The devastating cost of central banks’ caution

Timidity on monetary policy since 2008 has been as costly as the financial crisis

Martin Sandbu


Central bankers have fretted about being ready to 'normalise' monetary policy because they feared economies would overheat. Ten years on, we know how wrong this was © AP


An important group of economic actors have enjoyed undeserved impunity since the global financial crisis. I do not mean investment bankers, who will no doubt face revived opprobrium when the 10th anniversary of Lehman Brothers’ collapse is marked next month. I mean the central bankers, whose timidity since 2008 has been every bit as costly.

All the big central banks are now tightening or facing firmly in that direction. The US Federal Reserve is shrinking its balance sheet and steadily raising rates. The Bank of England just approved its second rate rise since the bottom. The European Central Bank, far behind the other two in the monetary policy cycle, has nonetheless announced an end to its asset purchase programme this year. Even the Bank of Japan is perceived by markets as at least considering a tilt towards tightening.

There is one fundamental truth about all these shifts: they have come much later than anyone — in particular central bankers themselves — thought they would. When central banks unleashed unprecedented monetary stimulus in late 2008, few expected that 10 years on, monetary policy would still be extremely loose by historical standards.

For years, central bankers have fretted about being ready to “normalise” monetary policy, a term whose main function has been to make a shift to monetary contraction in crisis-scarred economies sound responsible rather than risky. Their common concern has been that, without a timely contraction in monetary conditions, economies would overheat. The characteristics of growth beyond capacity — unsustainably high employment; inflation exceeding and potentially accelerating above target — would then be hard to rein in.

Ten years on, we know how wrong this was. Overheating is nowhere to be seen. In the US, the furthest ahead in the cycle, employers keep adding jobs without having to increase wages much. While unemployment has been at record lows for a long time, labour force participation remains below its historical peak even adjusting for demographic change. The growth spurt that followed Donald Trump’s huge tax cuts suggests that the economy can absorb a chunky aggregate demand stimulus.

In the eurozone, unemployment and underemployment have fallen but remain too high, showing the remaining slack. Estimates of their “sustainable” levels have dropped too, which means more slack than was thought. In the UK, wages are not picking up in response to high employment. The BoJ has not come close to jolting the Japanese economy out of deflationary expectations.

At best, central banks may be justified in thinking their economies are running out of slack soon. In the jargon, “output gaps” are now closing or already have. But to take this to mean all is well with monetary policy is to miss the much bigger lesson. If monetary policy is more or less appropriate now, then it has been catastrophically in error by being too tight for most of the past decade.

The error is this: if major economies are only now returning to full capacity, then central banks could safely have accelerated demand growth aggressively to close these output gaps much earlier. Once this mistake is acknowledged, the devastating cost comes into relief. For example, assume that the average output gap over the decade was 2 per cent of economic activity at full capacity. Halving this by boosting demand more and earlier would have saved 10 per cent of annual gross domestic product. That is enormous — and more than the immediate loss of GDP in the 2008-9 recession.

Still, this probably underestimates the damage. Many major economies remain some 15 per cent below the pre-crisis GDP trend. Either this reflects permanent damage to the supply side of the economy, or it is recoverable. If the former, some of the damage must have been caused by persistently weak demand, wearing down machinery and skills while discouraging new investment. If the latter, we are even further from full capacity than conventional measures suggest. Either way, central banks have done far too little.

What can banks say in their defence? Not that stabilising output was someone else’s job. This job was assigned to monetary policy as part of the pre-crisis understanding known as the Great Moderation. Nor can they say that inflation targeting lost traction on growth; they failed even to lift inflation to their own target. Central bankers fall back on the claim that they “ran out of ammunition”. This, too, is false. Some central banks stopped cutting rates before reaching zero; even those that did go into negative territory never pushed this policy to its limits. Asset-buying programmes all came with quantitative limits at the outset; those limits could have been higher.

Only the BoJ opted to target long-term rates directly, but did so late and timidly. Finally, no central bank tried the ultimate weapon in the monetary arsenal: issuing liabilities — cash — without acquiring assets in return, using its own equity, a policy instrument often dismissed as “helicopter money”.

Central bankers’ caution may have cost more in lost livelihoods than the recklessness of private bankers. Keep this firmly in mind during the Lehman anniversary.

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