aggravating not just the fiscal situation but inflation dynamics too.

Allowing the central bank to explicitly respond to fiscal variables improves matters, but the best result comes from eliminating fiscal dominance altogether, through fiscal action.

Lessons from Latin America: The interplay of monetary and fiscal policy under such different ‘regimes’ is not a purely theoretical consideration. The history of Latin American economies in dealing with debt issues presents us with an all too familiar experience from the recent past showing the very real concerns that markets and investors should have about the future path of monetary policy. Writing about the Brazilian central bank’s desire to pursue its inflation-targeting mandate in 2002-03, Blanchard (2004) proposed that targeting inflation by raising real interest rates in a “high debt, high risk-aversion” environment would have served to make government debt less attractive, leading to an increase in sovereign risk. The ‘correct’ solution was a fiscal one, and a credible fiscal reform did indeed resolve the crisis. Echoes of this experience can be found in the economic and market reaction to the ECB’s tightening of monetary policy in early 2011. In the wake of the rate hikes, the ability of peripheral countries to service their debt in a higher interest rate environment likely added to the concerns surrounding sovereign risk.

Fiscal policy is the right way to tackle inflation: In both discussions, that of the Taylor Rule and the Latin American experience, the onus of dealing with inflation falls on fiscal and not monetary policy. Meaningful fiscal consolidation, as and when possible, eases out the regime of fiscal dominance, thereby allowing central banks to revert to aggressively dealing with inflation. In the period of transition between a realisation of the need for fiscal consolidation and its achievement, monetary policy serves its inflation-fighting credentials best by not fighting inflation aggressively.

Could central banks already be incorporating fiscal dominance? Given that we are reading tea leaves from the cups of monetary policy statements and actions, it is certainly possible that we may be underestimating the importance that central banks actually assign to fiscal dominance which is not reflected in their official speeches and statements.

In addition, central banks might not actually consider inflation to be a home-grown problem, and hence are willing to tread relatively softly on inflation at this point of time. Considering the Bank of England, domestically generated inflation is very low while imported inflation accounts for the bulk of the UK’s inflation problems. Could such an inflation profile also be applicable to the US and the euro area, where growth and pricing power remain weak? If so, central banks may be inclined to pay less attention to inflation, given that the bulk of it comes from outside national borders, while monetary policy would have the greatest impact within the economy.

Finally, central banks may be using the ‘flexible inflation targeting’ approach that Chairman Bernanke discussed in his speech yesterday, whereby stabilising output in the near term (particularly under exigent circumstances) is seen to be an important part of stabilising inflation expectations in the medium run. This flexibility could provide central banks the opportunity to assign greater importance to ensuring that growth becomes entrenched rather than worrying about inflation becoming sticky.

Despite these considerations, it appears that central banks are playing down the impact of fiscal dominance. Some within monetary policy committees stand more ready than others to take action to address inflation. The dissenters within the FOMC show that the higher and more persistent-than-expected rise in core inflation is clearly causing discomfort – this despite the fact that the US economy still appears to be short of reaching escape velocity as far as sustainable growth is concerned. The decision by the Bank of England to engage in a further round of quantitative easing just a few days before inflation breached 5% will clearly raise more questions in some quarters. However, the most important ‘revealed preference’ of monetary policy-makers to tackle inflation comes from the ECB’s decision to raise policy rates in early 2011 despite risks to growth and fiscal sustainability. The resolve of central banks to deal with inflation may now be subdued, but it is far from dormant.

The added complication – the ‘conservative’ central banker: Rogoff’s seminal paper in 1985 drilled home the result that a person/body with a greater distaste for inflation than the ordinary economic agent could deliver both lower and less variable inflation. This important result was often used to pick ‘conservative’ central bankers who would deal with inflation aggressively. It is interesting to note that this line of thinking preceded the advent of inflation targeting but was not abandoned once inflation targeting was widely adopted. The need to preserve the conservative credentials of the central bank was also the rationale for asking for independence from outside influence, including the government. Granting the monetary policy committee, a non-elected body, independence from the preferences of elected representatives does not sit well with the principles of democracy (Blinder, 1993), but the importance of acting decisively against inflation was deemed strong enough to bypass such concerns.

When inflation targeting arrived, the presence of a conservative central banker leading an independent central bank only served to bring inflation down faster. In a regime of monetary dominance, this combination worked very well. Under fiscal dominance, however, it will likely only make an aggressive pursuit of the inflation target more likely and therefore more disruptive.

Is modern central banking history? Some hope from the EM experience: The experience of emerging market economies shows some reason for optimism, but not in the near future. The lessons in indebtedness of the Latin America and the Asian Financial Crisis of the late 1990s were taken very seriously by policy-makers. Under the discipline of a punishing market, EM economies lowered their debt burdens and now boast levels of indebtedness, growth and fiscal solvency that are very attractive compared to the fiscal profile.

Ironically, the fact that EM central banks were not quite as independent as their counterparts in the advanced economies actually helped during periods of fiscal dominance. EM central banks, with their famous preferences for growth relative to inflation, did little to upset the applecart during tenuous times, allowing fiscal policy-makers more legroom to reduce indebtedness. Once the regime of fiscal dominance had been eliminated, EM central banks quickly adopted inflation-targeting policies to further improve macroeconomic fundamentals. Of course, the fact that EM central banks are still only quasi-independent is part of the reason why EM inflation expectations and inflation itself have not moderated even lower.

The one stark difference in the EM experience is that the deleveraging process was carried out against the backdrop of very strong global growth, a luxury that DM economies do not have. Eliminating fiscal dominance may therefore take longer. In this ongoing period of transition, DM central banks may have to take their cue from the EM experience and try to mimic their preference for growth rather than for lower inflation.

Summary: The era of fiscal dominance that we are now living through requires a different strategy of monetary policy. Pursuing traditional inflation targeting aggressively is likely to lead to more, not less volatile inflation. Should it try to reduce inflation, the central bank would have to raise real policy rates, which would end up making sovereign debt unattractive. The subsequent u-turn by the central bank as it tries to stabilise the risk around sovereign debt would require even higher inflation further down the road. The ‘solution’ to dealing with higher inflation is therefore better fiscal and not more aggressive monetary policy. Going by the experience of emerging markets, a successful fiscal consolidation wipes out the constraint of fiscal dominance and restores traditional monetary policy and inflation targeting. Until that happens, though, monetary policy can best burnish its inflation-fighting credentials by not fighting inflation aggressively.

Source: Manoj Pradhan, Morgan Stanley, October 21, 2011.

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