At a time when major central banks are reviewing their policy strategies (the US Fed already did so in September 2020, see George Selgin‘s excellent analysis here), there is always the temptation to call for an extension of the remit of central banks, to go ‘bold’ and ‘modern’, which effectively means to go beyond maintaining price stability. As the leading British economist, Charles Goodhart (LSE), has put it before, if you want to know what major central banks will do in the future, check what the Reserve Bank of New Zealand (RBNZ) is doing now. Well, the RBNZ is already giving us a hint about what’s coming. As announced few days ago, the bank has been instructed by the government to consider ‘how it can contribute to the Government’s housing policy objectives, consistent with its financial stability objective of promoting a sound and efficient financial system.‘ In the reply of the RBNZ to the government’s instructions, the monetary authority makes it clear that this ‘requires the Bank to have regard to the impact of its actions on the Government’s policy of supporting more sustainable house prices, including by dampening investor demand for existing housing stock, which would improve affordability for first-home buyers‘.
Since the very launch of ‘inflation targeting’ as a policy strategy by the RBNZ in 1989, followed by many other central banks in the 1990s, the definition of what price stability means and how to measure it have been at the core of the policy and academic debates and discussions. At the time it was decided to measure price stability in terms of a consumer price index (CPI), which excludes asset prices. Of course, monetary policy decisions do affect asset prices (see a recent paper on it here, by Tim Congdon, IIMR); but adding asset prices to the remit of the central bank would mean that we know in advance what the long term equilibrium of asset prices is, that compatible with macroeconomic and financial stability. In real time, under uncertainty, we can identify trends and changes in asset prices which we may believe are not compatible with financial stability, but we can only know for sure ‘ex post’. Even if such a target for asset prices were easy to identify in real time, having both a CPI target and another one in terms of ‘sustainable house prices’ may become am impossible task for the central banks to achieve when both price indices move in opposite directions. For example, the aggressive response to Covid-19 crisis by major central banks since the Spring 2020 has resulted in an extraordinary increase in the amount of money broadly defined in major economies, indeed led by the USA; which has first affected asset prices, very much on the rise since then. However, CPI prices have not increased much yet (here we explain why CPI inflation will very likely increase later in 2021, particularly in the USA). At this juncture, should a central bank have a dual-price mandate, which prices should be prioritised?
The answer is very straightforward if central banks were to adopt a simpler and more effective policy strategy. By maintaining a moderate and stable rate of growth of money (broadly defined), central banks will be contributing to both CPI price stability and financial stability, but over the medium to the long term (approx. 2-3 years). Before the outbreak of the Global Financial Crisis in 2008, we observed a higher than 10% annual rate of growth in the amount of money in the Eurozone, while CPI inflation was still quite moderate. My colleague Pedro Schwartz and myself very much raised our concerns about this situation in 2007, in this report for the ECON Committee of the European Parliament. We didn’t know the extent of the crisis that was coming, but we knew that that rate of growth of money from 2004 to 2007 was not compatible with macroeconomic and financial stability. Of course, no one really paid much attention to it. As we estimated it at the time, following a price-stability rule would have meant a much lower rate of growth of money (broadly defined, by M3 in the Eurozone, see the red line below), around 5% – 6% per annum. The actual rate of growth of money in the Eurozone in 2007 (see the blue line below) doubled that benchmark rate compatible with price stability. M3 growth rates in the Eurozone are again in the double-digit territory (see IIMR February 2021 report here) and this can only mean higher inflation once the economy goes back to ‘normal’ (i.e. the demand for money reverts to levels closer to pre-crisis levels) and agents start to get rid of their excess in money holdings. We will see.
Let’s task central banks with what we know they can achieve. Central banks are very powerful policy-makers but they cannot do it all, and they shouldn’t either. Adding more tasks to their remits, be it an extra target in terms of asset prices, jobs creation, or contributing to a more green economy, among others, would put central banks in a very difficult technical and institutional position; one where they wouldn’t be able to achieve their mandate and they will be more exposed to political pressures. Let’s leave all the ‘extras’ for parliaments to deal with, if they like. This arrangement will preserve central bank independence and enhance their effectiveness in achieving monetary stability and financial stability, no more no less. Here you can find more details on this all in a 2020 report I wrote for SUERF on the ECB 2020-21 policy review strategy.
Thank you. Comments welcome.
Juan Castañeda
the old lady of threadneedle street 