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Archive for September, 2020

Central banks are not just interest rate setters: an introduction to modern central bank roles

This is the online presentation I made at the 2020 Freedom Week (by the Adam Smith Institute and the Institute of Economic Affairs) on August 21st. It is an overview of the major roles undertaken by modern central banks in our economies, which involves much more than setting the policy rate. Actually, since the outbreak of the Global Financial Crisis what leading central banks have been doing is to act as ‘bank of banks’, ‘bank of the government’ and, as regards monetary policy, to engage in asset purchase operations (i.e. Quantitative Easing). Once policy rates were brought down to the effective lower (nominal) bound, central banks have used outright asset purchases to be able to affect macroeconomic outcomes. Contrary to a very popular misperception, in purely fiat monetary systems, central banks cannot run out of ammunition, even when nominal policy rates are zero or close to zero. In this presentation, I briefly discuss (1) what central banks do as providers of services to the banking sector and to the government, as well as (2) the importance of monetary analysis to understand the effects of changes in the amount of money on inflation and output over the medium to the long term. This is at the core of what we do at the Institute of International Monetary Research.

I hope you find it a good introduction to central bank roles in modern economies. As ever, comments welcome.

Juan Castaneda

PS. If only for enjoying James Gillray‘s caricatures as a means to explain money and central banking, it may well be worth watching.

 

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A rule-based monetary strategy for the European Central Bank: a call for monetary stability

This is the paper I wrote on the current review of the ECB strategy, just published in SUERF Policy Note series (Num. 192, September 2020). As you will see in the summary below, I discuss different alternatives to reform the current strategy of the ECB, including the adoption of a (1) higher inflation target, (2) price level target, (3) average inflation target or (4) a nominal income rate target in line with a stable growth of money. I explain in the paper why I favour number 4, so that the ECB aims at maintaining a stable rate of growth of broad money, compatible with a stable rate of growth of nominal income over the medium term. This strategy would allow the ECB to accommodate to supply shocks much easier and without the need to intervene in the market: in case of a positive supply shock, prices would tend to fall in a growing economy, thus resulting in a more stable rate of growth of nominal income. Under this strategy, the central bank would not need to offset such fall in prices by an increase in the amount of money but to do nothing (G. Selgin explains this point masterly in his pamphlet, ‘Less than Zero’). This means that the amount of money in the economy would not be as pro-cyclical as it has been in the last 15 years; with too much money growth in the expansionary phase of the cycle and too little during recessions. The stability in the rate of growth of money, broadly measured, would become key to maintain a stable nominal income growth throughout the cycle.

The ECB will announce the outcome(s) of the review of its strategy in 2021. The choices made by the ECB will surely shape the bias of monetary policy in the Eurozone for one or two decades. Other major central banks are conducting similar exercises. The US Fed just announced its new strategy (see G. Selgin excellent analysis on it here) and the Bank of England’s strategy is also currently under review.

Clearly, ‘inflation targeting’, at least as applied in the years running up to the Global Financial Crisis, is not the best policy strategy to maintain both monetary stability and financial stability over the long term. Central banks should not just take the ‘easy’ option and adopt a higher inflation target or an (asymmetric and vague) average inflation targeting (AIT) strategy. The latter seems to be the option taken by the Fed. And I say ‘seems’ because it did not make it clear in the announcement made last week. How many years will the Fed use to average inflation around? And will it react equally to long periods of inflation and to long periods of disinflation? If a symmetric AIT, the Fed would both (1) adopt a below target inflation rate after a period of too much inflation, and (2) an above target inflation rate after a period of too little inflation. However, it seems unlikely that the Fed would systematically target a lower rate of inflation (lower than 2%) when inflation has reigned over a long period of time. In the current juncture these options (the outright increase in the inflation target or the average inflation target) may well give central banks room to be more inflationary in the next few years, but they will also likely harm their credibility if they cannot contain the growth of inflation in the future. We will see in the next few months/years how the Fed effectively applies his new AIT strategy. My fear is that, in the absence of enough information communicated to the market to assess its policies over the long term, the Fed has just adopted a strategy to be more inflationary in the next few years.

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Summary of the paper on the ECB strategy review (full paper at https://www.suerf.org/policynotes/16571/a-rule-based-monetary-strategy-for-the-european-central-bank-a-call-for-monetary-stability):

‘The 2020-2021 review of the ECB strategy will shape monetary policy in the Eurozone in the years to come. Crucially, it will also determine the scope and capabilities of the ECB within the ever-evolving architecture of the euro. As in the aftermath of the Global Financial Crisis and the subsequent Euro Crisis, Member States are discussing new mechanisms to enhance economic recovery and further integration which, one way or another, will involve the support of, or the coordination of fiscal policy makers with the ECB. The impact of the new ECB strategy in the current debate about the future direction of the single currency should not be overlooked. In this note, we offer a proposal for the reform of the ECB strategy incorporating the lessons learned in the recent crises. We discuss several options for the ECB and set up a rule-based strategy suitable to operate in an environment of persistently low inflation and near zero interest rates. Under our proposal, monetary stability becomes the guiding principle for providing macroeconomic stability over the medium and long term, as well as for enhancing the transparency of the ECB communication policies.’

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Comments and feedback welcome.

Juan Castaneda

 

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