Central banks should pursue flexible policy

One of the recent monetary policy milestones globally was the decision this month by the US Federal Reserve to extend its Operation Twist for another six months. Originally launched last September, the program has involved the bank selling $ 400 billion worth of short-term government securities in order to buy long-term ones. The prolongation of the scheme will involve another $ 267 billion, largely depleting the Fed's remaining holdings of short-term Treasuries. This 'non-decision' - since it did not really change the Fed's current policy stance - was in many ways an awkward compromise. It offered something to the hawks by stopping short of another wave of formal quantitative easing. But it also highlighted the fact that the economic situation remains far from normal even at a time when the euro zone crisis has pushed more money into US Treasuries thereby depressing interest rates to historic lows.
While not quite QE3, Twist has been a sizeable undertaking. The Fed has bought 63 percent all of 7-30-year Treasuries auctioned since its launch. The extent to which it has met its key objective of lowering long-term interest rates remains in dispute. In practice, however, long-term rates are low (due to a whole host of factors), further underpinned by the clear commitment to very loose monetary policy that Twist represents. The Fed has signaled that short-term rates are now unlikely to budge before 2014. More “Twisting” most immediately represents a response to the recent disappointing economic data. New job creation 226,000 a month in January-March, fell to 73,000 in April-May. Unemployment is expected to remain around 8.2 percent while the growth outlook for the year has been downgraded to 1.9-2.4 percent. Lurking in the background are also the multiple risks associated with the euro zone. In view of these realities, the Fed - predictably - highlighted its preparedness to loosen further if necessary.
The Fed decision reflects more generally the 'Curious Conundrum' of central banking at the moment. The general bias is toward greater loosening but at a very measured base. The UK recently launched the Extended Collateral Term Repo Facility and further quantitative easing is seen as likely. The European Central Bank seems in principle ready to reduce rates below the current 1 percent and has already broadened the range of securities it accepts as collateral for loans. These now include asset-backed securities based on car loans, consumer credit, corporate loans, and residential mortgages with haircuts applied to riskier instruments.
The relative caution contrasts with a deteriorating outlook for the global economy along with an unusually disturbing risk profile. Why the persistence of the reactive stance when the calls for proactive measures are rapidly multiplying? Perhaps most importantly, central bankers seem to be hedging their bets. The range of possible near-term outcomes for the global economy is unusually wide at a time when both fiscal and monetary policy the world over is generally highly permissive. This means that the authorities have limited unused ammunition left and there is an understandable desire to keep some of the powder dry in case the situation does take a sharp turn for the worse. Linked to this is the realization that additional monetary stimulus may be well past the point of diminishing returns. For instance in the US, the quantitative easing purchases of securities exceeded $2 trillion and took the Fed's portfolio above $ 2.8 billion. The real economic benefits may have included avoiding a disaster but a true recovery clearly remains frustratingly elusive. With each new initiative, the ability of unorthodox stimulus to support growth may be becoming less. The authorities may not wish to be too far down that road if and when emergency interventions become truly necessary. In the meantime, attempts to coordinate the stimulus at a global level have to date met with limited success.
The caution is also to an extent a response to the recent economic data, which suggests that the monetary aggregates and bank lending are edging up somewhat, especially in the US. At the same time, there is an often mandatory responsibility to avoid stoking inflationary pressures. Here, however, unconventional monetary easing may well become more justifiable in the near future as global inflationary pressures are generally weakening. Apart from the deteriorating growth prospects, the elevated unemployment rates in the advanced economies mean less pressure on wages. Moreover, economies are now further benefiting from lower oil prices.
In Europe, of course, the caution is partly linked to the ongoing awkward efforts to redesign the institutional and regulatory architecture of the euro zone. This is a deliberately slow process, subject to political and in some cases even legal constraints. For instance, one of the challenges for Germany is last year's Constitutional Court ruling, which essentially forbids ongoing German government support to indefinite bailout mechanisms and boosts the power of the parliament. This might potentially apply to the recently proposed European deposit guarantee as well.
But part of the caution is clearly linked to the fact that central banks are being asked to do a lot as bankers and elected politicians officials avoid - deliberately or not - tough decisions. Yet by doing more, central banks are assuming greater risks, which may not be prudent policy in the face of the current uncertainties. As the Bank for International Settlements recently noted, the current situation is one where "Central banks are being cornered into prolonging monetary stimulus, as governments drag their feet and adjustment is delayed. ... It would be a mistake to think that central bankers can use their balance sheets to solve every economic and financial problem." BIS estimated that the central banks of the advanced economies have some $ 18 trillion at risk through emerging lending to commercial banks and purchases of government bonds. The sum is equal to 30 percent of the global GDP.
Clearly, central banks, if they are to avoid an excessive concentration of risks, need to find a way of nudging other policymakers into action. In Europe, this will likely have to mean genuine steps towards an EU-wide bank regulator and a fiscal union. In the meantime, the real risk with the gradualist paradigm is that policy makers risk being overtaken by events. A period of market panic would call for immediate action, which is subject to the relevant regulations being available, even if the room for innovation is not completely nil. One option that likely merits greater attention that it is currently getting is a more flexible target-based monetary policy, for instance open-ended quantitative easing linked to particular macroeconomic objectives. Such instruments could be reactivated when the data calls for it as opposed to being entirely based on the discretion of policy makers or regulatory innovation.
— Jarmo T. Kotilaine is chief economist at
the National Commercial Bank, Jeddah.