Markets Insight

February 24, 2014 6:06 am

Time for central banks to step back

Focus should be on building a more robust financial system


Central banks have been on the back foot recently. The Federal Reserve has been criticised for its tapering strategy. Forward guidance in the US and UK has become a little discredited

Higher policy rate expectations are played down but are no longer an academic issue. The European Central Bank’s unused lender-of-last-resort policy tool for sovereign governments may have been rendered unusable.

Controversially, perhaps, we should welcome these developments. They could help us to stop obsessing about the capacity of central banks alone to address our economic challenges, and, more generally, to focus on building a more robust financial system.

There are no constants in central banking, and we should embrace the opportunity for change. Under Bretton Woods, central banks had to obey the rules dictated by fixed exchange rates. After 1971, they made up their own rules, until the necessity of fighting inflation. In the credit boom, they were part of the flawed consensus that economies would be self-correcting if only low, headline inflation targets were respected.

Since 2009, central banks have occupied the dominant role in economic policy making, driven partly by circumstance and partly by governments’ withdrawing from the sharp end of economic management.

We have ended up with a chronically unbalanced policy infrastructure that is liable to compromise our ability to cope with the next economic downturn or crisis. It is appropriate, therefore, for central banks to step back a bit.


The Federal Reserve’s quantitative easing exit strategy will sometimes sit awkwardly alongside short-term economic trends, and may again be blamed for financial instability in emerging markets. However, the Fed’s strategy to normalise monetary policy in keeping with its economic judgment is fundamentally right. Spillover effects into emerging markets are best addressed via central bank swap facilities if needed, and by the agreement of G20 governments on best practice policies designed to strengthen emerging countries’ resilience.

We also know that forward guidance does not have the “scientificproperties that were on the tin. It turns out, in fact, to be quite a woolly concept, as both Fed chairwoman Janet Yellen and Bank of England Governor Mark Carney have acknowledged.

Tenuous link

It was always tenuous to link nominal policy rates to real, labour market phenomena such as unemployment, especially when employment and participation rates, wages and hours worked are structurally in transition for demographic and technological reasons. We cannot be sure what a given level of unemployment actually means nowadays. Central banks will have to judge the glide path back to appropriate policy rates under new economic circumstances, but addressing those circumstances is the responsibility of governments.

The ECB’s Outright Monetary Transactions (OMT) programme is now subject to a future ruling by the European Court of Justice, but the German Constitutional Court also deemed it to be constitutionally illegal in Germany, and outside the capacity accorded to the Bundesbank. However these issues are resolved, the OMT programme may not be usable, and would in any case amount to much less than Mr Draghi’s whatever it takes within our mandate”. Perhaps it no longer matters, given that the current convergence of bond yield spreads is more related to deflationary conditions.


This makes QE by the ECB a much bigger call, economically, but arguments will rage about the meaning of the ECB’s mandate for price stability, what constitutes monetary financing of governments, and who bears the ultimate fiscal risk in the event of loss.

The ECB has an unequivocal mandate concerning lending to banks and improving the transmission mechanisms of monetary policy, but politics have undercut its capacity to perform other key functions. Perhaps, though, this will help Europe acknowledge that only governments can address the problem of asymmetric economic adjustment.

Time to call time

These developments in advanced economies suggest it is time to call time on fallible central banks. Unorthodox monetary policies have served their purpose but their legacy is increasingly one of politics, limitations and unintended, negative consequences. Instead, we need to deploy a wider array of policy tools, not least government policies that prioritise high levels of employment and training, more robust income formation, and a ‘long-termism’ that requires corporate and fiscal governance reform.

Central banks should not be accountable for economic outcomes that lie outside their remit. Their primary function should be financial stability, including the management of goods and asset price inflation, of narrower banking structures, and of international monetary transmission effects.

We would all be better off if central banks were reassuringly vague in carrying out monetary policy, rather than firm in holding out economic hostages to fortune. The price may be slightly more animated yield curves, and more volatile market interest rates, but in the bigger scheme of things, this would be no bad result.


George Magnus is a senior independent adviser to UBS, and former chief economist of UBS


Copyright The Financial Times Limited 2014

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