New challenges for central banks

A well known market saying is that “Six months ago the investment decision was easy.  And in six months’ time it will be obvious what one should have done.  But right now, markets are uniquely challenging”.

It sometimes seems that the same is true for central banks.   We have written a number of times over the years on the issues facing central banks, and nearly all our essays have concluded that at the time of writing, central banks are facing a more than usually difficult and uncertain policy environment which is posing new challenges to decision makers.

In part, this is inherent in financial policy making – the future is always unknown, and the feedback loops between policy-makers’ actions and the consequent actions of other market participants are complex and continually changing.  And it also reflects the fact that the nature of financial markets is to be always on the edge of disequilibrium:  markets settle at levels where the forces on prices are in exact and delicate balance, and any change in circumstances can and will affect that balance and move prices.

But there is a third reason why central banking is never an exact science, and that is that the central bank is not distinct from the general political economy.  Instead it is part of it, and this means that any central bank has to be aware of the other agents acting on the economy, and shape its actions according to what they are doing.  And in particular, central banks have to be aware of the goals and objectives of the political authorities, both their own government and other governments whose actions will affect their economy.

This is important, because while central banking’s objectives are relatively simple and relatively constant across time and across different countries (broadly speaking, all central banks seek to maintain a general equilibrium both within their economy, including the pursuit of low inflation, low unemployment and positive growth, and between their economy and others, including stable exchange rates and broadly balanced current accounts), the objectives of governments can and do show much greater variation.

We can divide the different situations that a central bank might face into four broad regimes:

1) The central bank (CB) and the political authorities (PA) have similar economic goals and are working together.

2) The CB and PA have similar economic goals but are not working together.

3) The CB and PA have different economic goals.

4) The PA is not prioritising economic goals and is driven more by geo-political objectives.

Under the first of these regimes, in which the central bank and the government largely agree on their goals for the economy and also how they should be achieved, a central bank will usually find that its policy options are relatively straightforward.  Fiscal policy will generally be supportive of, or at any rate not in overt conflict with, monetary policy, and the government may end up giving the central bank considerable de facto autonomy, even if it is not formally independent.  In such a regime, the central bank can usually be quite constructive, and the biggest danger for the central bank is that their time scales (which will be tied to the economic cycle) may not coincide with the government’s (which will be tied to the political, ie electoral, cycle).

This broadly describes central banking until about 30 years ago.  But the danger – the dissonance between the timescales at the bank and in the government – was ever present, and because of this, the more recent style in central banking has been to distance central banks from their governments, to make them more formally independent and to insulate their actions from the electoral cycle.

This has resulted in most central banks today operating under a version of regime 2.  The central bank will still share broad common goals with the government – often because the government will set them as the central bank’s mandate – but it will be left more alone to achieve them.  The greater autonomy and freedom of action that this gives has for much of the last 30 years been welcomed by central bankers, but it is not without some drawbacks, as central banks are more distant from the government’s economic planning and less able to influence government policy at an early stage.

On one level this has meant that central banking has become more reactive:  as the dialogue between central bank and government becomes less intimate, the central bank is more often reacting to government economic policy rather than helping shape it.  And at its worst, it can lead to the bank being reduced to “megaphone diplomacy”, as it has no other way to influence government policy other than public comment and criticism.

Two recent examples of this have been the European Central Bank’s attempts in 2010-13 to shift some of the burden of rescuing the EU economy after the Great Recession from their shoulders to those of the EU’s governments, so that the whole weight of countering the economic slowdown was not borne by monetary policy alone, and the Bank of England’s efforts during and post the EU referendum in 2016 to bring economic considerations into the political debate over Brexit.  In neither case was the central bank that successful, and in both cases they suffered noticeable reputational damage.

The difficulties faced by the ECB and the Bank of England were however as nothing compared to the challenges facing a central bank under regime 3, where their goals of economic equilibrium are not shared by the government at all.  Here a central bank will be constrained and may be politically vulnerable;  indeed in cases where the government’s objectives are not economically coherent the central bank may be in an impossible position, as it is unable to set policy either to achieve the stability it seeks or the political results desired by its masters in government.  There are many such dysfunctional CB-PA relationships in history, with perhaps Venezuela and Turkey the current two most notable examples.

And lastly we have regime 4, where the government has relegated economic objectives below some overriding political goal.  Here, a central bank may ironically be freer to pursue its chosen policy than under regime 3 (because the government is not so interested) but risks being the scapegoat if the government’s non-economic policies fail or cause economic disruption.

Such regimes, where political objectives are being pursued either despite the economic cost or even with disregard for the economic consequences altogether, used to be considered unusual in democratic societies.  Standard political theory holds that, times of war and other national emergencies aside, electorates will always prioritise the economy and will usually re-elect a government that delivers prosperity (Bill Clinton tapped into exactly this mantra in his 1992 election campaign with his slogan “It’s the economy, stupid”).   As a result, it has been the rare democratic government that has relegated economic considerations very far down their list of strategic goals.

But right at the moment, a number of major governments do clearly have significant non-economic objectives.  For our domestic readership, this is obviously the case for the UK, where Brexit dominates the government’s thinking and will be pursued in some form or other regardless of economic cost, and much the same is arguably true for the EU, where the sanctity of the Single Market and the 4 Freedoms is deemed paramount, whatever the consequences for the EU economy.

Globally, the US administration’s trade and taxation policies are part of a more general isolationist stance, and have upset world trade and destabilised several emerging market currencies – and may yet, courtesy of an over-extended domestic economy where loose fiscal policy is boosting already buoyant demand, cause problems at home too.  And other governments are responding in kind, most obviously China with retaliatory tariffs.

The boundary between regimes 3 (in which the politicians have different economic priorities from the central bankers) and 4 (in which the politicians have relegated economic objectives behind geopolitical ones altogether) is fluid, and it is a fine point where some central banks currently stand – the Federal Reserve may for example be in either regime 3 or 4 at the moment, depending on how one reads President Trump’s intentions, while the Bank of England is more clearly in regime 4 (politics dominating economics).

What is certainly true though is that it makes it an interesting time to be a central banker.  Their freedom to operate as they see fit is still considerable, with most central banks enjoying fairly complete autonomy of action.  But the political economy they are operating in has become more difficult, with government actions either unconstructive for global financial equilibrium or outright destabilising for it, and the gap between what the politicians consider important and what the central bankers are trying to achieve is widening.