11 October 2017
Central bankers usurped the titans of
As they gather in
In short, the new masters of the universe might not understand what makes a modern economy tick and their well-intentioned actions will prove harmful.
While there have long been critics of the power of central bankers on the left and the right, such profound doubts have never been so present within their narrow world. In the words of billionaire investor
The ability of central banks to resolve these questions does not just affect growth rates, but is fundamental to the health of the democracies of advanced economies, many of which have been assailed by populist uprisings.
"It we can't get inflation back up, we can't have political stability without wage growth," says
The root of the current insecurity around monetary policy is that in advanced economies - from
Deflation failed to materialise in the depths of the great recession of 2008-09 and now that the global economy is enjoying its broadest and strongest upswing since 2010, inflationary pressures are largely absent. Even as the unemployment rate across advanced economies has fallen from almost 9 per cent in 2009 to less than 6 per cent today,
Amid this forecasting nightmare, some frank talk is breaking out.
The details of macroeconomic models are fiendishly complicated, but at their heart is a relationship - called the Phillips curve - between the economic cycle and inflation. The cycle can be measured by unemployment, the rate of growth or other variables, and the model predicts that if the economy is running hot - if unemployment falls below a long-run sustainable level or if growth is persistently faster than its speed limit - inflation will rise.
The models are augmented by a concept of inflation expectations, which keep inflation closer to a central bank's target - usually 2 per cent - if the public trusts that central bankers will do whatever it takes to return inflation to that level after any temporary deviation. The holy grail for central bankers is to claim credibly that they have "anchored inflation expectations" at the target level.
In the model, the most important factors that explain price movements are therefore the degree to which the economy has room to grow without inflation, termed "slack" or "the output gap", and the public's inflation expectations.
The role of central banks in the model is to set the short-term interest rate. If a central bank sets its official interest rates low, people and companies will be encouraged to borrow more to spend and invest and discouraged from saving, boosting the economy in the short term. Higher interest rates cool demand.
The first fundamental problem with the model is, as
But many economists and central bankers are wedded to the underlying theory, which is about 30 years old, and seek to tweak it to explain recent events rather than ditch it in favour of less orthodox ideas. Such nips and tucks are occurring all over the world, although the explanations differ.
A second explanation is that the level of unemployment that is consistent with stable inflation has fallen. In 2013, the
The problem with such explanations, as
A third explanation is that central bankers have been so successful in anchoring inflation expectations, companies do not seek to raise prices any faster and workers do not ask for wage rises even when jobs are plentiful.
"Over my time at the Fed, I came to worry that inflation expectations are bearing an awful lot of weight in monetary policy these days, considering the range and depth of unanswered questions about them," says
The BoJ, meanwhile, frets that companies are cutting employees' hours and raising productivity rather than paying more, which is hampering its ability to push up inflation despite extremely low unemployment.
If it was not bad enough that the link between the economic cycle and inflation has broken down, the second fundamental problem in central banking is that estimates of the neutral rate of interest - seen as the long-term rate of interest that balances people's desire to save and invest with their desire to borrow and spend - appear to have fallen persistently across the world.
Whether it is because ageing populations want to save more or because of a global "savings glut", as former Fed chair
Regardless of the terminology, the two problems combined suggest central bankers cannot easily determine whether their economies need stimulus or cooling and do not know whether their monetary tools are helping them do their job. And there is increasing concern, even expressed by
"Essentially you are setting policy on things you don't know and can't measure and then reasoning after the fact," says
At a conference last month to celebrate the
New research is needed to question whether current thinking is deficient, she said, "and if such research suggests our ideas explaining how the economy works are wrong or need to change, then central bankers need to embrace those ideas".
The most aggressive critic of the consensus is
He asks: "Is it reasonable to believe that the inflation process should have remained immune to the entry into the global economy of the former Soviet bloc and
His concern is that by keeping interest rates low, central bankers have no effect on inflation or the economy other than to increase the level of debt. The result is that it will be harder "to raise interest rates without causing economic damage, owing to the large debts and distortions in the real economy that the financial cycle creates".
It is not a popular view, but it is no longer dismissed out of hand.
"Persistently easy monetary policy might also eventually lead to increased leverage and other developments, with adverse implications for financial stability," she said.
With central bankers credited for keeping the economic show on the road over the past decade, it will come as a shock to many to hear how little confidence they have in their models, their policies and their tools.
One question posed by
For now, the public still trust the women and men who work in the marbled halls of central banks around the world. But that confidence is fragile. Central bankers might have been the masters of the universe of the past decade, but they know well what happened to the previous holders of that title.
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