Central Banking With a Straight Face

BASEL – How often have you heard that the US Federal Reserve has a dual mandate to promote both price stability and maximum employment? Did you know that the claim is false? Under the Federal Reserve Reform Act of 1977, the Fed also has a third mandate: to ensure moderate long-term interest rates.

There is nothing unusual about this objective. Central banks over the years have sought to prevent sudden increases in government bond yields. In the 1930s, for example, the US Treasury wanted the Fed to cap bond yields, leading to a compromise whereby the Fed agreed to maintain orderly market conditions. Even the landmark Treasury-Fed Accord of 1951, which restored the central bank’s independence after World War II, required the Fed to “assure the successful financing of the government’s requirements and, at the same time, to minimize monetization of the public debt.”

In fact, the Fed has a fourth objective, because it (like virtually all other central banks) is responsible for ensuring a stable financial system. The catch, here, is that most major central banks before the 2008 financial crisis had only one monetary policy instrument with which to carry out these tasks: the overnight interest rate in interbank markets. Hence, conventional academic thinking in the 1990s focused on a single, short-term instrument, which proved very convenient for keeping central banks out of political trouble.

But having more objectives than policy instruments is a violation of the famous Tinbergen Rule, so named for Jan Tinbergen, the Dutch economist who won the first Nobel Memorial Prize in Economic Sciences in 1969. Tinbergen argued that n policy objectives require n independent policy instruments, and in the aftermath of the 2008 crisis, central banks rose to the challenge by transforming their balance sheets into a key instrument of monetary policy.

This development was not purely a consequence of the policy rate hitting the zero lower bound, nor was it particularly unconventional, considering that central banks have always made extensive use of their balance sheets. Nonetheless, we have yet to feel the full economic impact of a larger and more diverse policy toolkit.

Consider the European Central Bank. When the short-term interest rate was its only instrument, the same monetary policy applied for all eurozone members irrespective of national circumstances. With a balance-sheet policy, it could partly address this gap in the name of pursuing 2% inflation throughout the eurozone. For example, a special medium-term lending program for banks (with the same conditions applying to all) is attractive to banks in countries with poor market access or where bank loans are more expensive. A similar argument can be made for buying financial assets in markets under pressure.

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The ECB’s balance-sheet policies can therefore provide greater monetary stimulus in countries where it is most needed. In a recent statement about its monetary policy strategy review, it emphasized the continued use of “asset purchases and longer-term refinancing operations,” and that it would “consider, as needed, new policy instruments.”

Putting the balance sheet at the center of monetary policy amounts to a revolution. As I argued in a recent National Institute of Economic and Social Research monograph, radical whatever-it-takes monetary expansion has prevented three huge shocks (the 2008 global financial crisis, the near-collapse of the euro in 2012, and COVID-19) from triggering a global depression at a time when fiscal policies in the United States and Europe were restrictive. The prolonged pull of deflationary forces vindicated this policy choice.

But all policy innovations create new dangers, and there is now a greater risk that the shift to government fiscal laxity will encroach on monetary-policy independence. Moreover, larger financial-risk exposures (especially in bond markets) could make monetary tightening a more hazardous endeavor, with a heightened risk of policy error.

Even more troublesome is that the success of balance-sheet policies has created unrealistic expectations about what central banks can achieve. The limitless scale and diversity of balance-sheet instruments means that the public can expect, logically if not wisely, central banks to achieve many new objectives.

For example, ambitious public infrastructure programs and plans for a more rapid transition to a green economy could be furthered by central-bank (or regulatory) support for private bond issuance. Affordable housing for the young could be championed in a similar way. You name it, and the central bank can be expected at least to listen. And politicians might well be ready to mandate central banks to take on new objectives. After all, the simple rejoinder that “central banks don’t do this” no longer works. Modern societies are complex, and great expectations have been placed on public authorities.

How, then, to protect central banks? To implement monetary policy effectively, they must retain the right to sell any asset they purchase – be it green bonds, infrastructure bonds, mortgage-backed securities, foreign securities, or anything else. But on top of that, we need an independent review of the costs and benefits of their transactions. The International Monetary Fund’s Independent Evaluation Office is a model that could be emulated for this purpose.

Central banks also might occasionally ask for explicit government guidance when asset transactions are motivated by non-monetary policy objectives. Similar explicit arrangements should be made when regulators lower the risk weights on government-favored assets.

None of this will be easy. Central bankers are perfectly able to explain with a straight face why whatever actions they take fit with their core responsibilities to ensure macroeconomic and financial stability. But heavy pressure on central banks to do more means that some actions will undermine the credibility of their commitment to their core functions.

There is no time to waste in creating procedures to minimize this danger. Independent central banks capable of pursuing innovative (and thus controversial) measures have been one of the big economic policy successes of the past 20 years. The erosion of their independence is a threat that must be resisted fully.


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