Global: Central Banking Discredited
By Stephen Roach (New York)
Feb 17, 2004
SourceThey are yesterday’s heroes. Central banks ruled the world during some 22 years of disinflation. But like most champions, they have overstayed their welcome. The world’s major central banks — the Federal Reserve, the Bank of Japan, and the European Central Bank — have squandered the capital they built up in the long and arduous war against inflation. And now, with their policy arsenals dangerously depleted, they are woefully ill-equipped to cope with the ever-daunting complexities of a post-inflation era. Bondholders beware: Your once-proud defenders have met their match. I fear modern-day central banking is on the brink of systemic failure.
It all started, of course, with the Bank of Japan. Not only did the BOJ fail to address the perils of a major asset bubble in the late 1980s, but it also made a series of well-known policy blunders in belatedly coming to grips with the aftershocks of the post-bubble climate. Unfortunately, for Japan the impacts of its bubble had spread well beyond equity and property markets — not only infecting its financial system but also leading to a severe overhang of excess capacity in the real economy. While the BOJ hardly deserves all of the blame for the Japanese disease, the central bank certainly could have acted far more aggressively to deal with those problems than it did.
Sadly, with its policy interest rate at zero and the Japanese economy in a serious deflation, the BOJ is now saddled with the painful legacy of a failed central bank. Its so-called zero-interest-rate-policy (ZIRP) is reflective of a monetary authority that has all but abdicated control over the real economy and financial system. Nor is the BOJ likely to change its stance on the heels of a 4Q04 GDP growth rate that we reckon hit 4.7%, the fastest increase in three years. If anything, Takehiro Sato of our Japan team believes that the Japanese central bank is now sending a signal that the ZIRP exit strategy has been pushed further out into the future (see his January 9, 2004 dispatch, Pragmatic BOJ: Toward Phase Two).
Alas, there’s far more to the BOJ’s post-bubble travails than the challenges of managing a dysfunctional Japanese economy. The central bank also had to come to grips with global pressures that are bearing down on the Japanese economy. In an effort to prevent a strengthening yen from exacerbating an already serious deflation, the BOJ has become the enabler in the Ministry of Finance’s massive program of currency intervention. And massive it is: The Japanese government’s supplementary budget for FY2003 provides for an additional ¥21 trillion (US$200 billion) funding to the MOF for currency intervention, following the previously approved ¥79 trillion (US$750 billion). Actual intervention in 2003 appears to have totaled US$184 billion — unprecedented in the annals of currency support operations.
In acting as an agent for the MOF and incorporating the currency dimension into its policy struggle, the BOJ has framed the central bank dilemma in a very different light. Long gone are the days when the monetary authority could afford the luxury of focusing on “closed” models of country-specific economic performance. Globalization — and the increasingly integrated and fast-moving flows of goods, services, and financial capital — demands “open” models of policy formulation. On that score, the BOJ is being pushed well out of its comfort zone to engage in the functional equivalent of unlimited currency intervention. Nor are the impacts of such policies without their own unintended consequences: To the extent currency intervention results in massive purchases of US Treasuries, that has the effect of reinforcing the Fed’s efforts to suppress American interest rates. That could well further exacerbate imbalances in the US economy and in the US-centric global economy.
The Fed, for its part, has gone out of its way to assure market participants that it has learned the lessons from the Japanese experience (see Alan Ahearne et al., Preventing Deflation: Lessons from Japan's Experience in the 1990s, Federal Reserve International Financial Discussion Paper No. 729, June 2002). That remains to be seen, in my view. The US central bank has all but refused to modify its policy framework to cope with extreme fluctuations in asset markets. Chairman Alan Greenspan has led the debate, arguing instead that the monetary authority had best be prepared to deal with post-bubble damage containment rather than take preemptive actions to stave off speculative excesses (see Greenspan’s recent speech, Risk and Uncertainty in Monetary Policy, remarks presented at the meetings of the American Economic Association, San Diego, California, January 3, 2004).
The Fed’s approach in dealing with asset bubbles suffers from three serious shortcomings, in my view:
* First, it may only be a “one-bubble” success story. In a low inflation climate, aggressive post-bubble easing can take the policy rate down to exceedingly low levels. Witness today’s 1% federal funds rate — dangerously close to the zero nominal interest rate boundary. If the Fed is unable or unwilling to lift rates for any reason, then it will be lacking in the ammunition required to deal with subsequent post-bubble shakeouts or other deflationary shocks.
* Second, it creates a moral hazard dilemma. The fear of lingering post-bubble deflationary perils — a classic by-product of an asset bubble — can lock a central bank into a protracted monetary accommodation. It doesn’t take investors and speculators long to figure that out — especially with the Fed now back to its old tricks of wordsmanship (i.e., splitting hairs between “considerable period” and “patient” insofar as the duration of monetary accommodation is concerned). Persistently low nominal interest rates are a breeding ground for subsequent asset bubbles. Recent activity in property, bond, high-yield debt, credit markets — to say nothing of renewed froth in equity markets — hardly makes that idle conjecture.
* Third, it perpetuates the risks of an asset-driven economy. The lingering asymmetrical biases of post-bubble monetary policy accommodation and the surging asset markets such policies support, keep the US economy heavily dependent on wealth effects. That exacerbates the imbalances of reduced saving and increased indebtedness. Should the economy suffer from a shortfall of income generation — precisely the case with America’s jobless recovery — an asset-driven economy may be all the more vulnerable to the inevitable back-up in real interest rates that normally afflicts an unbalanced economy.
In other words, the jury is still out on America’s Federal Reserve. From where I sit, the evidence is not very comforting. Yet “Fed-spin” has shifted into high gear. The US monetary authority has gone overboard to convince financial markets it has learned the painful lessons of Japan. In the end, however, it may well be that the Fed and the BOJ have all too much in common.
The European Central Bank is now headed down the same slippery slope. But unlike the BOJ and the Fed, the ECB has not fallen victim to the perils of an asset bubble. Instead, it remains fixated on inflation targeting at precisely the time when Europe is actually facing deflationary risks. With structural reforms lagging, domestic demand weak, the currency on the rise, and inflation finally receding through the 2% threshold, the ECB can hardly afford to rule out a deflationary endgame. In that context, the last thing Europe needs is an intransigent central bank. That’s precisely the risk as the ECB refuses to flinch on its increasingly irrelevant inflation-targeting mandate.
Yet Europeans are remarkably blasé about the possibility of deflation. Such complacency is all the more worrisome in light of widespread deflationary pressures still evident elsewhere around the world. In this climate, and with future currency appreciation more likely than not, the ECB cannot afford to play the odds. Unfortunately, the European monetary authorities are digging in their heels at precisely the time when they should be more flexible. A stubborn ECB has all too much in common with its counterparts at the BOJ and the Fed.
All this spells a sad assessment of the state of central banking. History has long demonstrated that monetary policy is far better equipped to deal with the ravages of inflation than the perils of deflation. For that reason, alone, the record of central banking in recent years is all the more disturbing. Yet few seem concerned. In fact, with recovery in the global economy having finally gained some traction in the past couple of quarters, a new complacency is setting in. One central banker — namely Fed Chairman Alan Greenspan — has even had the audacity to claim vindication for a job well done (see his January 3, 2004 speech noted above). Hubris in this climate could end up being very regrettable, to say the least.
The toughest aspect of this conundrum is that there may well be no easy or painless way out. Mindful of lingering deflationary perils, central banks are continuing to err on the side of aggressive accommodation. In an exceedingly low inflationary climate, such accommodation spells exceedingly low policy interest rates — “zero” in the case of Japan, 1% for the US, and 2% for Europe. That leaves the authorities with precious little in the way of remaining ammunition to cope with any unexpected shocks. Meanwhile, the tensions of a lopsided global economy are being vented in currency markets in the form of a weaker dollar — triggering a realignment in relative prices that only puts greater pressure on Europe and Japan. To the extent that central banks counter those pressures through currency intervention, America’s interest rates would be held artificially low and the excesses of an asset-driven US economy would only mount. The Fed could well be trapped in a dilemma of its own making — unable to raise policy rates because of lingering deflation perils and without any ammunition to deploy in the event of another shock.
In retrospect, we probably asked too much of monetary policy. At its best, it is a very blunt instrument — well-equipped to deal with the excesses of inflationary expectations but ill-equipped to deal with the subtleties that come into play near the hallowed ground of price stability. That leaves central bank mandates hopelessly out of step with today’s deflation-prone global economy. Old-fashioned CPI-based inflation targeting simply doesn’t suffice if success in hitting such a target gives rise to a steady stream of asset bubbles, saving shortfalls, and external imbalances. At exceedingly low rates of inflation in goods and services, I believe central banks should abandon narrow CPI-based targets in favor of broader targets including asset prices. Unfortunately, that requires a flexibility that few central banks possess.
A systemic failure of monetary policy also raises the risk of a political backlash that could jeopardize the hard-won independence of central banking. In my view, politicians will not sit by idly if central banks repeatedly mismanage their economic mandates. A politicization of central banking cannot be ruled out if that turns out to be the case. Anti-inflation discipline would probably be the first thing to go in such a new regime. And that would be the last thing an over-bought bond market needs at the end of nearly a 22-year secular rally. Ironically, there are those now bemoaning the extinction of the bond-market vigilante (see “The Last Vigilante,” by PIMCO’s Bill Gross, February 2004). The downfall of central banking may yet give those grizzled old warriors a new lease on life.