A virtual accord? Major central banks flex monetary policy muscles
Central banks from Washington to Frankfurt via London are revising their strategies in light of stubbornly low inflation. A repeat of the 1980s Plaza and Louvre accords is unlikely this week but there is mutual movement towards looser policy
Until recently, debates over the outlook for monetary policy and the actions of central banks were far from being the central attraction of the annual meetings of the International Monetary Fund and the World Bank.
During the so-called “great moderation” in the first decade of this century, the debates at the international monetary and financial committee, the IMF’s steering body, focused on maintaining decent levels of global growth, preventing financial crises and boosting support for low income countries.
Monetary policy was often confined to one paragraph of the IMFC communiqué, advising central banks to be ready to contain any inflationary pressures.
How times have changed. The great financial crisis of 2008/09, the eurozone debt crunch two years later and now the devastating impact on the economy of the Covid-19 pandemic and the measures taken to control its spread have meant central banks have been at the forefront of the response.
With many advanced economies increasingly indebted by the cost of their fiscal response to each successive downturn, finance ministers have passed the baton to their central banks.
As the US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England cut their base rates to zero or below and injected trillions of dollars, euros, yen and pounds into the economy, it was clear their governors were now the true masters of the financial universe.
But with power comes responsibility. The tactics and strategies of these banks have been under the spotlight from critics who believe their actions have ramped up asset prices at the expense of ordinary working people by flooding markets with liquidity.
Jerome Powell, chair of the US Fed, was first out of the blocks when he unveiled the results of its pioneering public review of its monetary policy framework at the Jackson Hole symposium in late August.
The Fed will now adopt “a flexible form of average inflation targeting”, so that rather than targeting a 2% inflation rate, the Fed will now seek to achieve inflation that averages 2% over time.
This in effect commits it not to tighten policy until inflation is persistently above 2%. “In a few short lines, the Federal Reserve has set the stage for a quiet shift in central banking,” says Neil Shearing, group chief economist at analysts Capital Economics.
“Given a period of below-target inflation over the past few years, it follows that a burst of above-target inflation will not just be tolerated, it will actively be targeted.”
So far, the jury is out. Markets have moved little in the wake of the announcement. Indeed, analysis by economists from Federal Reserve Bank of Cleveland and leading US universities of a poll of 1,500 Americans after Powell’s speech found that most had not heard the news and the few who had did not pick up a shift towards average inflation targeting (AIT). “These results paint a relatively bleak picture of households’ understanding of the announcement of a move to AIT,” they concluded.
Economists are somewhat more informed, and a poll of almost 50 leading US academics by Chicago Booth’s IGM Forum found that only a fifth thought it would make a practical difference to monetary policy over the next decade.
Sceptics, such as Chicago University economics and finance professor Anil Kashyap, are unimpressed. “Their ability to forecast and control inflation is a lot more tenuous than their rhetoric suggests,” he says.
Others are more swayed. “It is a sensible revision at the lower bound,” says William Nordhaus, an economics professor at Yale University. “A decade is a long time, and this could help the recovery once under way.”
While it will be hard to tell whether the changes will have an impact on economic outturns for years to come, the immediate question it raises is whether other banks will follow its lead.
That debate will be at the heart of this week’s meetings, where the IMF is expected to push for more fiscal stimulus and continued support by central banks in the form of ultra-loose monetary policy.
Andrew Milligan, former head of global strategy at Aberdeen Standard Investments and now an independent investment consultant, says the IMF will encourage governments around the world “to do more on the fiscal side than necessarily try to unify what is happening on the monetary side”.
But he adds: “Central bankers can put the necessary conditions into place for the recovery in economic activity in the coming year — necessary but not sufficient without a turnaround in consumer and business confidence, which in turn may require more government support as well as a successful vaccine to bring about.”
Mark Haefele, chief investment officer at UBS Global Wealth Management, says he expects central banks worldwide to accept moderately higher levels of inflation while excess capacity is run down.
“Policy makers could also consider a variety of other changes to policy frameworks, such as yield curve control, in order to ensure financial conditions remain accommodative and support the economic recovery,” he says.
The focus will be on Christine Lagarde, the president of the ECB, which launched a review of its monetary policy strategy in January in light of its continued inability to get eurozone inflation anywhere near 2%. The outcome has been delayed from the end of this year into the second half of 2021 because of the Covid-19 pandemic.
Reza Moghadam, chief economic adviser at Morgan Stanley and former head of the IMF’s European department, says that the ECB has found itself “out-doved” by the Fed.
“By comparison, the ECB’s commitment to ‘below but close to 2%’ inflation — a target it has consistently undershot since 2012 — sounds decidedly austere,” he says, adding that there is considerable concern in Europe that the appreciation of the euro since early July may gain new momentum.
However, key members of the governing council disagree with a shift to an average inflation target. Fabio Panetta has said the ECB should err on the side of doing too much rather than too little, while Yves Mersch has argued the outlook has not changed and risks may have even receded.
“Overcoming that opposition will be a heavy lift for the ECB,” Moghadam says. “Bringing the review forward therefore does not seem a viable option.
Instead Lagarde, who is giving a keynote speech at this week’s meetings, will have to operate within the limits of the existing ECB rules but will continue to hint at the bank’s ability to act.
In her testimony to the European Parliament’s economic and monetary affairs committee a fortnight before the meetings, she said the bank would conduct net asset purchases under the pandemic emergency purchase programme (Pepp) “until at least the end of June 2021” — a possible date for the review.
She gave a strong hint in a speech on the eve of the meetings that central banks should commit to explicitly make up for inflation misses when they have spent quite some time below their inflation goals. “The usefulness of such an approach could be examined,” she said.
Observers such as Haefele and Moghadam believe that the ECB will raise its Pepp injections in December and extend its reach to the end of 2021 — something that markets will be listening out for in her remarks in Washington.
On the other side of the English Channel, the Bank of England is going through its own communication issues. Governor Andrew Bailey caused a stir in August when he raised the idea that negative interest rates were part of its “toolbox” but then said there were no plans to use them.
Despite similar public disagreements between members of its monetary policy committee that have been seen in the ECB, the Bank managed to get all nine members to sign up to a statement in the minutes of its September meeting that it will begin “structured engagement on the operational considerations” of negative rates in the final quarter of this year.
Robert Woods, UK economist at Bank of America, sees the bank laying the ground for a cut in the bank rate to zero from 0.1% and further quantitative easing in November, leaving it room to cut rates into negative territory in the case of a failure by the UK and European Union to agree a deal over Brexit.
“Publishing this paragraph feels like news,” he says. “It suggests to us that the Bank of England is more prepared to use negative rates than we thought. They just opened the door further to negative rates — not just next year, but for an extended period — potentially triggered by any negative economic shock.”
All three are way behind the Bank of Japan, which moved ahead of the Fed. Since 2016 it has pledged to continue expanding the monetary base until core inflation exceeds 2% and “stays above that target in a stable manner”.
But the fact that four of the most influential central banks have all taken steps to reframe the way they set monetary policy to allow inflation to rise further is not the same as active collaboration.
China’s dog hasn’t barked
A repeat of the Plaza Accord of the G7 countries in 1985 to depreciate the dollar and the Louvre Accord two years later to halt its decline is unlikely: those were initiatives to produce a specific outcome in the foreign exchange market rather than a strategic shift in policymaking.
A more likely forum will be the meeting of finance ministers and central bankers of the G20, which has superseded the G7 as the informal co-ordinating body for monetary policy following its co-ordinated intervention to tackle the global financial crisis at its 2009 summit.
One hurdle to a consensus among the G20 is that China, the second largest economy, is ploughing a very different monetary policy farrow. As Milligan, the independent economist, points out, in contrast to what is happening in Europe and the US, the People’s Bank of China has held back from significant monetary intervention.
This is partly because Chinese firms are benefiting from a big exports boost connected to the global recovery in consumer spending and inventory rebuilding over the summer, he says.
“Chinese money supply growth has not exploded, as it has in some other countries. The authorities there seem to be relying much more on, firstly, the export stimulus, which China has benefited from, and then local support for the housing market as well, which is really rather strong,” he says.
A useful role for the IMF and the World Bank would be to find a solution to their savings glut in Asia that has contributed to the repression of inflation and interest rates, according to Jagjit Chadha, director of UK think tank the National Institute of Economic and Social Research (NIESR).
“Financial engineering and innovation are required in the saver countries and that means the development of pensions savings vehicles, domestic investment and mortgages,” he says.
“You need enough savings vehicles across countries or the creation of bonds or assets that are stable so there is not this level of capital flows out of emerging economies. Real interest rates at zero is unheralded and is driving all kinds of distortions in the world economy.”
Milligan says the role of the central banks at the annual meetings should be to encourage governments to give more support to consumers and businesses via taxes, public spending and deregulation. The Fed, in particular, has made it clear that the bank will ensure it does not repeat past mistakes by overreacting to any inflationary pressures as and when they appear.
“The message we are receiving is that it will be some time before inflation reappears, and even when it does the Fed will be happy to see inflation running above target for a period of time to allow the economic recovery to blossom. In other words, it may be years before they take the punchbowl away.
“That’s an important signal to investors, to industry, to the man or woman in the street.”
New Fed mandate on jobs raises questions over targeting inequality
The US Federal Reserve is already unique having a dual mandate to pursue maximum employment and stable prices, but chair Jerome Powell wants to focus even more closely on the labour market.
He pointed out in his Jackson Hole speech that the historically strong labour market did not trigger a significant rise in inflation. In fact, forecasts from both members of the Fed and private sector analysts have routinely shown a return to 2% inflation that was never realised on a “sustained basis”.
The implication is that the Fed will allow recoveries to go on unimpeded by monetary policy — even if unemployment rates get very low — as long as inflation remains subdued.
In a notable shift of focus, the revised mandate emphasises that maximum employment is a broad-based and inclusive goal. This change reflected “our appreciation for the benefits of a strong labour market, particularly for many in low and moderate-income communities”, according to Powell.
Andrew Milligan, an independent economist, says if the Fed wants not just to reduce the current high levels of unemployment but improve employment opportunities in key sectors such as minorities and low income groups, that represents a “fairly significant shift” in policymaking. “How significant, of course, we will only know in perhaps five years’ time,” he says.
A policy paper published by three IMF economists — but which does not represent official policy — looked at whether central banks should care about inequality when setting monetary policy.
“Major central bank officials are increasingly discussing distributional issues,” they wrote, citing Powell’s speech as well as remarks by his predecessor, Janet Yellen, in 2014 and by former ECB head Mario Draghi in 2016.
They found “some support” for making inequality an explicit target for monetary policy, particularly if central banks followed standard Taylor rules that the central bank chooses an interest rate based on current output and the inflation gaps and then augments it with an inequality target.
They found that beyond targeting just inflation and output gaps, a central bank could achieve higher welfare by placing a small negative weight on consumption inequality: “Such an augmented Taylor rule allows both a more effective stabilisation of consumption inequality but also stabilises inflation and output gaps.”
As Tyler Powell and David Wessel of the Brookings Institute, the Washington think-tank, have pointed out, research shows minority groups and low and moderate-income communities enjoy disproportionate gains from very low unemployment rates.
But Jagjit Chadha at UK think-tank the National Institute of Economic and Social Research (NIESR) warns there is a danger of central banks having a two-stage target to control inflation and then achieving another objective. “If central banks are told, ‘you have hit inflation targeting, now go and look at something else like income inequality’, that then means inflation will take off because agents will see that central banks don’t care about inflation any more.” —P.T.