Monday, 2 November 2009

Where now central banks

Funny how we often see commonalities across disciplines. A famously clever man once said about the field of physics:

"There is nothing new to be discovered in physics now, All that remains is more and more precise measurement."

Lord Kelvin

Similar sentiment was probably held with regards to monetary economics until very recently. We just seemed to know it all, more or less, and the fruits of that understanding appeared to be ripening on the vine with low and stable inflation and interest rates.

Prior to the recent difficulties economists were probably guilty of complacency. Central banks seemed to have found their ideal role as independent guardians of price stability, with sole discretion over the use of monetary policy. That is entirely understandable. It was and still is believed that (1) "money is neutral", that is it has no long term influence on real incomes and that (2) inflation creates net costs and (3) inflation is purely a monetary phenomenon. Those three beliefs led to the 1990s craze for independent central banks tasked with meeting specific inflation targets.

An associated development was the division of roles, traditionally both held by a single central bank, where responsibility for regulation of the financial system went to a new and separate organisation.

And things appeared to be moving swimmingly. Monetary policy from Britain to Australia, via the US and Euroland was tweaked up and down by the various independent price guardians as demands appeared to dictate. Inflation was subdued and relatively stable everywhere that this was practiced. Sure, there was debate about rapidly rising asset prices (asset price inflation) and the need for monetary policy to consider this in an inflation targeting remit. But that argument didn't gain traction and was really at the periphery while goods and services inflation remained low and apparently under control.

The rest of course is history as the financial world neared complete implosion and we entered into a deleveraging process that might lead to anemic growth in a number of countries for a few years yet. So what will come out of this in the form of debate and possible reform of regulation and monetary structures and policy approaches? Here is a a few things that I think will come to the fore:
  • Rethink on the separation of financial regulation and monetary policy roles. Many now better understand the potential for the two to be closely intertwined. A purist might say that things worked as they should; the world levered itself up on debt and tried to inflate itself via excess demand for goods and services (as well as assets), but central banks held tight on the money lever and inflation never took hold and eventually led to the end of the party before inflation could take hold. However, a more circumspect view might be that given the deflation that has now occurred in many countries policy wasn't optimal - was there a way to understand that non-monetary developments were a threat to price stability (i.e. a potential for a collapse and deflation) and that the regulatory environment might have had some role to play in mitigation? That is the debate to be had. Should financial regulation and monetary policy be closely considered in such a way that only a single organisation should be tasked with overseeing both in a coordinated fashion?
  • Appropriateness of monetary targets. Up until today, despite some differing views, it is accepted in the mainstream that monetary policy should be used as an instrument to meet an inflation target defined as goods and services price inflation. Some have questioned in the past whether asset price inflation should have some weight in monetary policy decisions directly (as opposed to indirectly), but that argument has not held sway. Maybe that question needs to be opened afresh and rethought.
  • International interdependence. With a floating exchange rate and an independent monetary authority (central bank) it is thought that an economy is insulated from monetary shocks from abroad. It doesn't matter if Ben Bernanke goes off on a bender and inflates the US economy because other countries can follow their own inflation targets and allow nominal exchange rates to adjust for changing relative prices. This adjustment occurs through money and foreign exchange markets. But have we seen, via highly integrated and increasingly large asset markets and importantly increasingly large balance sheets on financial intermediaries that straddle national regulatory boundaries, a potential short circuit to that independence? It is something that is worth understanding better.

It will be worth watching, but monetary economics should be one area of research that returns to focus over the immediate future, after suffering recently from being "pretty much solved".

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