What connects the Bundesbank’s suicidal resistance to the European Central Bank’s ramping up its balance sheet, then ECB president Jean-Claude Trichet’s maddening bid to sacrifice global economic stability on the altar of so-called price stability via rate cuts in both July 2009 and April 2011 and the curious case of the euro dollar exchange rate of 1.48, also in April 2011?
Answer: central banks’ restrictive mandates and the subsequent rules-based dogma inherent in monetary policy circles.
In September 2010, an IMF working paper, penned by chief economist Olivier Blanchard, broke policy taboo – given the lender’s hawkish history – by suggesting central banks should aim for a higher level of inflation in "normal times in order to increase the room for monetary policy to react to such shocks". Central bankers could target 4% inflation, rather than the 2% goal that is basically the case now – and the Fed’s newfound target, as of January 2012 – the IMF paper suggested. The logic was simple: higher inflation in benign economic cycles would give policy-makers more juice to cut in lean times, it argued. Although this paper shifted the debate by arguing that the G10 monetary policy agenda was wide of the market, the IMF neglected to wax lyrical about how such a shift in policy calculations would necessarily entail a change in G10 central banks’ mandates. What’s more, events this year have thrown into sharp relief just how the growth/inflation trade-off is yesteryear’s challenge. In the current market environment of deleveraging, attempting to ward off inflation via rate cuts exacerbates the deleveraging process while reducing economic growth.
Enter Morgan Stanley. In a note on Thursday, Morgan Stanley’s brilliant emerging market economist Manoj Pradhan sought to open a debate hitherto closed: amending central banks’ mandates, with a policy prescription that goes further than the IMF. Inflation-targeting puritans – those that are left – should look away, now:
| "Time to change central banks’ mandates: Until private and public sector debt become sustainable, we believe that monetary policy will have to choose higher inflation over the risk of derailing growth and deleveraging. Tightening policy to fight inflation, at least from the major central banks, would create ripples not just domestically, but across the globe. The impact of monetary tightening when the debt sword of Damocles looms overhead was adequately showcased in the 2011 episode when the ECB tightened policy to try to fend off inflation risks. Higher interest rates pushed the euro economy into recession and aggravated the sovereign debt crisis, with well-known global repercussions. Further, in the current fragile situation where the global economy is stuck in a twilight zone between expansion and recession, tighter global monetary conditions could put the transition of emerging markets to more sustainable drivers of growth in question |
The current monetary policy course entails a mismatch between the unholy trinity of debt, deficit and deleveraging, and neglects the post-modern era of fiscal dominance, argues Pradhan. He makes the following points:
1. The Taylor Rule – the conventional benchmark to assess the output gap – is a pre-crisis reaction function for a central bank, since it assumes public debt sustainability.
2. By logical extension:
| "when the sustainability of private and public debt is in question, the central bank will need to smooth the path of deleveraging by keeping rates lower than the Taylor Rule would suggest. This is because the ‘neutral’ real rate of interest (the unobservable real policy rate at which output and inflation are steady in the medium term) is likely much lower in a highly indebted economy. Why? Lower potential output will lead to a lower neutral real rate by itself. However, lower potential output will also mean a lower sustainable level of debt. The latter, in turn, will mean an even lower neutral real rate of interest for the economy. Thus, the policy prescription would be to account for a lower neutral real rate not only because of potential output growth, but also because of debt-sustainability issues. Ignoring this indirect but strong effect on the neutral rate can be counter-productive." |
Interest rate hikes aimed at reducing inflation could actually increase inflation, he argues:
| "In a highly indebted economy with rising inflation, a central bank that tries to quell inflation can actually increase inflation volatility. How? If the central bank raises policy rates to fight inflation, then debt looks less attractive because servicing costs increase with policy rates and output growth falls as real rates rise. This prods investors away from financing debt and ends up creating deflationary risks. The central bank then has to come in, reverse its tightening stance and ease policy quite aggressively to induce investors to return to debt markets. The end result is, perversely, an increase in inflation risk. This recounts rather well the ECB’s hiking of policy rates in early 2011, the ensuing crisis in sovereign debt markets and the subsequent aggressive easing via the LTROs and the OMT.
Whether DM central banks acknowledge it or not, they are in a regime of fiscal dominance, and business as was usual before the crisis no longer is." |
Recognizing these risks, Morgan Stanley thinks central banks will probably opt to tolerate above-target inflation but reckons it would actually boost their credibility by hard-wiring new policy objectives in their mandates via a lower real neutral rate of interest rather than pursuing a nominal inflation target. All very political stuff:
| "A change in mandates would break this vicious cycle most effectively, though it remains the most contentious way of doing so. Specifically, central banks need to account explicitly for a lower real neutral rate of interest rather than pursue a nominal inflation target. If there is a lower bound for policy rates and bond yields, then remaining beholden to an upper bound for inflation amounts to capping how negative real interest rates can become. Policy-makers have discussed negative (nominal) policy rates, but whether they will take them deep enough into negative territory is debatable, in our view. A rather easier way of generating more negative real interest rates is through higher inflation. The actual manner of implementing this change of mandate remains debatable and will likely be heavily contested, we think. One way to achieve this would be to set a conditional inflation target, one that allows inflation to be higher until both growth and debt move to sustainable levels. Such conditionality would not be new." |
On the latter point, the Fed has debated for years about how to agree on inflation/employment targets that should help to anchor monetary policy, with the Fed's asset purchase programme intensifying this policy challenge, but there is little sign of agreement.
Hard money fetishists would no doubt be incensed at the suggestion that lower-bound effective policy rates won't necessarily fuel inflation. Scary that in the age of the super-hero central banker, monetary economists disagree so starkly on the price-stability implications of the current G10 monetary stance.