Many forces are pushing central banks to change how they operate: low inflation; hesitant fiscal policy; climate change; anemic growth; financial instability. Low inflation claimed the first scalp, when it led the Federal Reserve to switch to an average inflation targeting regime. Climate change may be the next.
The FT reports that:
This is a big deal, even if it might sound like gibberish at first.
Right now, to stimulate the economy, central banks print money (it’s slightly more complicated) to buy government and corporate bonds from the private sector. The idea is that this lowers bond yields, which lowers interest rates, and moves money into other parts of the economy. In theory, interest rates for governments and corporations fall, and lending should increase to businesses and consumers, stimulating the economy. This is Quantitative Easing.
Today, central banks do this without taking the environment into account. A corporate bond from Shell is the same as a corporate bond Vestas (they make wind turbines). For several years now, people have been saying that central banks should use Quantitative Easing in an environmentally conscious way. This mean that, when it buys a corporate bond from Shell, it should acknowledge that Shell is a polluter. When it buys a corporate bond from Vestas, it should acknowledge that Vestas is not a polluter. It could do so by charging a premium for example.
This has been fiercely resisted to date. The fact that the head of the French central bank, who has a seat on the ECB’s Governing Council, is in favour, speaks to how much the consensus is changing.
Please do read the whole thing
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(Implicit) coordination between monetary and fiscal authorities has been increasing since the GFC. This year, 70% of the debt issued by the Euro area was bought by the ECB. According to this piece in the FT, prior to its latest round of QE last week, the Bank of England owned 44% of outstanding government bonds.
While coordination is subtly back on the table, they caution against seeing this as a revolutionary return to the days of explicit fiscal and monetary policy coordination. Coordination, especially in the EU, has usually come with conditions attached, and central banks have been the ones to set the conditions for intervention and coordination, not governments.
This is an enormous amount of power given how important these interventions have been for maintaining the continuation of politics. Absent Draghi’s “whatever it takes,” the EU could have fractured. Absent central bank’s massive and repeated interventions into government bond markets since the crisis, the world could have been thrown into economic depression.
Adam Tooze argued “the integrity and the cohesion of monetary and fiscal policy should be the premise, not as it were, something that we contingently agree to because the circumstances demand it.”
But he also cautioned against progressives calling for this absent a constellation of forces to guarantee it.
It reminded me of Zach Carter’s discussion of reactionary Keynesianism in his biography of Keynes; big spending government can just as easily be attached to projects like the Vietnam War and nuclear armaments as it can to health and education.
Daniela, who writes lots on green finance and monetary policy, framed an essential question for central banks looking to ‘green the financial system’: will they enforce rules of the game created by private actors (who often have an incentive to greenwash), or develop their own rules to enforce?
Fair warning, this is going to be a wonky post. (If you’re unsure what asset purchases or quantitative easing is and you’re wondering why in the world i keep talking about it, see this explainer.)
This week was a big one for acronyms. The Fed’s Federal Open Market Committee (FOMC) and the Bank of England’s Monetary Policy Committee (MPC) met on November 5th. The Reserve Bank’s Board (surprisingly no one calls it the RBB) met two days earlier on November 3rd. These are the respective committees at each central bank that make decisions on policy like interest rates or quantitative easing.
Bank of England
The BoE kept interest rates at 0.1% and added an additional £150 billion in government bond purchases, taking the total stock to £875 billion. In their words:
The Committee does not intend to tighten monetary policy at least until there is clear evidence that significant progress is being made in eliminating spare capacity and achieving the 2% inflation target sustainably.
The BoE predicts inflation will be back at 2% in two years time. Given the potted history of central bank inflation predictions, this should be taken with a grain of salt. Still, policy looks set to stay incredibly accommodative for at least two years.
Reserve Bank of Australia
The cash rate was lowered to 0.1% and $100 billion in new government bond purchases was announced. The RBA is also one of the few central banks in the world to do Yield Curve Control (YCC), where they commit to keeping the yield on a certain category of bond (in this case a 3-year Australian Government) at a certain rate. It is an open-ended commitment to buy any quantity of bonds required to achieve the target rate, which is 0.1%. In simple terms, the Australian Government can take out three year loans at 0.1% as long as the RBA keeps this policy in place. How long will policy stay like this?
For its part, the Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. Given the outlook, the Board is not expecting to increase the cash rate for at least three years. The Board will keep the size of the bond purchase program under review, particularly in light of the evolving outlook for jobs and inflation. The Board is prepared to do more if necessary.
Its important to note that while the cash rate is staying where it is for at least three years, the RBA might wind back its bond purchases or YCC. Either way its an incredible commitment, especially given inflation has been so subdued globally for the last decade.
The Fed switched to average inflation targeting this year. Instead of just apologizing for missing their inflation target, the Fed will now attempt to average out past inflation performance. Put simply, if the target is 2% and inflation averaged 1% between 2010-2020, then inflation needs to average 3% between 2020-2030. It is a little more complicated because the Fed has not been explicit about what periods they will use, how they will calculate the average, or how high they will let it go, but that’s the basic premise. Here’s the relevant part of the statement:
With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved.
The Fed kept interest rates where they were, 0-0.25%, and will continue to purchase bonds at the current pace of $120 billion a month.
Chairman Powell continues to emphasise minorities and low-income groups:
The economic downturn has not fallen equally on all Americans, and those least able to shoulder the burden have been hardest hit. In particular, the high level of joblessness has been especially severe for lower-wage workers in the services sector, for women, and for African Americans and Hispanics
Powell’s appeals for more fiscal stimulus come at a time when the prospect of a Republican Senate and Democrat President make new stimulus increasingly fraught:
As I have emphasized before, these are lending powers, not spending powers. The Fed cannot grant money to particular beneficiaries. We can only create programs or facilities with broad-based eligibility to make loans to solvent entities with the expectation that the loans will be repaid. Many borrowers are benefiting from these programs, as is the overall economy. But for many others, getting a loan that may be difficult to repay may not be the answer. In these cases, direct fiscal support may be needed. Elected officials have the power to tax and spend and to make decisions about where we, as a society, should direct our collective resources
Monetary policy looks set to be incredibly accommodative for at least two more years, possibly longer should inflation continue to be stubborn. What are the implications?
Financial stabilityrisks: The longer monetary policy is accommodative, the greater the financial stability risks. This is no secret and banks have macroprudential policy (MPP) tools at their disposal. Still, MPP is a newish field and there are still questions about the best approach.
Will monetary policy continue to crowd out fiscal policy? Over the last five years or so, central banks have become increasingly vocal about the need for fiscal stimulus. Covid-19 finally forced open the purse strings, but its an open question how long it will last. Before the second wave, the UK Chancellor was already talking about debt, and the austerity hawks are never far from the opinion pages of the Australian or the Washington Post. Will the commitment of three years of super expansionary monetary policy make it easier for governments to take their foot off the gas?
There is no easy solution to this problem, in part because its the result of the system working as intended. Independent central banks were partly set up as a check on fiscal policy, and to take as much discretionary macroeconomic policy out of the hands of elected politicians as possible. We are now in the awkward position where the politicians have learnt the lesson too well, and are happy to hand off macroeconomic management to central banks.
No one knows what monetary policy normalization will look like: The Fed’s asset portfolio is north of $5 trillion, the ECB’s €3 trillion, the BoE almost £1 trillion. Japan is another universe; the Bank of Japan’s portfolio is bigger than Japan’s GDP. (The chart below is pre-Covid, so the numbers are actually significantly higher – the Fed has added almost a trillion in asset purchases this year.)
The point is that these numbers are so large they are probably impossible to eliminate, especially because central banks have been clear that QE is now a standard part of counter-cyclical policy. To date it looks as if central banks holding nearly 50% of their government’s outstanding debt is fine? In fact central banks regularly insist these holdings are “market neutral.” The point is, we’re in a Wild West where the only thing we know is that the limits of the past were figments of our collective imagination or a world that now lives only in history books. This is good news for progressives.
A new NBER paper argues that there may be conflicts of interest in Central Bank research.
Central Banks are primarily research institutions. They house hundreds of research economists focused on analysing all parts of the economy, but monetary policy in particular. They are the main source of monetary policy research outside academia, and exert significant influence on the monetary policy research done within academia.
As a result, Central Banks are usually in charge of evaluating their own policy decisions, Quantitative Easing in particular.
Some excerpts from the paper:
we compare the research findings of central bank researchers and academic economists regarding the macroeconomic effects of quantitative easing (QE). We find that central bank papers report larger effects of QE on output and inflation. Central bankers are also more likely to report significant effects of QE on output and to use more positive language in the abstract. Central bankers who report larger QE effects on output experience more favorable career outcomes. A survey of central banks reveals substantial involvement of bank management in research production
while all of the central bank papers report a statistically significant QE effect on output, only half of the academic papers do.
central bank papers use more favorable language in their abstracts: they use more positive adjectives and, to a lesser extent, fewer negative adjectives compared to academic papers
I’m not sure this sounds as compelling as the author’s think it does:
Importantly, we do not argue that central bank research should be discounted. In many ways, central banks are in an excellent position to provide accurate assessments of their own policies. Like pharmaceutical firms studying their own drugs, central banks have superior information about their own products, exceptionally strong expertise in the subject matter, and an intense desire to preserve their reputation
The paper raises the valuable question of whether powerful independent institutions should be in charge of evaluating their own performance. Its a theme I will be returning to over the next few weeks in a longer piece.
Worth reading in full. Please do make sure to read through the methodology section and make sure you find it appropriate and compelling.
In my latest piece for the AIIA I talk about some of the longer run political trends behind the recent announcements from the Fed at Jackson Hole. For a quick and dirty summary of the Jackson Hole conference, check this out.
A few excerpts:
So, what will change? Right now, not a lot. The Fed is signalling that policy will remain accommodative for a long time to come, and markets have continued their bull run. COVID-19 has depressed both inflation and employment, so it will be many years before the Fed’s new lenient attitude to inflation is tested.
But discretion-based policy making is risky business for a politically independent institution. “We have your best interests at heart” is cold comfort to those on the wrong end of an interest rate hike. The kinds of creative policy that discretion allows, like bank bailouts and negative interest rates, generates controversy. Discretion is doubly risky in a political climate where Trump has normalised once inconceivable attacks on the Fed.
Greater transparency and public engagement help offset the immediate political risks associated with discretion, but they open monetary policy to future debates that Central Bankers might find uncomfortable. In admitting the policy errors of the prior framework (like the 2018 rate hikes), the Fed opens the door to future questioning. With no rules, the Fed’s judgement is up for criticism, even as greater public engagement introduces new, sometimes angry voices to the conversation.
(If you can’t get enough about macro, you might also enjoy this piece I wrote about why we need new macroeconomic folk tales.)
The Federal Reserve had its September Board meeting yesterday (Australian time). Apart from the time difference, the most frustrating thing is the Fed appears to host the press conference video themselves, and there is no button to adjust playback speed.
The press conference and statement offered some useful clarifications on the big announcements made last month at Jackson Hole (see forthcoming piece – hopefully this week!)
There were a lot of questions about how the Fed’s new average inflation targeting approach would work, how far above 2% would inflation be allowed to go and for how long?
With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent
So what will policy be like in the meantime?
The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time
Low for loooooooong baby! Remember inflation has barely touched 2% over the last decade. The projections of Board members show no one thinks inflation will reach 2% before 2022/3. The median projection for unemployment is 4% in 2023, but the range goes all the way up to 7.5%. The Fed has already issued a mea culpa for raising rates in 2018 when unemployment dropped below 4%, so it is unlikely they will do so again. All this adds up to low rates for the next few years, barring something extraordinary.
Preemptive tightening in the face of unemployment is officially dead and buried.
We view maximum employment as a broad-based and inclusive goal and do not see a high level of employment as posing a policy concern unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals
Powell acknowledged the new normal; low interest rates are now part of the furniture.
In turn, well-anchored inflation expectations enhance our ability to meet both our employment and inflation objectives, particularly in the new normal in which interest rates are closer to their effective lower bound even in good times
Aside from all the technical announcements, two short sections caught my eye:
As I have emphasized before, these are lending powers, not spending powers. The Fed cannot grant money to particular beneficiaries. We can only create programs or facilities with broad-based eligibility to make loans to solvent entities with the expectation that the loans will be repaid
Elected officials have the power to tax and spend and to make decisions about where we, as a society, should direct our collective resources. (is monetary policy not?)
Firstly, it is simply not true that the Fed cannot grant money to particular beneficiaries. Legality aside, it is certainly possible operationally. It would be politically momentous, sure, but lets not kid ourselves about what Central Banks can and cannot do.
Secondly, the second paragraph implies that monetary policy, unlike fiscal policy, is not one of society’s collective resources. Again, I disagree. The money supply is a collective resource, and even if its creation and control currently sits outside day-to-day political control, that is a choice. It is neither inevitable nor eternal and we do ourselves a disservice when we blithely reify the specific institutional arrangements we happen to have today.