Central banks will be rewarded for their crucial crisis response with more missions that threaten their effectiveness and independence.
If the reward for good work is more work, pity our central bankers.
Following their stunningly successful response to the pandemic lockdowns, the world’s monetary policymakers now face a treacherous collection of challenges with little visibility and limited tools. The risk for markets is that rising political frustration will curb their independence and undermine their effectiveness when the next crises strike.
Confusing price and growth data recently makes it too easy to focus on the risks that current monetary policy is all wrong and forget just how decisively the world’s central bankers intervened last year to avert catastrophe. From Washington and Frankfurt to Moscow and Pretoria, the action was swift and comprehensive.
They didn’t get everything right, but one shudders to think of a world that had to await fiscal support from politicians. The responses required a granular analysis of market dysfunction, a differentiated understanding of local conditions, and a careful calibration of intervention, but ultimately they essentially threw a lot of money at the problem and it worked.
The challenges ahead are far more complex, the disagreements over policy are more intense, and the risks of getting it wrong are much higher.
The immediate test, of course, is the recent surge in prices, including last week’s whopping U.S. Consumer Price Index reading at 6.2%. Central bankers and economists still believe these pressures should unwind next year as the surge in demand normalizes and supplies recover. They know that raising interest rates won’t produce more port capacity or truck drivers—and that patience is a virtue.
Assuming they are right about inflation, the next challenge is deflation. A combination of demographic pressures, globalization, and technology have conspired to drag developed market growth rates lower in recent decades, and it’s not clear that the pandemic reversed this trend. The Fed and the European Central Bank have announced new frameworks that allow inflation to overshoot their 2% targets in the hope of raising the average, but this remains a hope. Negative interest rates could help a little, but their effectiveness may dwindle over time. Of course, the Bank of Japan has little to show for its extensive experimentation to boost growth or prices.
Just this week, the Fed highlighted a third major headache, sharing its concerns about froth and exuberance that threaten financial stability. Given the amount of money that governments have injected to underpin the recovery, the possibilities for unintended consequences are plentiful. In particular, the Fed report cites potential risks from inflated asset prices, rising leverage, and funding risks. Ominously, perhaps, it calls out funding risks to the nascent “stablecoin” sector.
Next on the list is the cost of government debts, which jumped more than 15 percent of GDP in many advanced economies during the pandemic. If central banks need to snuff out inflationary pressures with higher rates, they will be directly adding to the debt costs of their national governments. There are a few immediate concerns about countries tipping into an unsustainable spiral, but politicians will surely start to ask why central banks aren’t doing more to save taxpayers’ money.
Finally, the very size and effectiveness of central banks has raised calls for more muscular responses to climate change and wealth inequality. But as laudable as these goals may be, the tools don’t necessarily fit the task. As supervisors, central banks can ensure that banks do more to measure and disclose climate risks or even encourage lending in poor neighborhoods, but most of the responsibility on these questions still rests with lawmakers.
As these challenges grow more complicated, so will the uncomfortable questions for central bankers. Why is a little inflation so bad if it brings jobs to those in desperate need? Do you realize that raising interest rates takes money from worthy government programs? Is there anyone you won’t bail out?
Even if the questions don’t lead to new legal mandates, markets start to provide their own answers. Maybe inflation will begin to run hot so the Fed can argue it’s doing all it can to create jobs for the poor. Maybe rate hikes are delayed because they risk blowing a hole in the budget. Worst of all, uncertainty around its tools for crisis intervention may hamstring central banks’ ability to do what they have demonstrated they can do best.
As General Electric, America’s most storied conglomerate, announces plans to split up its businesses to better focus on sustainable profits, there may be lessons for monetary policy, too. The best way to protect the effectiveness of central banks is to appreciate what they can accomplish, but respect what they can’t.