What Should Central Banks Do? Central Bankers Volcker, Mishkin, Rajan, and King Provide Excellent Guidance.

Sveriges Riksbank

Economists have been asking this question for well over a century (or perhaps since Sweden established the Riksbank in 1668.)  The answers have changed over time; however, in the 1990s, economists seemed to have reached a consensus that price stability is the primary objective, if not the sole objective, for central banks.  Clearly, the financial recession of 2007 to 2009 or 10 obliterated this comfortable consensus but left central bankers without a well-defined focus for their attention.  Should price stability be the only goal?  What about economic stability?  If economic stability, how should central bankers measure and interpret it?

This blog posting revisits these questions and concludes, in agreement with former Bank of England Governor Mervyn King, that the uncertainties and complexities of modern economies yield no definitive answers.  Furthermore, given such volatile factors, political processes are unlikely to prescribe appropriate instructions for central bankers; however, legislators should indicate in broad terms the goals central bankers should use in setting policy.

Paul Volcker died at the age of 92 on December 8, 2019.  Although he only chaired the Federal Reserve (FED) for 8 years (1979 to 1987), he should be remembered as the central banker who brought credibility back to the FED by treating inflation as “public enemy #1” and taking actions consistent with that objective. Within four years, partly as a result of leading the Open Market Committee of the FED to set a federal funds target rate of interest as high as 20% in March of 1980, the inflation rate came down from over 13% in 1979 to below 4% by 1982.  This decline was much more rapid than most economists anticipated. Of course, one consequence was a major recession with the unemployment rate exceeding 10%, but inflation was permanently tamed, stable economic growth returned, and the Fed had regained its credibility.  

When President Obama needed to gain credibility in establishing macroeconomic policy in light of the great recession (2007-2009), he appointed Volcker to head the Economic Recovery Advisory Board.  One result was insertion of what became known as the Volcker Rule in the Dodd-Frank legislation to reform financial markets.  This rule sought to ensure that banks with deposits insured by the Federal Deposit Insurance Corporation (FDIC) don’t do proprietary trading on their own account; that is, it separated how insured depositors’ funds could be invested from what financial markets (both debt and equity investors) allowed banks to do.

FED Chair Paul Volcker testifying before Congress

In a December 9th Washington Post obituary, Catherine Rampell eulogized Volcker as follows:

But the more lasting impact of his life’s work lies in his own demonstrations of moral and political courage. …Volcker did things that made him unpopular with presidents, with Congress and with the general public. He elicited their enmity not because he was a provocateur or masochist. He undertook unpopular actions because he believed they were the right things to do, and he cared more about the long-run health of the country than he did about his own career.

When I first thought about the question posed in the title to this blog posting, Frederic Mishkin’s Homer Jones Lecture at the St. Louis Federal Reserve Bank in 2000 came to mind .  Mishkin identified seven principles that should guide central bankers:

• Price stability provides substantial benefits;

• Fiscal policy should be aligned with monetary policy;

• Time inconsistency is a serious problem to be avoided;

• Monetary policy should be forward looking;

• Accountability is a basic principle of democracy;

• Monetary policy should be concerned about output as well as price fluctuations; and

• The most serious economic downturns are associated with financial instability.

To satisfy these principles, Mishkin argued that legislators should set the goals for central banks (hence accountability to those elected to represent a country’s citizens), but the governors of central banks should be free to choose how to meet those goals.  Furthermore, price and financial stability rise to the top, as necessary conditions to meet all seven principles. For further discussion on how central banks can be both held accountable and deliver on these stability goals, I encourage you to read his lecture.

In recent times, largely because legislators have failed to align fiscal policy (the intentional use of budgetary policy) with monetary policy (interest rate and capital adequacy) to delivery stable output or time consistency, central banks have become, as Mohammed El-Erian has opined, The Only Game in Town .  Thus, we have seen the primary central banks in the industrial world (the Bank of Japan, the Bank of England, the European Central Bank, and the Federal Reserve) resort to NIRP (negative interest rate policy), ZIRP (zero interest rate policy), and near ZIRP policies.  I have addressed the economic distortions created by these policies in a previous blog posting. In short, such interest rates put long term economic growth and stability in jeopardy.

Former chief economist for the IMF and governor of the Reserve Bank of India Raghuram Rajan stresses the cost of having central bankers as “the only game in town.”  In a recent Project-Syndicate opinion piece, he argued that central banker success in taming inflation while generating relatively stable economic growth in the 1990s and early 2000s generated lofty expectations for them to constructively respond to all sources of economic instability including to policies that are known to increase rather than decrease it.  Consequent, he opines that central bankers have become the “fall guys” for many economic ills.

It is no surprise that populist leaders would be among the most incensed at central banks. Populists believe they have a mandate from “the people” to wrest control of institutions from the “elites,” and there is nothing more elite than pointy-headed PhD economists speaking in jargon and meeting periodically behind closed doors in places like Basel, Switzerland. For a populist leader who fears that a recession might derail his agenda and tarnish his own image of infallibility, the central bank is the perfect scapegoat.

Rajan, however, finds a silver lining in these efforts to knocking central bankers from their high “priesthood” status.

Shattering the mystique surrounding central banking could open it to attack in the short run, but will pay off in the long run. The sooner the public understands that central bankers are ordinary people doing a difficult job with limited tools under trying circumstances, the less it will expect monetary policy magically to correct elected politicians’ errors.

Not surprisingly, the economics profession no longer holds a consensus regarding what actions constitute optimal monetary policy.  In The End of Alchemy: Money, Banking and the Future of the Global Economy, former governor of the Bank of England Mervyn King argues that in an era of radical uncertainty, central bankers must decide whether to target the long term, real equilibrium path for the economy or short term price stability. For him, this choice goes well beyond the single mandate of price stability set by many central banks (e.g., the Bank of Canada, the Bank of England and the European Central Bank) and the dual mandate of price stability and maximum employment set by the Federal Reserve Bank in the U.S.  As I summarized previously, King believes central bankers should consider the following in setting monetary policy.  

  • In the contemporary world economy, many shocks to the economy are unpredictable; thus, one cannot use probability-based forecasting models to design policy to stabilize economies. As King puts it, “stuff happens;” we can’t plan in advance for failures in large, highly leveraged investment banks, country defaults, common market dissolution, or other disruptive political forces. 
  • Policies designed to stabilize economies in the short run, such as aggressive monetary and fiscal policies, leave a residue inconsistent with long run economic growth unless stagnation is viewed as the desired norm.
  • Central banks that serve as “lenders of last resort” may evolve into “lenders of continuous resort,” as seems to be the case for the Bank of Japan and the European Central Bank (despite legislated statements that state the primacy of price stability.)

To ensure long term economic stability, King concludes that central banks should evaluate the assets of banks on a regular basis and, if illiquidity arises, lend only to institutions that have assets that would be acceptable as “good collateral” – consistent with what is required by the Federal Reserve Act (1913) and Walter Bagehot’s prescription in Lombard Street (1873.) In short, the uncertainties and complexities of modern economies make “the proper role of a central bank in guiding the economy … thorny and controversial…” (King, page 172).

In my view, if monetary policy is left to politicians who are elected on a relatively short term basis, countries face incentives to manipulate monetary policy to serve short term ends. Such incentives are strengthened by recognition that the lag between monetary policy and output is much shorter than that between monetary policy and both inflation and financial fragility.  We need the Paul Volckers of the world to sustain long term economic viability by targeting both price and financial stability.  I, for one, recognize his contribution to economic vibrancy in the United States and mourn his passing.


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