Limiting Central Banking

Since 2007, and especially over the past year, actions of public officials have blurred the lines between monetary and fiscal policy almost beyond recognition. Central banks have expanded both the scope and scale of their interventions in unprecedented fashion. This fiscalization risks central bank independence, thereby weakening policymakers’ ability to deliver on their mandates for price and financial stability. In our view, to find a way to back to the pre-2008 division of responsibilities, officials must establish clearer limits on what central banks can and cannot do.

In that division of official labor, it is fiscal authorities that ought to make the unavoidably political choices that directly influence resource allocation. And governments should not conceal such fiscal actions on the balance sheet of the central bank. In a democracy, doing so lacks legitimacy and would become unsustainable….

Is Inflation Coming?

For more than a generation, the U.S. inflation-targeting framework has delivered impressive results. From 1995 to 2007, U.S. inflation averaged 2.1% (as measured by the Federal Reserve’s preferred index). Since 2008, average inflation dropped to only 1.5%, but expectations have fluctuated in a narrow range: for example, the market-based five-year, five-year forward (CPI) inflation expectation rarely dipped below 1.5% and never exceeded 3%.

However, the pandemic brought with it many dramatic changes. Fiscal and monetary policy mobilized, responding swiftly to the economic plunge with a combination of extraordinary debt-financed expenditure and balance sheet expansion. As a matter of accounting and arithmetic, these actions have had a profound impact on the balance sheets of banks and households, spurring dramatic growth in traditional monetary aggregates. From the end of February to the end of May 2020, broad money (M2) grew from $15.5 trillion to $17.9 trillion—a 16% jump in just three months.

Won’t the record 2020 gain in M2 be highly inflationary? We doubt it, and in this post we explain why. At the same time, we highlight the chronic uncertainty that plagues inflation. In our view, the difficulty in forecasting inflation makes it important that the Fed routinely communicate how it will react to inflation surprises—even when, as now, policymakers wish to promote extremely accommodative financial conditions….

Fiscal Space Has Limits, Too

In the battle against the economic impact of COVID-19, governments around the world are pulling out all the stops. In advanced economies, leading central banks have pushed interest rates to zero or below. And, a recent IMF estimate puts the combination of discretionary spending and automatic fiscal stabilizers (including unemployment insurance and progressive income taxation) at $9 trillion―more than 10 percent of global GDP.

With bond yields low or negative, the limits to monetary policy are clear (see our pre-COVID post). How large is the scope for additional countercyclical fiscal policy? With sovereign yields so low, the cost of additional financial expansion looks to be minimal, at least for now (see, for example, Blanchard).

Nevertheless, each time public debt-to-GDP ratios ratchet higher—as they did in the 2007-09 crisis and are now doing again—the question of “fiscal space” reemerges. When the next economic shock hits, will governments again be able to provide relief and stimulus on the scale required to meet society’s needs?

In this post, we highlight recent fiscal developments in advanced economies, and review the factors affecting the sustainability of their high and rising levels of debt. To foreshadow our conclusion, the fact that many countries’ fiscal positions were precarious even before the COVID crisis does not weaken the current case for stimulus. But, doubts about fiscal space are growing. So, it is important that governments find a way to make a credible commitment to future fiscal consolidation when their economies have returned to full employment. Failure to do so could threaten confidence both in government finances and in economic performance….

Helicopters to the Rescue?

Is helicopter money here? Do we need it now? Is it coming? The short answer to these questions is that it is not here and we currently do not need it, but should the economic disaster brought on by COVID-19 continue for much longer, that might change.

To be clear, the relief checks that governments are sending out to households and businesses are not helicopter money. Despite their enormous scale, the financing of these transfers is no different in character from that of traditional government benefits: governments are collecting taxes and issuing debt to the public.

Helicopter money is when the central bank finances government expenditure directly. In these circumstances, the fiscal authority, through its debt management policies, controls the size of the central bank’s balance sheet. This is monetary finance arising from fiscal dominance: to increase seignorage, the fiscal authority usurps the role of the independent central bank in determining the size of base money (currency plus reserves held by banks at the central bank).

Should monetary policymakers consider surrendering their independence in this way? In our view, a far better alternative is to peg the long-term interest rate at zero. Currently in use by the Bank of Japan, this policy of yield curve control allows central banks to retain a small, but significant degree of monetary control. It also captures the features of U.S. monetary policy from 1937 to 1951, when the Fed capped the long-term bond yield to support U.S. wartime finance (see here)….

Inflation is not (and should not be) a key worry today

A very simple version of 1960s monetarism has two elements. First, controlling money growth is necessary and sufficient to control inflation. Second, leaving aside a financial crisis, the monetary base―the sum of currency in circulation and commercial bank deposits at the central bank―determines the quantity of money. Putting those together means that, in order to control inflation, all central bankers need to do is ensure that their liabilities grow at the appropriate rate. Conversely, when the central bank’s balance sheet grows quickly, inflation inevitably follows.

This simple monetarist reasoning was still on display in 2010, when Ben Bernanke received this letter from a group of 24 economists warning against further large-scale asset purchases by the Fed. At that stage, the central bank’s assets exceeded 250% of their level in September 2008. Over just over two years, the Fed had purchased roughly $400 billion in Treasury securities and $1 trillion in federally guaranteed mortgage-backed securities. But, as Bernanke explained at the time, the purpose of these asset purchases was to aid the economy in recovering from the crisis-induced recession. Moreover, in contrast to prior norms, since October 2008 the Fed had been paying interest on reserves, raising the opportunity cost for banks to lend.

Subsequent experience proved the letter writers very wrong. The Fed’s balance sheet continued to grow, peaking at $4.5 trillion in early 2015. And, over the decade just ended, inflation (measured by the Fed’s preferred consumption expenditures price index) averaged 1.6%―below the central bank’s long-run goal of 2%. If anything, in recent years, and despite massive central bank balance sheet expansions, inflation both in the United States and in other advanced economies has been too low, not too high.

With central bank balance sheets now surging again, we recount this history in the hopes of blunting any inflation concerns, which we see as profoundly misguided. Over the six weeks ending April 22, the Fed’s assets have grown by the same amount as they did from September 2008 to March 2013. While this does raise some serious concerns, inflation is not high among them….

The Fed Goes to War: Part 1

Over the past two weeks, the Federal Reserve has resurrected many of the policy tools that took many months to develop during the Great Financial Crisis of 2007-09 and several years to refine during the post-crisis recovery. The Fed was then learning through trial and error how to serve as an effective lender of last resort (see Tucker) and how to deploy the “new monetary policy tools” that are now part of central banks’ standard weaponry.

The good news is that the Fed’s crisis management muscles remain strong. The bad news is that the challenges of the Corona War are unprecedented. Success will require extraordinary creativity and flexibility from every part of the government. As in any war, the central bank needs to find additional ways to support the government’s efforts to steady the economy. A key challenge is to do so in a manner that allows for a smooth return to “peacetime” policy practices when the war is past.

In this post, we review the rationale for reintroducing the resurrected policy tools, distinguishing between those intended to restore market function or substitute for private intermediation, and those meant to alter financial conditions to support aggregate demand….

Italeave: Mother of all financial crises

After years of calm, fears of a currency redenomination—prompted by the attitudes toward monetary union of Italy’s now-governing parties and the potential for another round of early elections—revived turbulence in Italian markets last week. We have warned in the past that an Italian exit from the euro would be disastrous not only for Italy, but for many others as well (see our earlier post).

And, given Italy’s high public debt, a significant easing of its fiscal stance within monetary union could revive financial instability, rather than boost economic growth. Depositors fearing the introduction of a parallel currency (to finance the fiscal stimulus) would have incentive to shift out of Italian banks into “safer” jurisdictions. Argentina’s experience in 2001, when the introduction of quasi-moneys by the fiscal authorities undermined monetary control, is instructive….

Central Bank Independence: Growing Threats

The median FOMC participant forecasts that the Committee will raise the target range for the federal funds rate three times this year. That is, by the end of 2017, the range will be 1.25 to 1.50 percent. Assuming the FOMC follows through, this will be the first time in a decade that the policy rate has risen by 75 basis points in a year. It is natural to ask what sort of criticism the central bank will face and whether its independence will be threatened.

Our concerns arise from statements made by President-elect Trump during the campaign, as well as from legislative proposals made by various Republican members of Congress and from Fed criticism from those likely to influence the incoming Administration’s policies....

Inflation and Fiscal Policy

Why is it proving so difficult to raise inflation? For generations after World War II, this was not something that worried economists. Yet, today, even as central banks lower policy rates close to zero (or below) and expand their balance sheets beyond what anyone previously imagined possible (see chart), inflation remains stubbornly below target in most of the advanced world.

Nowhere is this problem more profound than in Japan, where mild deflation was the norm for nearly two decades and where inflation still remains well shy of the Bank of Japan’s 2% target. Even as monetary policymakers expanded the central bank’s balance sheet by nearly one-third of GDP and nudged its policy rate slightly below zero, consumer price inflation (as measured by our preferred trend measure, the 10% trimmed mean) has slipped from 0.9% to 0.1% over the two years to July 2016...

Learning from Japan: It's Hard to End a Deflation

In 1974, when the Fed faced rising inflation, the U.S. government sought to “Whip Inflation Now” by encouraging people to wear “WIN” buttons. Today, the problem is reversed. Several central banks are having trouble creating inflation. Unfortunately, we doubt that “SIN” buttons – “Support Inflation Now” – will be any more effective than the earlier variety, which served mainly as fodder for late-night comedy.

As has been the case for some time, Japan is blazing the trail into the monetary and fiscal unknown. Today's Bank of Japan's (BoJ) leadership is far more determined to promote price stability than its predecessors over the past two decades. But the deflationary hole that Japan is climbing out of is so deep that the BoJ may need some help...

Commentary

Money, Banking, and Financial Markets