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Central bankers out of bullets

When the marginal utility of debt falls to zero (or negative) you have a problem.

From FT.com:

These are uneasy times in central banking.  The big beasts of the profession who met this month in Jackson  Hole, Wyoming, were once the ultimate masters of the universe. Now they are  nagged by self-doubt.

Four years on from the worst moment in the financial crisis, unemployment  remains high across the developed world and the global economy is losing  momentum. Risks from the eurozone and US fiscal policy loom large.

After the European  Central Bank’s decision to counter speculation of a euro break-up by proposing  to buy short-dated government bonds in peripheral European countries, the US  Federal Reserve must this week decide how best to help an economy its chairman  described as “far from satisfactory”.

Yet the deeper central  bankers delve to solve the developed economies’ woes, the more some in the  profession fret.

“I am a little – maybe more than a little bit – worried about the future of  central banking,” said James Bullard, president of the Federal Reserve Bank of  St Louis, in a Financial Times interview at Jackson Hole. “We’ve constantly felt  that there would be light at the end of the tunnel and there’d be an opportunity  to normalise but it’s not really happening so far.”

“What I’m worried about is this creeping politicisation,” said Mr Bullard.  Pressure from politicians is often for central bankers to do more.

The biggest worry on display at Jackson Hole was whether these bureaucrats,  sitting at the heart of every mature economy, still have the power to influence  demand now that interest rates cannot fall much further. Lurking behind many  debates was this question: if central bank policies are so effective, why is the  global economy not growing faster?

For an answer, many reach for the insights of Carmen Reinhart and Kenneth  Rogoff, who described how recoveries after a financial crisis tend to be painful  and slow in their book This Time is Different.

Yet all of the central banking activism of the past four years is based on  the belief that while this crisis may be similar to those of the past, there  must be a cocktail of policies that will make the recovery different this  time.

That faith is coming into question, however.

“I’ll confess that when that book came out I was a little sceptical about  whether this was going to happen in the United States but they were right and I  was wrong,” said Alan Blinder, a Princeton economics professor and former  vice-chair of the Fed, from the platform at Jackson Hole. “We haven’t deviated  that much from the pattern of a Reinhart-Rogoff recession.”

There are a few possible reasons why repeated rounds of central bank  communication and quantitative  easing, as the policy of buying long-dated assets in an effort to drive down  long-term interest rates is known, have not brought about a strong recovery.

One is that something structural has changed to hold back growth. Speaking  from the floor in Wyoming, Donald Kohn, another former Fed vice-chair now at the  Brookings Institution, raised the possibility of “something deeper going on”, perhaps related to savings behaviour or the changed distribution of income  between labour and capital.

Another is that the tools work, even if current conditions blunt their  effect. If there are new headwinds, then the answer is to use them more  aggressively. That is the mainstream view among central bankers.

“A balanced reading of the evidence supports the conclusion that central bank  securities purchases have provided meaningful support to the economic recovery  while mitigating deflationary risks,” said Ben  Bernanke, the Fed chairman, in his remarks at Jackson Hole.

A third possibility is perhaps the most alarming for central bankers such as  Mr Bernanke, who have staked their reputations on successive rounds of  quantitative easing: that it simply does not work.

In his presentation at Jackson Hole, Columbia University professor Michael  Woodford presented evidence that, to the extent asset purchases have lowered  long-term interest rates in the US, their effect was indirect. People saw the  purchases as a signal that short-term interest rates will stay lower for longer,  he argued.

That paper gave the assembled central bankers some food for thought, but will  have little bearing on their immediate policy choices.

Central banks have worked hard to sell the idea of inflation targeting.  Adopting a “target path for nominal gross domestic product” – an idea gaining  momentum in academic circles – would be even harder to explain.

Even so, it may be the best possible solution to the problem that interest  rates cannot go below zero.

Such a policy, advocated recently by Michael Woodford of Columbia University,  would mean two changes for central banks.

First, the central bank would target the rise in total cash spending in the  economy – nominal GDP includes real growth plus inflation – rather than just  prices.

But second, and more important, it would target a constantly rising level of  nominal GDP, rather than just the current rate of growth.

That is crucial, because it would link inflation in the future to conditions  in the past. If nominal GDP growth was too low, the central bank would have to  allow higher inflation to return it to the target path.

If a central bank, such as the US Federal Reserve, had been targeting a  nominal GDP path in the past few years, markets would automatically assume  interest rates of zero for years to come, as there is a big gap to make up. With  the central bank promising to generate enough inflation to return eventually to  the target path, people would have no reason to hold back on spending – and  their expectations of the future get around the problem that rates cannot fall  below zero today. Mr Woodford and economists such as Paul Krugman and Christina  Romer advocate the policy for precisely this reason.

Central bankers worry about communication. A nominal GDP target all but  guarantees they would sometimes have to target inflation higher than 2 per cent,  and they fear there would be a cost to their credibility.

They also wonder how they will make good on the promise of higher inflation  in times, such as today, when the only immediate policy tool is quantitative  easing.

It may be particularly hard to introduce such a target now, when the economy  is so far from its pre-crisis path, implying a lot of inflation to catch up. But  the case for a switch is strong and growing stronger.

Successful academic ideas generally take time to gain acceptance by policy  makers, so nominal GDP targeting is not about to be implemented. But watch the  Scandinavian central banks. They are often first to latch on to new ideas.

After August  payroll growth came in at 96,000 jobs – below estimates and scarcely enough  to allay Mr Bernanke’s “grave concern” about the stagnation of the labour market – the Fed has three options to consider when it holds its two-day meeting this  week.

It could buy more assets in another round of QE. It could extend its forecast  of low interest rates beyond the current date of late-2014. Or it could cut the  25 basis points of interest that it pays to banks on their excess reserves.

Mr Bernanke spent most of his speech on the pros and cons of more asset  purchases, and QE3 remains the Fed’s main option for a substantial stimulus. One  idea that has gained a lot of ground on the rate-setting Federal Open Market  Committee is open-ended action: buying a certain amount a month or meeting with  no fixed target.

The difficulty is how to define a goal. More hawkish members of the FOMC want  discretion to stop buying assets at any meeting. Doves want a pledge to keep  buying until a condition for improvement in the economy has been met. They would  want that condition, most likely in words and not numbers, to imply a  substantial QE3 unless the economy picks up.

A similar issue applies to the alternative of extending the Fed’s forecast of  low interest rates into 2015. Doves would not want it interpreted simply as a  prediction that the economy will stay weak. Instead, they would want to signal a  change in the Fed’s behaviour, and that it plans to keep rates low even as the  economy picks up.

What the Fed does will depend on whether the committee can agree on such a  condition for improvement in the economy. If it cannot, then a straightforward  chunk of asset purchases is more probable.

The last option, of cutting interest on reserves, has become somewhat more  likely since the ECB cut its overnight deposit rate to zero without causing an  apocalypse in the financial system. Few Fed officials think it would make much  difference, however, and some continue to see modest risks. Certainly, it is  unlikely except in conjunction with other actions.

. . .

But it is not just the Fed that is grappling with difficult policy issues.  The ECB is faced with the threat of the disintegration of the single currency  and a painfully slow international political process.

Its latest response has been to promise to buy bonds of European countries  that have accepted potentially sweeping conditions of a programme of fiscal  consolidation and economic reform – potentially in unlimited quantities. Buying  only securities with short maturities, the ECB sees this as a monetary policy  operation designed to bring short-term interest rates back into harmony across  the eurozone. It wants to remove the devaluation risk premium in certain  countries’ government bonds.

But the agreed operation – outright monetary transactions – is extremely  controversial, with the Bundesbank, Germany’s  ultraconservative central bank, viewing them “as being tantamount to  financing governments by printing banknotes”. In addition, it sees the danger  that if things go wrong, the potentially unlimited bond purchases “may  ultimately redistribute considerable risks among various countries’ taxpayers” in the eurozone.

In Britain, too, the Bank of England, has moved away from buying government  bonds in the hope of reducing long-term interest rates to seeking to intervene  more directly to bring down the borrowing costs of households and companies.

Like the Fed, it insists QE is working. But the BoE is placing a lot of faith  in the idea that by providing cheap funding for banks on the condition that they  step up lending to the real economy, it will boost demand.

But there are other suggestions out there, some getting rather close to an  arbitrary line across which central bankers fear to tread: the one that divides  monetary from fiscal policy.

. . .

Some see value in pre-commitment to policy stimulus until it works. Mr  Woodford argues for commitment to keeping interest rates low for a period that  is linked to the performance of the economy. By holding rates down, even as  inflation rises somewhat above a target such as the Fed’s 2 per cent, a central  bank could make up for the period when the ideal interest rate would have been  lower than zero.

And a rising number of voices, often those not so close to policy making  circles but privately including some within the club, suggest central bankers  could become more radical still. Central banks are being urged to buy assets  other than government bonds, breaking a taboo that they should not accept credit  risk on to their balance sheet.

While none of this is palatable, it is better than the really radical ideas  that may gain traction if economic malaise lingers, such as the infamous “helicopter drop”. A central bank could simply credit the bank accounts of the  citizens in a country, directly boosting incomes for a period and encouraging  them to spend.

A variant of this proposal is to finance the spending of government  temporarily, allowing it to cut taxes for a period. This monetary financing of  government is outlawed in Europe for the good reason that when it has previously  been tried direct money-printing has ended in hyperinflation. An economy cannot  provide sufficient goods and services to match all the newly minted cash at  prevailing prices, and inflation takes hold.

Being conservative by nature, no central banker wants to consider ideas that  have been off limits for decades. But there are rumblings afoot.

The textbook is not providing the answers. When that happens more radical  options come to the surface.

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