Whether they raise or hold, central bankers are due a fall

Sebastian Mallaby

In future it may have to be budget stimulus that rides to the rescue

     (Photo by Mark Wilson/Getty Images)                                                          ©Getty

WASHINGTON, DC - MAY 20: Newly redesigned $100 notes lay in stacks at the Bureau of Engraving and Printing on May 20, 2013 in Washington, DC. The one hundred dollar bills will be released this fall and has new security features, such as a duplicating portrait of Benjamin Franklin and microprinting added to make the bill more difficult to counterfeit.

America’s monetary priesthood convenes next week amid more than the usual scrutiny. It has been 11 years since the Federal Reserve last initiated a tightening cycle, and the fateful moment of lift-off may now approach, if not at this meeting then at least before Christmas. But whatever the Fed’s interest-rate committee determines, we can be sure of one thing: few will doubt its competence. Gone are the days when theFed was a holding pen for cronies and chancers — placemen such as the redoubtable James K Vardaman Jr, appointed to reward his service as a plodding presidential aide, sworn into office in 1946 in the full regalia of a navy commodore.

Do modern central bankers deserve their exalted reputations? In one sense, yes: like the economics profession writ large, they have become more scientific and sophisticated. But in another sense there is a danger in pushing this reverence too far. The Fed still grapples with surprisingly basic questions about its purpose. Should it stabilise inflation, or a combination of growth and inflation, or perhaps employment, or maybe even asset prices? And how, for that matter, do its tools really work?

By toggling short-term rates, the Fed hopes to guide the more important long-term ones that matter to homebuyers and businesses, but the transmission mechanism is unstable. As for quantitative easing and the rest of the modern monetary toolkit, it is a work of improvised brilliance, dazzling and yet prone to fail. It is not a trusty set of spanners.

When it comes to unmasking the uncertainties behind the Fed’s technocratic façade, the transcripts of past interest-rate meetings are a boon to historians. A particularly fine example is to be found in the transcript of February 1989, when the Fed’s doctrinal confusion was at one of its high points.

Back then the Fed was still operating in a monetarist fashion: it steered the economy by tinkering with the quantity of credit available to households and businesses, which it did by manipulating banks’ financial reserves and hence their lending capacity. At the same time, the Fed’s attention was shifting from the quantity of credit to its price — from the money supply to the interest rate. Caught awkwardly between two approaches, the Fed tried to have it both ways: it would adopt a target for the supply of credit, but also assume a target interest rate. Cue confusion.

At one point in the February 1989 meeting, Alan Greenspan, the chairman, proposed keeping the money-supply target constant. Richard Syron of the Boston Fed worried that this status-quo course might actually lead to looser policy as measured by the Fed’s key short-term rate — the federal funds rate.

“We might see some decline in rates,” Mr Syron suggested.

Mr Greenspan appeared bemused: “Exchange rates?”

“Under your proposal you would not want to see a decline in rates in the short term,” Mr Syron persisted.

“Do you mean the funds rate?” Mr Greenspan asked this time.

“Yes, the funds rate.”

“No, I would not.”

“What funds rate level would that be?” asked Thomas Melzer, president of the St Louis Fed.

“Where we are right now,” Mr Greenspan responded.

“9 1/4 per cent?” asked Mr Melzer.

“9 1/8 per cent,” somebody answered.

“9 to 9-1/8,” another voice corrected.

“Did we clarify that?” Mr Greenspan asked.

“Yes,” Mr Melzer declared, courageously.

Could it be that, behind the veil, today’s Fed leaders are equally muddled? One presumes not; and yet they and their foreign counterparts are evidently stumped by two big challenges.

The first is low inflation. The major central banks have jabbed at their economies with newfangled monetary cattle prods for years, but have failed to get inflation moving — and now the China shock threatens to subdue prices further. This creates a near-term danger of deflation, and Japan teaches us how hard it is to escape that deadly trap. But it is also a problem for the future. In the two US downturns before 2008, the Fed cut its policy rate by more than five percentage points to rekindle growth. Next time, central banks will begin with interest rates so low that it will be impossible to respond equivalently.

The other big conundrum concerns asset prices. The 2008 crisis belied the notion that these could simply be ignored. But central bankers now want to contain bubbles not with interest rates but with regulation. Sadly, regulation is not up to the task. It is slow-moving, porous and, especially in the US, hamstrung by agency turf fights.

Fortunately for the Fed, it need not advertise its frailties. Next week it will announce its decision; traders will swoop; the rest of us will marvel at the power of this unelected priesthood.

But, in the not-too-distant future, this superman image may suffer two kinds of blow. Come the next recession, it may have to be budget stimulus, the handiwork of grubby politicians — not the monetary stimulus ordained by central bankers — that rides to the rescue. And come the next financial bubble, the inadequacy of regulatory countermeasures will be painfully exposed.

The priesthood, after all, is fallible.

The writer, a senior fellow at the Council on Foreign Relations, is writing a biography of Alan Greenspan

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