Commentary |
11 March 2020

Central bank reputations at risk from impossible targets

Central banks around the world are caught in the same bind: inflation is below their target. Originally published in The Australian.

Stephen Grenville
Stephen Grenville

Central banks around the world are caught in the same bind: inflation is below their target. There is no shortage of ideas for alternative targets, but the problem is not the target: it’s the inability of the central banks’ instrument — the short-term interest rate — to stimulate economies that have lost their investment mojo. Central banks have been assigned an impossible task, and their ongoing failure to achieve this puts their reputation at risk.

Lael Brainard, an influential US Fed board member, favours replacing the US target of 2 per cent with an average of 2 per cent over the course of the cycle, similar to the Australian target. Former Fed chair Ben Bernanke would raise the target figure temporarily whenever the policy interest rate fell to zero. Former IMF chief economist Olivier Blanchard would set a higher target permanently. Others have suggested replacing the inflation target with a nominal GDP target, or targeting wages rather than prices.

All this is like debating the number of angels that can dance on a pinhead. It may demonstrate theological dexterity, but is irrelevant to the real world. The problem is not that the target is inappropriate, but rather that the central banks’ instrument is incapable of achieving any of these targets.

There are minor variations in the specification of inflation targets around the world, but all of them serve the key purpose well enough. Ideally, the economy should be running fast enough to put gentle pressure on productive capacity and keep the labour market fully employed. An inflation rate somewhere near 2 per cent is still the best indicator that the economy is running at around full capacity.

It’s not that monetary policy is without impact on the current economic environment. Just think what would happen if interest rates returned suddenly to the levels that prevailed before the 2008 crisis. The issue, instead, is that the interest-rate instrument has reached its limit of effectiveness. Any benefit from wealth effects, cheaper borrowing costs or a lower exchange rate is offset by the damage done to savers and the distorted price signals that absurdly low interest rates give to financial markets, asset prices and business decisions.

To see just how distorted present interest rates are, compare the near-zero policy interest rate with the sort of return that business expects from investment. Whether measured in terms of return on equity, hurdle rates or profits as a share of GDP, the return on investment is close to its historic level, somewhere around 10 per cent. When borrowing costs are in the low single-digits and typical returns are so much higher, why aren’t businesses expanding capacity eagerly, raising GDP and employment?

Some businesspeople say that short-term interest rates are not relevant to their long-term investments. But longer-term borrowing is also extraordinarily cheap: government long-term bond yields are below 1 per cent. Others cite risk concerns. But has risk increased enough to justify inaction in the face of the yawning gap between borrowing rates and investment returns? Why is a bond offering a minuscule return and the prospect of capital loss more attractive than a sound infrastructure project?

In some industries, management is constrained by the need to deliver consistent short-term success, best achieved through cost-reducing downsizing or mergers. Shareholders demand return of capital through share buybacks rather than expanded capacity. Some firms are in a “winner-takes-all” environment of limited competition, with little incentive to expand capacity if this means reducing per-unit profit margins.

In other industries, the regulatory framework is far more important than the cost of funds. The privatisation push of recent decades has put previously government-run infrastructure services into private hands. Electricity poles and wires and gas pipelines are just two examples. These are monopoly providers, so have to be regulated with binding price controls. Such regulation is necessary but presents huge risks to the private investors, whose business model can be destroyed by the political pressure on regulators to keep consumer prices low. In energy markets, regulators are still learning how to get the structure right.

Then there is that substantial part of GDP where the government is still the dominant provider: education, health and transport infrastructure. This is outside normal market forces, unresponsive to rates changes.

Clever policymaking could address many of these issues, providing incentive not only to invest, but also to use productive capacity more fully, to the benefit of all. A sharper competitive environment and a smarter regulatory framework for finance, construction and privately owned utilities could energise management by reducing investment risk. Huge energy investment, in both production and distribution, would be unleashed if the climate debate could be conducted on a rational basis. Where the government is still the principal provider, especially in infrastructure, cost/benefit and consumer demand ought to motivate investment, rather than outmoded ideas on budget balance and government debt.

This is the environment in which monetary policy now operates. None of these constraints on investment can be ameliorated by lower interest rates. More damaging still, monetary policy is seen as the “only game in town”. It is expected to respond to deficiencies elsewhere in the economy, beyond its relevance. Two consequences follow from assigning central banks an impossible task. Central bank reputation, vital to performing its core function, is put at grave risk by the apparent impotence. And global interest-rate settings are now at levels that make no sense.

Stephen Grenville is a non-resident fellow at the Lowy Institute and former deputy governor at the Reserve Bank