Ever since the 'taper tantrum' in May 2013, global financial markets have been on tenterhooks, anxiously anticipating the first increase in US interest rates in almost a decade. Now it's happened and the sky hasn't fallen in. Perhaps, as one market observer has suggested, we can start obsessing about something else.
In itself, the increase has very little meaning. A quarter of a percentage point on interest rates isn't going to bring the US recovery to a halt. Nor is it enough to assuage opposite concerns, that low interest rates were inviting asset price inflation. Fed Chair Janet Yellen was careful to signal the change in advance, and to convey that it was not the start of a rush back to interest-rate normality, but, rather, was a tiny step in that direction, with future moves 'data-dependent'. Elsewhere, forward policy guidance remains some version of 'low for long'.
Nonetheless, there are good reasons for moving rates closer to normality as soon as this can be done without upsetting fragile confidence. Investors should be reminded that 'normality' is not near-zero, and it's certainly not sustained negative interest rates. It can't be sensible to encourage investment projects that are viable only when funded at a negative rate.
Monetary policy has changed greatly since the 2008 financial crisis, as policy-makers explored ways of coping with the initial financial crisis and the subsequent feeble recovery. For a start, the crisis distracted central banks from monetary policy, as they grappled with the other element of their mandate; financial stability.
Then the downturn was so deep and the recovery so anaemic that even lowering interest rates to near-zero was not enough to trigger a recovery. Hence the use of quantitative easing (QE) by US, UK, the European Central Bank and Japan. This has often been called 'printing money'. But it is actually just an expanded version of the usual monetary operations, where central banks buy bonds from the public in exchange for central bank money ('base money').
The legacy of QE is two-fold. First, it has left the balance sheets of central banks with huge bond-holdings and commercial banks with enormous counterpart deposits at the central bank. These will have to be unwound over time, with uncertain impact. In the meantime, QE-expanded balance sheets are at substantial risk from interest-rate mismatch.
Second, and more fundamentally damaging, QE created the idea that central banks can support economic activity, without limit or cost.
This touching faith in the power of monetary policy was promoted by Ben Bernanke's discussion of 'helicopter money' in 2002, when he was a Fed board member (not yet chairman). In QE, the central bank exchanges bonds for base money. In contrast, with helicopter money, the public receives a cash gift. There is no doubt that the latter would be much more effective than QE in boosting economic activity, but it should properly be seen as fiscal expenditure, not monetary policy. The 2009 Australian 'cash splash' was a successful example of such expenditure, but it was funded by bond issue, not by the central bank. Helicopter money breaches a key principle of central banks; they do not directly fund budget deficits.
While no country has actually implemented 'helicopter money' so far, the idea has taken hold. Adair Turner, head of the UK Financial Services Authority during the 2008 crisis, is an advocate. British opposition leader Jeremy Corbyn has called for 'people's QE'.
Before 2008, most central banks operated with an inflation targeting regime, which gave prominence to price stability, and a subsidiary role to economic activity. This prioritisation made good political sense, as it protected central banks from populist pressures to maintain an overly accommodating monetary stance. With the focus on price stability, central banks had a mandate to 'take away the punch-bowl just as the party gets going'.
Since 2008, the priorities have reversed. Supporting economic activity has become the primary focus. Moreover, monetary policy — rather than fiscal policy — is the favoured instrument for restoring the economy to a satisfactory pace of growth.
Rather than focus on the essentially trivial issue of the timing of the next policy interest rate hike, financial markets could more usefully debate how monetary policy can be returned to a normal footing, where its role in supporting economic activity is secondary and there is no confusion between budget expenditure and monetary policy.
Before the 2008 crisis, inflation targeting was the near-universal best practice framework for monetary policy. It was so explicitly simple, transparent and accountable that it could be implemented by independent central banks, outside the constraints of the parliamentary decision process. This halcyon period for central banks might have been seen at the time as the 'end of history'; the arrival at a stable and optimal framework for monetary policy. History was upended by the 2008 crisis, and the task of returning to this kind of policy framework should be a current obsession of both financial commentators and policy-makers.
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