Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

Why these are difficult times for central banks

The problem is not limited to possible side effects of unconventional policy

The possibility of another rate hike by the US Federal Reserve has created uncertainty in financial markets once again. They witnessed significant volatility at the beginning of the year after the Fed raised rates in December. Although the immediate trigger was traced to China, the Fed had to convince global markets that the pace of its future rate hikes would be gradual and has effectively delayed the policy normalization process. It is possible that markets will force the Fed to go back to the drawing board.

The world of central banking is getting increasingly complex. Gone are the days when managing the supply of money smoothened the business cycle, brought stability and ushered in an era of “Great Moderation". Major central banks in the developed world today are in an extremely difficult spot after having taken a visible leadership role in reviving economic activity in an environment of “secular stagnation."

As standard tools have stopped yielding results, central banks in advanced economies are pushing the envelope of policy experimentation without much clarity on risk-return trade-offs.

While the Fed has managed to raise rates at least once, others such as the European Central Bank and the Bank of Japan are pursuing aggressive unconventional policies with promise to do more if necessary. As the path of asset purchases and even the audacious experiment of negative interest rates are not able to convincingly push economic activity and prices, talk of permanently monetizing government debt is now gaining ground.

There are multiple problems with this idea. For instance, it is not clear whether this will work or not in the given circumstances and how much monetization will be sufficient to attain the desired outcome in different economies. More importantly, the standing of fiat currency is based on trust and it is unclear as to what will happen if central banks start creating money, literally out of thin air.

It’s a catch-22 situation for central banks. If they don’t do more, they could be blamed for not doing enough. But if they continue to use unconventional tools aggressively and still fail to revive output, or end up creating problems for the future, they could lose credibility.

Economist Mohamed A. El-Erian has aptly described the situation in his book The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse: “Being ‘the only game in town’ means that central banks are especially vulnerable to the winds of political backlash should economic mediocrity continue and financial instability return. This is particularly important in a world in which unconventional monetary policy is also altering the configuration of financial services, actively taxing one segment of the population to subsidize another... Rather than just act as referees, central banks have also taken the field in quite a range of sports."

Experts including Reserve Bank of India governor Raghuram Rajan have warned against the risks associated with aggressive use of unconventional tools. But the problem is not limited to possible side effects. Central banks are also facing the risk of losing their hard-won autonomy and independence in case of greater political review.

Therefore, this is probably the most difficult time for central banks ever and it remains to be seen as to how they attain, if at all, the twin objectives of restoring growth and protecting credibility.

One possible way out is that policymakers in general and central bankers in particular accept that there are limitations to monetary policy as well. In this context, they would do well to reflect on more fundamental issues as also highlighted by Mervyn King, former governor of Bank of England in his book The End of Alchemy: Money, Banking, and the Future of the Global Economy: “The fact that the recovery is far weaker than we expected, even with the extraordinary monetary stimulus that we have in fact put in place, suggests that something is amiss. We need to tackle the underlying disequilibrium. Easy monetary policy is necessary but it is not sufficient for a sustained recovery."

It is also important to note that the era of great moderation was also supported by more favourable demographics, high productivity and higher global growth—all missing at this point.

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