THERE IS NO EASY WAY OUT FOR CENTRAL BANKS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

There is no easy way out for central banks

By Wolfgang Münchau

Published: July 26 2009 19:12

Ben Bernanke was elegant, concise, and yet he missed the point. Last week, in his testimony to congress, the chairman of the Federal Reserve presented his “exit strategy” – a toolkit of policies to prevent an increase in inflation once the economy starts to recover. The policies are the best modern central banking has to offer.

But simply possessing such tools does not make an exit strategy. For that, Mr Bernanke would, at the very least, need to define the circumstances that would trigger the use of such tools. I doubt very much that either Mr Bernanke, or his counterparts in Europe, are in a position to provide a credible definition at this point.

Before 2007, independent central banks would have had no problem presenting credible exit strategies. They would have pointed to their inflation target, and how they would use their medium-term inflation forecast or some other analytical framework to ensure that the price level would remain on a stable trajectory. The financial markets would have mostly agreed with the central bank’s decision on interest rates, give or take a quarter point.

That is simply not the case any longer. There are two big problems that need to be considered. One is the commercial banking system. This is more of an issue for the Europeans than the Americans, given the European governments’ inability to resolve the difficulty of continued bad debts. If the European Central Bank, for example, decided to exit tomorrow by raising interest rates, the likely consequence would be a banking meltdown. A credible monetary exit strategy, in Europe at least, would read like a suicide note.

The other problem, which is more troublesome for the US than the eurozone, is fiscal policy. As James Hamilton, professor of economics at the University of California, San Diego, pointed out in a recent analysis*, the direction of US debt, combined with the intermingling of monetary and fiscal policy, is inconsistent with the goal of long-term price stability.

It is important to remember that this debate is about the future. Nobody in their right mind would want to implement an exit strategy any time soon despite sightings of mythical green shoots. At this point, the threat of a W-shaped recession is higher than that of an overheating recovery. But eventually this crisis will end, and it is then that the exit strategy becomes relevant.

We are not talking about exiting this year and probably not even next year, but perhaps sometime in 2011. If you take into account the lags through which monetary policy works, you could easily see how the Obama administration might get nervous in terms of the electoral timetable. Given the intermingling of monetary and fiscal policy, a rise in the Fed’s funds rate and the use of the exit tools described by Mr Bernanke would constitute a significant and simultaneous fiscal and monetary tightening.

Mr Hamilton makes another point, namely that US policy is premised on a belief that it can fund any government deficits without any damage to the currency. That belief was justified in the past, but there are doubts whether this is still true now. Should there ever be a funding crisis, it is not clear how the Fed could easily raise interest rates under such circumstances without causing a political and economic bloodbath.

The intermingling of fiscal and monetary policy is the result of the central banks’ policies. Take, for example, the ECB’s recent extraordinary €442bn ($630bn, £380bn) injection of one-year liquidity at an interest rate of 1 per cent. This is a win-win game for the banks, especially since they were able to post collateral consisting of less than perfect securities, to put it mildly – those with a rating of BBB- or higher.

This repo auction was at least as much a fiscal as a monetary policy operation. It is part of an unpleasant strategy that consists of avoiding the political drawbacks of using taxpayers’ money to recapitalise banks, while abusing the central banking system by forcing it to undertake a quasi-fiscal rescue operation. The broad idea is to help the banks rebuild their depleted capital through helping them to notch up a few years of large risk-free profits. It would take a very long time to resolve a banking crisis that way, but eventually it would succeed, at a crippling cost to the economy.

As central banks take on these additional roles, their core function is bound to change. I cannot see how either the Fed or the ECB can pursue pure price stability policies under these circumstances. Such policies would be so damaging that no one in their right mind would want to advocate them.

That is why it is impossible to formulate ex-ante exit strategies in the current situation. The problem is not that central bankers are blind to the risks. The ones I know in Europe and the US are all inflation-averse and would not voluntarily advocate an extended period of price instability. Of course, they differ in their analytical frameworks and their views of how the channels of monetary policy work. But they would not readily adopt policies that they know would lead to excessive inflation later on.


The point is that they may have no choice.

Copyright The Financial Times Limited 2009