Thursday, November 27, 2014

Central Bankers on the Ground

NEW DELHI – Markets are in turmoil once again, following the US Federal Reserve’s indication that it might reduce its bond purchases toward the end of the year. The intensity of the market reaction was surprising, at least given the received wisdom about how the Fed’s quantitative-easing policy works. After all, the Fed was careful to indicate that it would maintain its near-zero interest-rate policy and would not unload its bond holdings.

The dominant theory of how quantitative easing works is the portfolio-balance approach. Essentially, by buying long-term Treasury bonds from private investors’ portfolios, the Fed hopes that these investors will rebalance their portfolios. Because a risky asset has been removed and replaced with safe central-bank reserves, investors’ unmet risk appetite will grow, the price of all risky assets (including remaining privately-held long-term Treasury bonds) will rise, and bond yields will fall.

A central element of the theory is that the stock of bonds that the Fed has removed from private portfolios, not the flow of Fed purchases, will determine investors’ risk appetite. Unless investors thought the Fed was going to buy bonds forever, news about a reduction in Fed purchases should have had only a mild effect on their expectations of the eventual stock of bonds the Fed would hold. So why such a violent reaction in markets worldwide?

One possible answer is that the volume of monthly Fed purchases also matters for global asset prices. Another possibility is that investors around the world read far more into the Fed’s statements than the Fed intended. Either answer is worrisome, because it would suggest that central banks – which are now holding trillions of dollars in assets – have less ability to manage the process of exiting quantitative easing than we would wish. Perhaps Winston Churchill might have mused about quantitative easing, “Never in the field of economic policy has so much been spent, with so little evidence, by so few.”

Quantitative easing has truly been a step in the dark. Given all the uncertainty – why it works, how to make it most effective, and how to exit – why have central bankers, for whom “innovative” is usually an epithet, departed from their usual conservatism in adopting it?

One possibility is that in the past, crises typically occurred in countries that lacked the depth of economic training that exists in, say, the United States or Europe. When emerging economies’ policymakers were told that they needed to implement significant austerity, as well as widespread bank closures, to cleanse the economy after a crisis, they did not protest, despite the prospect of years of high unemployment. After all, few had the training and confidence to question the orthodoxy, and those who did were considered misguided cranks. Multilateral institutions, empowered by their control over funding, dictated policy from the economic scriptures. In sum, those determining policy were distant from the pain.

When the crisis hit home, Western economists were much less willing to accept that pain was necessary, or so the explanation goes. Keynesianism, which promises painless answers, was resurgent once again. The Fed, led by perhaps the foremost monetary economist in the world, proposed creative solutions that few in policy circles, including the usually conservative multilateral institutions, questioned. After all, they no longer had the power of the purse or the advantage in economic training.

But this is not an entirely satisfactory explanation. Nobel laureates like Joe Stiglitz did protest very publicly about the kind of austerity to which Indonesia, for example, was subject. While many more protest austerity today, it was not that smart economists were totally oblivious of the pain emerging economies were going through when they were hit by crisis.

Consider another explanation: Perhaps central bankers’ success in preventing the collapse of the financial system after the 2008 crisis secured for them the public’s trust to go further. Perhaps their successful rescue of the banking system also misled some central bankers into believing that they possessed the Midas touch. After all, despite their natural conservatism, it would have been hard for central bankers to do nothing if they believed that there was something, anything, they could do to improve growth and reduce unemployment.

Yet this, too, seems to be only a partial explanation. Few among the public were happy that the big banks were rescued, and many did not understand why the financial system had to be saved when their own employers were laying off workers or closing down.

Indeed, perhaps a better explanation is that instead of creating more room for central bankers, the banking rescues narrowed their political room for maneuver. Perhaps what forced central bankers to act creatively was the political difficulty of doing nothing after having spent billions rescuing private banks. After all, how could one let a technical hitch like the zero lower bound on nominal interest rates stand in the way of rescuing Main Street when innovative financing facilities had been used to save Wall Street? Once central bankers undertook the necessary rescue of banks, perhaps they became irremediably entangled in politics, which made quantitative easing an inevitable outcome.

As with much concerning recent unconventional monetary policies, there is a lot about which we can only guess, including why it has happened. The bottom line is that if there is one myth that recent developments have exploded it is probably the one that sees central bankers as technocrats, hovering independently over the politics and ideologies of their time. Their feet, too, have touched the ground.

The views expressed here are the author’s own.

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    1. CommentedParrain Boursorama

      Inflation does not come from too much money. It comes from too much money chasing too few goods and services. No chasing, no inflation.

    2. CommentedProcyon Mukherjee

      Some of the statistics of recent times seem to point to the morass. The first indication is that for every $500,000 of ‘ease’ there is only one job created per month. The second is that inter-bank lending which had to go through a lot of adjustment after the crisis, should have returned to normal, has not done so and is at historic low, which leads one to examine the argument that excess bank reserves parked in central banks by the commercial banks that earn an interest is perhaps a better bet than what it could have otherwise earned through inter-bank lending, such is the state.

      The M2 growing at 6% is no measure of income growth as the best that we see is a safe-estimate of 2% as the current potential, which is exactly the gap that goods and services have found the monetary transmission somewhat delude.

        CommentedJose araujo

        QE inefficiency was due to the change in risk perception and preference for liquidity. i.e. Liquidity Trap.

        Now QE was inefficient but nowhere cause what the bloody Austrians that troll the net claim. Hayek was wrong and been proved wrong time and time again.

        QE didn't cause inflation like was predicted by these guys, and nowhere hyperinflation which again proves the Austrians WRONG, the supposed Bubble in the markets most probably is the product of the imagination of people that don't have anything to lose, because there is no evidence of market exuberance

    3. CommentedJose araujo

      First, regarding the portfolio impacts of QE, Rajan is a finance professor so this should be simple for him. By issuing money and buying bonds, Central Banks are also replacing high yeld senior debt by low interest reserve deposits.

      Second, the amount of assets the Central Banks hold are virtual, in the sense that most of what they hold are tresury bonds, that they can simply burn.

      Third, QE didn't work because we are in a Liquidity Trap situation, and by the way only someone with a big imagination can say QE is innovative monetary policy.

      QE hasn't work, but does no harm also, think of it like lowering the interest burden, for a Finance guy like Rajan, with clear limitations on the understanding at Macro level, think like this is a share issue to replace outstanding debt on a moment when the required return on equity is much lower then the interest rates you are paying.

    4. Commentedcaptainjohann Samuhanand

      But for Indian Central bank's strict Monetary poicy, the Indian politicians who are most indebeted to the world Bank IMF theories would have taken the country much more down hill than it is today. the weakening of Indian rupee is soleley due to Foreigners taking out their money from Indian bond market

    5. CommentedFrank O'Callaghan

      QE has been "Keynesianism for the rich". Huge amounts of money were made available at no interest for those who already had huge amounts of money. Meanwhile in the austerity countries the resources of the rest have been attacked. The rich had no need of this and the rest could not afford the debt.

      Keynesianism will work very well if we transfer wealth from the rich to the rest. It is not the work of central bankers but of tax and other policy instruments.

        CommentedJose araujo

        Why this idea. The rich were also the ones holding the Debt the federal reserve purchased, no effects here on the wealth of the rich.

    6. Portrait of Michael Heller

      CommentedMichael Heller

      A prime (bipartisan) example of central bank error in the lead up to crisis was -- I quote new book by Justin Lin -- “Loose monetary policy introduced in 2001 in response to the bursting of the dotcom bubble, magnified by financial deregulation and innovations in financial instruments, resulted in a boom in the US housing market.”

        CommentedJose araujo

        Sorry, but that is just not empirical verifiable and possible a big lie.

        First the looser monetary policy in the 2000 didn't impact much on mortgage rates.

        Second the housing bubble was not due to low interest rates but to FRAUD from the financial system

        Third, low interest rates don't cause bubbles, those can exist both in low and high interest rates periods

        Fourth, we shouldn't even discuss this theory, the ACB, and Hayek has been proved wrong time and time and time again.

    7. Portrait of Michael Heller

      CommentedMichael Heller

      I like this article a lot, especially the inference relating to whether a policy position matches the capability in terms institutions and expertise. Time and time again left wing economists like Joe Stiglitz forget or ignore the fact that economic activism (whether in industrial or monetary policy) requires levels of administrative impersonality, knowledge, and efficiency that developing countries - by definition - do not posses (though with its superb economists India probably has unusually good access to the knowledge).

      Therefore an ideologically attractive second- or third-best activist policy -- industrial or monetary, discretionary or general -- which might work for a limited period when carried out by a really ‘self-disciplined’ authoritarian polity (e.g. Korea or Taiwan in the 70s and 80s) is destined to quickly fail in most developing countries (classic example being Latin America).

      Despite the swings of Suharto’s nationalist-neoliberal policy pendulum, and the lamentable gradual descent into chronic cronyism and rent-seeking, in the view of most economists who studied Southeast Asia in the 1980s and 1990s Indonesia did remarkably well for several decades (particularly in reducing poverty) by largely keeping step with much of the orthodox and conditionality-conditioned advice given by multilateral organisations.

      The international economists did not feel much discomfort personally, of course, but you will know they were over there conscientiously integrated in the Jakarta offices working amicably face-to-face with the local technocrats. Anyway, if policy is consistently improving the situation, then ‘pain’ is an inappropriate concept. ‘Pain’ is a concept applicable to the nasty sensation of populations in societies which experienced debt- and subsidy-fueled premature or artificially-prolonged prosperity, followed by bankruptcy-nemesis (e.g. Greece and Argentina).

      I also enjoyed the fascinating insight here into the possibly humdrum human/corporate motivations driving the behaviour of central bankers. Whatever the reason for their actions, it did not take long to dispel the illusion that central bankers could be detached from politics and ideology. A lot of their credibility originates in the great job they did taming inflation. But they made a fateful error or two in the run up to the 2008 crisis. Then the reckless ‘Do Something Now’ mentality of Keynesians infected their reactions to the crisis. Some must also have persuaded themselves that central banking is structurally unique in its capacity to overcome normal economic constraints by massively engineering the money function.

      So, great article!

    8. CommentedAdam Harper

      Brilliant piece. Unfortunately, their feet are going to be even more firmly planted "on the ground," at least in the US.
      Bernanke will be gone next year because Obama doesn't think his policy has been easy enough.


      Our President isn't about to let the needle be taken away on his watch, no sir!. Bernanke will be cut loose in favor of Bernanke-squared and the addictions of Wall Street and the Federal government will only worsen.