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What should central banks do when politicians seem incapable of acting?Thus far, they have been willing to step into the breach, finding new and increasinglyunconventional ways to try to influence the direction of troubled economies.But how can we determine when central banks oversteptheir limits? When does boldness turn to foolhardiness?
Central banks can play an important role in a cyclical downturn.Interest-rate cuts can boost borrowing – and thus spending on investment andconsumption. Central banks can also play a role when financial markets freeze up. By offering to lend freely againstcollateral, they “liquify” assets andprevent banks from being forced to unloadloans or securities at fire-sale prices.Anticipating such liquidity insurance, banks can make illiquidlong-term loans or hold other illiquid financial assets.
To the extent that unconventional monetary policy – including variousforms of quantitative easing, as well as pronouncements about prolonging lowinterest rates – serves these roles, it might be justified.
For example, the US Federal Reserve’s first round of so-calledquantitative easing (QE1), implemented in the midst of the crisis, was doubly effective: By purchasing mortgage-backedsecurities, the Fed brought down interest rates in that important market (inpart, probably, by signaling its confidence in those securities), and restoredit to vitality. Similarly, with its outrightmonetary transaction (OMT) program, the European Central Bank has offered tobuy peripheral eurozone countries’ sovereign bonds in the secondary market –provided that they sign up to agreed reforms.
The logic is that conditionality willensure that countries are solvent, while OMTs will restore trust to a marketthat has broken down because investors fear that the countries concerned will exit the eurozone. Again, its effect, thus far,has been significant.
Other unconventional policies, however, have been undertaken to stimulatethe economy, rather than to deal with broken markets. The benefits have been commensurately smaller. QE2, in which the Fedbought long-term government bonds, did not have a discernibleeffect on long-term government interest rates. Indeed, with its recent decisionto pursue QE3, the Fed is focusing once again on the mortgage-backed securitiesmarket; but, given that the market is much healthier now, it is unclear howmuch good this will do.
Recently, the Fed expressed its intent to keep policy rates low for a longtime – until employment picks up strongly.The hope is that if investors consider this announcement credible, long-terminterest rates will come down further, encouraging spending. But the immediateeffect on long-term bond rates has not been encouraging.
As central banks venture farther into unchartedterritory, advocates argue that at worst they will do no harm. In fact, no onereally knows.
For example, sustained low interest rates hurt savers who traditionallyprefer safe short-term investments. Pensioners and those near retirement,facing low income from interest, may cut back further on consumption, weakeningthe economy. Bolder pensioners, desperate to generate higher returns, may take undue risks – for example, investing in junk bonds– that could jeopardize their nest eggs.And, unfortunately, such financial risk-taking may have little impact in termsof spurring corporations to assume more risk by investing.
Similarly, a potential downside toquantitative easing is that low interest rates send capital to higher-growth,high-interest-rate countries. In theory, as capital floods in, these countries’exchange rates will appreciate rapidly, making them look unattractive andautomatically stemming the flow. In practice though, as investors make money ontheir trades, they bring in yet more money, forcing further currencyappreciation. All too often, the process does not end smoothly but in a crash.No wonder recipient countries resist inflows of hot capital.
We also know little about how smooth the exitfrom quantitative easing will be. In theory, as the economy picks up andinterest rates begin to climb, central banks will simply pay higher interestrates on their reserves, so that they can finance their holdings of long-termsecurities and shrink them slowly. But higher interest rates also imply largecapital losses for central banks’ asset holdings.
Even if some of these losses are offsetfor the government as a whole (as the central bank loses on its holdings ofgovernment debt, the treasury gains in equal measure, because the debt it owesis worth less), the losses on long-term private debt holdings are real.Moreover, the argument that losses are offset is not easy to explain to thepublic. Will opinion be sympathetic to the Fed when politicians like Ron Paul excoriate it for losing tens of billions ofdollars monthly on its asset holdings? Will bond markets fall sharply (andinterest rates rise) as markets fear that the Fed will be pushed to sell itsenormous holdings in short order?
A last defense offered by advocates of continuing on the path of adventurous monetary policy, even when theperceived benefits are small, is that, because politicians refuse to settletheir differences and act, monetary policy is “the only game in town.” Indemocracies, when there are no other alternatives, politicians often eventuallydo the right thing. By creating the impression that something beneficial isbeing done, unconventional monetary policy relieves pressure on politicians.So, when central bankers argue that they are the only game in town, they areensuring that outcome.
Central bankers nowadays enjoy the popularity ofrock stars, and deservedly so: their response to the difficult anduncertain environment during and after the financial crisis has been largely impeccable. But they must be able to admit whenthey are out of bullets. After all, the transformation from hero to zero can be swift.
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