By Anthony Harrington
In a speech in mid-May, Jaime Caruana, general manager of the Bank for International Settlements (BIS) told a London audience that central banks were now deep in unchartered waters.
“Central banks have had to think “outside the box” to address unprecedented financial instability and to provide monetary stimulus in trying times,” he said in his opening comment.
Monetary stimulus was essential with major economies, (the U.K., the U.S., Japan, the EU) all showing zero to sluggish growth, but the big central banks face some severe challenges figuring out the way ahead in a world where interest rates are at or near zero, he argued.
Changes in the conduct of monetary policy in response to changing market circumstances are not unusual. The past century saw considerable changes along these lines, he told his audience. Focusing on price stability has brought considerable benefits to central bank monetary policy management in recent decades, but it came out of the double digit inflation era of the 1970s and 1980s. Getting central banks independent of political control has also been hugely beneficial. But while these lessons should not be forgotten, today’s challenges call for different responses and a further evolution of central banking thinking, he argued.
While there is no question that at the height of the crisis the response by the central banks prevented the global financial system from imploding, banks now need to find new ways of addressing lacklustre growth. However, the role of central banks is limited, he warned, by the fact that a boom and bust such as we had in 2008 “leaves in its wake not only too much debt, but also too much capital and labour in the wrong sectors." Countries need to look at structural reforms of their labour and capital markets to help squeeze out inefficiencies in the economy and to speed up the reallocation of labour and capital to areas of the economy that are working.
This is not a central bank function and until it is put in hand, central bank pulling on whatever levers are available to it, can only be at best palliative, he suggested.
“Monetary policy can buy time to implement the necessary balance sheet repair and structural reforms, but it cannot substitute for them,” he warned.
Accommodative monetary policy can actually be counter to this restructuring, since it gives politicians more room to “kick the can down the road” he said, making a point that any Austrian economist would be only too happy to applaud. One obvious – and often made – criticism of the current accommodative stance by central banks is that it has allowed countries, companies and individuals to postpone deleveraging and reducing debt, and has in fact led to increases.
“... although some private sector deleveraging is occurring in some countries, and the financial system is better capitalised, the total debt figures are not reassuring. Since the end of 2007, total debt of the G20 non-financial sector, both private and public, has risen by more than 30 trillion US dollars, which runs counter to deleveraging, at least as I understand the term. It is noteworthy that over the same period global central bank assets have increased by roughly 10 trillion US dollars."
The other big danger of accommodative policies (money printing, in short) is that it could stoke inflation, and has done so many times in the past. However, Caruana argues that “this time is different”. Inflation is low in most jurisdictions, he points out, though we could be seeing the start of a major spike in asset prices ahead of a surge in goods and price inflation. Another “evil” they spawn is that extremely low rates in advanced markets stimulate a “hunt for yield” and as investors shift their attention to emerging markets they automatically push up rates in those countries. Emerging markets can try to deflect this by lowering their own rates, but that tends to drive a domestic credit boom (not a problem in advanced markets when consumers and banks are both trying to deleverage and demand for credit is weak). If they put up their rates, on the other hand, that simply adds fuel to the flames and creates an even stronger demand for their currency. All this means that central banks in advanced markets have to look ahead and work out their exit strategies from today’s overly accommodative markets.
This is likely to be a lot harder to do than it is to say: “While central banks surely have all the tools available to technically engineer an exit, it cannot be taken for granted that (such an exit) would prove smooth,” he warns.