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Policy learnings and limits



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(credit photo: NN Investment Partners)

To say that central bankers have gone from “heroes to zeroes” may be a bit strong, but the aura of inviolability they once enjoyed is definitely a thing of the past. Before 2008 central banks were the undisputed champions of the Great Moderation.

They had anchored inflation expectations firmly to their inflation targets and this gave them ample room to reduce the volatility of the business cycle. Because financial markets love a high-return, low-risk world, it was no surprise that they became the biggest cheerleaders for central banks. The fact that Alan Greenspan managed to nip the danger of a financial meltdown in the bud more than once only added to their enthusiasm. When the world was on the brink of financial collapse in 2008, central bankers once again managed to avert disaster.

However, they could not prevent painfully slow recoveries in developed markets, or several periods in which divergence between developed and emerging markets triggered a global soft patch. What’s more, to achieve these meagre results, central banks had to venture far into unconventional territory by pushing short-term rates below zero, flattening money market curves and suppressing term premiums. This led some pundits to ask whether this increased the risk of misallocation in financial markets and other adverse side effects.

At the most elementary level all these accusations can be brought back to two simple issues: either too much is expected from monetary policy, or it has become overburdened because other policymakers have not lived up to their responsibilities. The requirement that monetary policy pursues financial stability next to price stability is an example of the former.

In the end, the job of monetary policy is to deliver a stable predictable growth path for nominal GDP which can serve as a benchmark for private sector decisions. Under the assumption that monetary policy cannot systematically affect the real economy (which might not be entirely beyond dispute) this boils down to delivering stable, on-target inflation. Because financial assets are a claim on future nominal income (or GDP), this is also the best way for monetary policy to promote financial stability. Any further effort to prevent asset price bubbles may backfire because it can push the underlying nominal GDP path permanently lower and/or make it more volatile. Therefore, to achieve financial stability we need an additional instrument in the form of macro-prudential policies.

Over the past 10 years monetary policy has clearly become overburdened in the US and in Euroland. Fiscal policy can, to a considerable extent, be blamed in both cases.

It is often argued that these policies created negative side effects in the form of an excessive search for yield and a decrease in the profitability of financial and pension funds.

Over the past years fiscal policy has once again made the Fed’s job a lot more difficult by giving the US economy a big boost while it was already in overheating territory. Trump’s protectionist policies added insult to this fiscal injury. For most of last year this mix forced the Fed to be more hawkish than it would have been otherwise as the US economy grew well above potential while financial conditions were easing. Still, the mix of higher dollar funding costs and protectionism proved to be a severe headwind for EM space and thus global trade. Late last year this triggered a severe increase in risk aversion in financial markets. When the chickens of this inconsistent policy mix came home to roost in the US, President Trump chose to blame the Fed for the turmoil, which of course only made it worse.

In Euroland, the ECB also had to contend with a far too tight fiscal policy stance for years on end. In addition to that, it was confronted with the incompleteness of fiscal and banking union institutions.

What’s more, if the ECB had not acted, the Eurozone might well have broken up, in which case we could have seen a much nastier side of populism. Still, this does not take away the fact that it would be highly desirable if other policymakers in the Eurozone would start to live up to their responsibilities. This applies in particular to the need to provide a solid institutional roof for the monetary union and to continue with structural reforms to make the individual economies more flexible. Ideally, it should also apply to the need for an EMU-wide public investment program to promote infrastructure, innovation, education, green energies, etc.

Before 2008 many countries believed they had found the holy grail of macro policymaking by making central banks independent and putting them in charge of the management of the business cycle. The most important lesson we have learned in the past 10 years is that monetary policy does not operate in a vacuum. Its success depends very much on other policymakers taking up their responsibilities as well. As such more coordination between monetary, fiscal and structural policies remains desirable.

 

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