Below-average global economic recovery and low worldwide inflationary pressure have enabled a very expansive monetary policy in recent years. There are, however, concerns that this policy is causing new imbalances on financial markets, which could trigger the next downturn.
The global financial crisis of 2008-2009 was clear proof that financial markets are crucial for both economic and price stability. But how, or whether, central banks should take the financial cycle into consideration when setting their monetary policies is less clear. It does indeed seem that we are further than ever from consensus.
The Bank for International Settlements (BIS) has long argued that monetary policy should “lean against the wind” of growing potential imbalances and that the instrument of interest rates should be used with a view to financial stability, even if the inflation target is temporarily undercut.
In its annual report, the BIS explains that the global economic boom presents an opportunity not to be missed and calls for monetary policy to be normalized sooner rather than later. Macro-prudential tools, which are supervisory and regulatory instruments designed to strengthen the financial system’s resistance to shocks, could indeed be used to complement the instrument of the base rate. But they alone cannot tame the financial markets.
The U.S. Federal Reserve vehemently opposes this approach. Janet Yellen, the Fed’s chairwoman, recently noted she saw no current need for monetary policy to divert from its primary focus on prices and full employment because of worries about financial stability. According to Ms. Yellen, a resilient financial system could cushion unexpected developments. Thus, it would be less important to identify bubbles and “lean against the wind.” Ms. Yellen believes that primarily macro-prudential instruments should be used in the pursuit of financial stability.
The controversy between the BIS and the Fed is gaining relevance through the seemingly increasing incompatibility of price stability (generally defined as an inflation rate just under 2 percent over two to three years) and financial stability. On the one hand, it is assumed that the economy’s “natural” rate of interest has decreased and will remain low for some time. Newly coined terms such as “the new normal” and “the new neutral” underline this belief. On the other hand, booming financial markets could probably cope with higher interest rates, which might even be necessary to avoid imbalances.
Interest rates seem too high for the real economy and too low for financial markets. This clear divergence between the interest rate needed for stable consumer prices and full employment, and the rate needed for financial stability, raises a number of questions: When did this divergence begin? With regards to the goal of price stability, the interest rates of the 1970s and 1980s were certainly not too high. On the contrary, lax monetary policy led to high inflation. The divergence is therefore a phenomenon of the last 20 years. This is also consistent with the accelerated growth of the financial sector in the same time period.
What could be the cause of this divergence – perhaps monetary policy itself? The BIS seems to hold that view. An asymmetrical monetary policy would be responsible for the decrease in interest rates, because the policy takes no countermeasures during upturns, and yet is aggressively relaxed during downturns. This leads to a downward distortion in interest rates and an upward distortion in the level of debt. This, in turn, makes an increase in interest rates difficult without affecting the economy – it is a debt trap.
What are the costs and risks of this divergence? My conviction is that a persistent divergence brings with it inevitable temporary misallocations, possibly in the form of excessive consumption, excessive debt and bad investments. Such undesirable developments must eventually be corrected.
Booming financial markets could probably cope with higher interest rates - they might even be necessary to avoid imbalances.
What will such a correction look like? Will it be soft and slow with a gradual increase in interest rates, as the Federal Reserve apparently expects? Or will it be hard and abrupt, as the BIS seems to suspect? The world economy’s weak recovery despite zero rates indicates that this divergence will not be eliminated for the moment. It could, in fact, persist. If asymmetrical monetary policy is the reason it emerged in the first place, then holding on to this incredibly lax policy could open it wider rather than close it.
Should the central banks really prioritize the conventional goal of an inflation rate just below 2 percent over two to three years and set their base rates accordingly – even if this could spell long-term financial instability and ultimately a financial crisis? Or should central banks think more long-term and orientate their monetary policy, for instance, to more toward financial stability? And should they react to developments in the credit, money and investment markets as well as to asset prices and exchange rates – even if they are not in keeping with the conventional inflation goal?
A look at the prior control of money supply by the German central bank, Deutsche Bundesbank, and the Swiss National Bank suggests that long-term orientation was always the priority, and that price and financial stability were the goals. This was without giving in to the temptation of a short-term fine-tuning of inflation and growth.
I still regard these and other key aspects of the question as to how central banks should integrate the financial cycle in their planning, as unanswered. There is certainly a lot, and increasingly more so, at risk.
In the meantime, monetary policy is pinning high hopes on macro-prudential measures bridging the gap between a zero base rate and the interest rate, which would be necessary for equilibrium on financial markets. In my opinion, macro-prudential measures like anti-cyclical capital buffers are no panacea, and they come with costs and risks.
A look at the prior control of money supply by the German central bank, Deutsche Bundesbank, and the Swiss National Bank suggests that long-term orientation was always the priority.
The success of macro-prudential measures presupposes an omniscient regulator who defends the public well-being against all special interest groups and analyses measures, makes decisions and implements them, all in real time. Unfortunately, reality is different. Furthermore, macro-prudential policies are always only the second-best solution, because a change from an allocation of capital dictated by the market to one that is manipulated suppresses the price mechanism, nullifies economic incentives and leads to a considerable loss of efficiency.
Some macro-prudential measures, such as liquidity rules which favor government securities, come close to financial repression. You could call government measures to facilitate financing public debt at the expense of domestic savers financial repression. But the most important instrument of this is a policy of low interest rates.
Financial repression is one of five possibilities to reduce an excessively high burden of debt. The other ways out of a debt crisis are unexpected inflation, economic growth, fiscal consolidation or payment default.
Which route will Europe choose? Austerity is becoming increasingly unpopular, inflation and growth prospects are currently low, and the politicians have sensibly excluded a new partial payment default like the one in Greece. That makes financial repression the last remaining instrument in the struggle against excessive indebtedness in the euro zone. Politicians are playing a dangerous game, however, if they concentrate exclusively on zero interest rates and macro-prudential measures.
Monetary policy strategies have always changed in the past alongside the environment. It would be naive to believe that the current paradigm of inflation-targeting can be sustained over the long term. On the contrary, the last 20 years have shown its weak points. Monetary policy decision-makers should constantly question their own thoughts and actions. Nobody can assume that the prevailing monetary policy concept today represents the best recipe for the future. In my opinion, the financial crisis has raised doubts whether the strategy of inflation targeting was ever fit for that purpose.
Axel Weber is board chairman of the Swiss bank UBS AG and a former president of the German central bank, Deutsche Bundesbank, and can be reached at: firstname.lastname@example.org