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Central banks should embrace their new powers

On Wednesday I encouraged central bankers to suppress their urge for “normalisation” in monetary policy. It is better for all if they are reconciled to abnormal economic conditions that look set to stay. But that advice goes further than short- to medium-term monetary policy decisions. The way in which the world has changed since the global financial crisis also offers an occasion to consider deep reforms that would improve the way the monetary and financial systems function. That’s an opportunity to be grasped with both hands.

The area of reform linked most closely to monetary policymaking is the debate on what policymakers should target when they set interest rates. We have previously written on the call for the Federal Reserve to raise its targeted inflation rate, and pointed out that a better reform may be to target the price level (or the level of the economy’s nominal value). This has the merit of requiring central banks to make up for past under- (or over-) shoots of inflation. In today’s context, consider that the persistent below-target inflation rates in most economies since the crisis mean that debt burdens are bigger in real terms than lenders or borrowers expected when they agreed their transaction. That unintended redistribution cannot have helped the recovery. Sticking to normal — simply retaining existing inflation targets — misses an opportunity to consider a switch to a target that encourages better policy.

Beyond that, there is the question of what to do with the new tools central banks have deployed since the crisis, in particular the purchase of large amounts of financial securities with central bank money (quantitative easing). Normalisation here would be to aim ultimately to wind down these assets and return to the negligible central bank balance sheets of the pre-crisis past, simply using interest rate-setting to make policy. That, too, would miss an opportunity to manage credit conditions better. Ricardo Reis’s paper at last year’s Jackson Hole conference is one important contribution to thinking about how large asset holdings could be retained and used for policy purposes in the future.

Another is suggested by Hélène Rey’s lecture that we mentioned on Wednesday. She demonstrates that in a world of open borders for financial flows, domestic interest rates lose power to influence credit conditions (regardless of the exchange rate regime). Quantities of credit as well as prices are important in their own right; which means there is an important role for central banks to influence directly the quantity or size of financial flows — in particular in the provision of safe assets for which demand fluctuates.

And this line of reasoning goes further. As Reis’s analysis shows, the liabilities central banks create (central bank reserves) are at least as significant as the assets they buy with them in terms in shaping market and macroeconomic conditions. So central banks would be wise to explore how to use their liabilities as a policy tool. The most interesting thinking on this is around making deposits at the central bank available to more users in the economy. The logical limit is official ecash available to all as, an alternative to deposits with private banks. John Barrdear and Michael Kumhof at the Bank of England are among those who have explored the macroeconomic consequences of central bank digital currency and found that it could substantially improve an economy’s performance.

For policy purposes, the debate around central bank ecash remains esoteric. (Free Lunch has advocated it strongly, most recently by way of commending the Swedish central bank for exploring the idea.) But since the crisis, so much has been up in the air that this could easily change. Tony Yates points out — presciently, we may find out — that the game will be up as soon as the question is asked: “If banks can have deposit accounts with the central bank, why shouldn’t everyone be allowed to?” There is no good answer to that question, so if there were a push for an official digital currency it would be hard to resist. Central banks would be wise to be ahead of the curve.

To their credit, many central banks are thinking hard about all these questions. But there is a palpable yearning for normalisation also in an intellectual sense: a sort of nostalgia for the days of the “great moderation” when monetary policy seemed relatively straightforward and the problem of business cycle stabilisation was considered to have been solved. It never was, of course, which is one reason why the nostalgia is misplaced. The most robust attitude in the face of economic abnormality is not to wish it away, but to master it. That is the only way to normalise what we should learn to love as the new abnormal.

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