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The Disturbing Evolution of Central Banking

One of the more disturbing meta-trends in markets these days is the direction the evolution of central banking seems to be taking.

I have written before (and pointed to others, including within the Fed, who have written before[1] ) about the disturbing lack of attention being paid in the discussion and execution of monetary policy to anything that remotely resembles money. Whether we have to be concerned about money growth in the short- and medium-terms, ultimately, will depend on what happens to the velocity of money, and on how rapidly the central bank responds to any increase in money velocity. But there are trends that could be much more deleterious in the long run as the fundamental nature of central banking seems to be changing.

Today the Bank of England released its Quarterly Inflation Report, in which it introduced an “Evans Rule” construction to guide its monetary policy looking forward. Specifically, the BoE pledged not to reduce asset purchases until unemployment dropped below 7% (although Mark Carney in the news conference verbally confused reducing asset purchases with raising interest rates), unless:

“in the MPC’s view, CPI inflation 18 to 24 months ahead is more likely than not to be below 2.5 percent; secondly, if medium-term inflation expectations remain sufficiently well anchored; and, thirdly, the Financial Policy Committee has not judged the stance of monetary policy — has not judged — pardon me — the Financial Policy Committee has not judged that the stance of monetary policy poses a significant threat to financial stability, a threat that cannot otherwise be contained through the considerable supervisory and regulatory policy tools of various authorities.”

This is quite considerably parallel to the FOMC’s own rule, and seems to be the “current thinking” among central bankers. But in this particular case, the emperor’s nakedness is revealed: not only is inflation in the UK already above the 2.5% target, at 2.9% and rising from the lows around 2.2% last year, but the inflation swaps market doesn’t contemplate any decline in that inflation rate for the full length of the curve. Not that the swaps market is necessarily correct…but I’ll take a market-based forecast over an economist consensus, any day of the week.

So, for all intents and purposes, while the BOE is saying that inflation remains their primary target, Carney is saying (as my friend Andy the fxpoet put it today) “…the BOE’s inflation mandate was really quite flexible. In other words, he doesn’t really care about it at all.”

Along with this, consider that the candidates which have so far been mooted as possible replacements for Bernanke at the US Fed are all various shades of dovish.

Here, then, we see the possible long-term repercussions of the 2008 crisis and the weak recovery on the whole landscape of monetary policy going forward for many years. In some sense, perhaps it is a natural response to the failure or monetary policy to “get growth going,” although as I never tire of pointing out monetary policy isn’t supposed to have a big impact on growth. So, the institutions are evolving to be even more dovish.

At one time, I thought it would happen the other way. I figured that, since the ultimate outcome of this monetary policy experiment is clearly going to be higher inflation, the reaction would be to put hawkish central bankers in charge for many years. But as it turns out, the economic cycle actually exceeded the institutional cycle in duration. In other words, institutions usually evolve so slowly that they tend not to evolve in ways that truly hurt them, since the implications of their evolution become apparent more quickly than further evolution can kick in and compound the problem. In this case, the monetary response to the crisis, and the aftermath, has taken so long – it’s only half over, since rates have gone down but not returned to normal – that the institutions in question are evolving with only half of the episode complete. That’s pretty unusual!

And it is pretty bad. Not only are central banks evolving to become ever-more-dovish right exactly at the time when they need to be guarding ever-more-diligently against rising inflation as rates and hence money velocity turn higher, but they are also becoming less independent at the same time. A reader sent me a link to an article by Philadelphia Fed President Plosser, who points out that the boundaries between fiscal and monetary policy are becoming dangerously blurred. It is somewhat comforting that some policymakers perceive this and are on guard against it, but so far they seem ineffectual in preventing the disturbing evolution of central banking.

[1] Consider reading almost anything by Daniel L. Thornton at the St. Louis Fed; his perspective is summed up in the opening sentence of his 2012 paper entitled “Why Money Matters, and Interest Rates Don’t,”  which reads “Today ‘monetary policy’ should be more aptly named ‘interest rate policy’ because policymakers pay virtually no attention to money.”

  1. August 7, 2013 at 2:53 pm

    I just read Mauldin’s outside the box which presented a very interesting view of growth by Rob Arnott which essentially said the last 50 years growth has been enhanced by about 1% per annum by favorable demographic trends and now the demographics are turning the other way around so there will be a headwind of equal amount.
    If this is correct, and it certainly does an excellent job of explaining the weakness in the current recovery (think of the rapid decline in the employment participation rate) what exactly do central bankers think they will do to boost growth in the face of long term trends of this nature?
    Once upon a time I wrote that the Fed will never tighten policy again as they will never see the growth or employment numbers they crave. Is that increasingly plausible?

    • August 7, 2013 at 3:10 pm

      It is certainly plausible. And it’s plausible because it is completely plausible that one thousand economists at the Federal Reserve don’t add up to a single Rob Arnott.


  2. eric
    August 7, 2013 at 3:50 pm

    I wonder if you saw this a few days ago. Interesting read.


    it also helps to read the Stein speech as backstory: http://www.federalreserve.gov/newsevents/speech/stein20130207a.pdf

    I also wonder if you’ve been reading Cullen Roche’s recent entries on SA about why excess reserves are not inflationary and if you have a short version as to why he is wrong.

    • August 8, 2013 at 8:39 am

      I haven’t been reading them, but he’s right. Excess reserves aren’t inflationary. The problem is that we don’t know how to keep them in excess reserves, other than to keep jacking up the IOER, and we don’t know how sensitive the level of Excess Reserves is to the interest rate paid on them. It is clear that if the Fed simply does nothing, the excess reserves will eventually all leak into required reserves, where they will be inflationary.

      But I think where most inflation-phobes screwed up early on was in thinking that QE itself was inflationary. It would have been if the Fed wasn’t paying IOER. Of course, then the question is “why did the Fed give money to the system, and then pay banks to keep it out of the system?”

  3. eric
    August 8, 2013 at 1:32 pm

    Sorry, I should have said “ER are not _potentially_ inflationary” (according to him.)

    for example:

    “There were three basic interpretations of this chart – 1) the Austrians, hyperinflationists and some prominent mainstream supply side economists said this would cause high inflation; 2) the liquidity trap theorists said it wouldn’t cause high inflation YET because the banks wouldn’t be incentivized to lend out their reserves YET; 3) people like me have repeatedly said that the higher monetary base would not lead to more lending, not because of a liquidity trap, but because banks NEVER lend their reserves (even outside of a supposed “liquidity trap”) and that inflation would remain low because the economy would remain far too weak to create high inflation (because demand for credit was weak and banks were tight).

    The thinking there basically said that banks would normally lend out their reserves, but they wouldn’t do so in this particular environment because of the liquidity trap. But banks NEVER “lend out their reserves”. Reserves are deposits issued within the interbank system and they stay within the interbank system. They’re used for two primary purpose: 1) to meet reserve requirements; 2) to settle payments. When a bank wants to make a new loan it doesn’t check its reserve balances first. It checks the creditworthiness of the borrower and measures the risk of the loan. If it needs reserves it will find them in the interbank market or borrow from the Fed AFTER the fact. A bank is always capital constrained, but never reserve constrained. There’s no “multiplying” of reserves in this process.”

    • August 8, 2013 at 1:55 pm

      We will see. People like him have been arguing this for a long time, but I’m not sure he has ever worked in a bank. It is correct that banks can be capital constrained, but whether a bank has capital today almost never affects a lending decision. What affects it is the profitability of the loan, which is at least 50% about how the loan is funded. So, if he thinks the presence of essentially zero cost money is irrelevant, he’s simply wrong.

      But it’s irrelevant anyway. He’s arguing about whether the process from ER to RR and then inflation will happen because banks do more lending. That’s not my claim, so it’s not necessary that it be correct. My claim is that I don’t know HOW the translation of ER into RR will happen (it doesn’t have to be via a lending decision)…but that it will.

      A simple refutation of his argument would run like this: if the level of excess reserves has nothing to do with the cost/return on excess reserves (which is implicit in his argument), then there is no reason to pay interest on excess reserves. But, of course, we all know that if there was no IOER, then the market for reserves would clear at a deeply negative level where there WOULD be more lending. If not, then why pay IOER? So his argument is sort of absurd, when you think about it.

  1. August 8, 2013 at 7:04 am

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