The monetary-policy maze
Apr 23rd 2009 | WASHINGTON, DC
From The Economist print edition
The simple rules by which central banks lived have crumbled. A messier, more political future awaits
... Central bankers still believe that once the crisis has passed they will return to their pre-2007 roles as apolitical technocrats pulling a single lever and eyeing a single variable. It may be a vain hope. “When you question the basic premise which you have worked under for the last 15 to 20 years, which is that markets are rational and efficient, there is a case for a different approach to both monetary policy and regulation,” says Thomas Mayer, chief European economist of Deutsche Bank.
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But withdrawal may be harder than it sounds. A study last year by IMF staff asked, “What will ‘normal’ look like?” It argued: “There is no expectation that markets will return to their pre-crisis mode of operation soon, if ever. Market spreads taking account of credit and liquidity risk had arguably become too compressed pre-August 2007, and are now wider than they should be long-term. But it is not clear what the appropriate level should be.”
After the Bank of Japan became the primary supplier of overnight funds to banks earlier this decade, the interbank market atrophied. It remains a fraction of its former size. European banks today are now heavily dependent on the Fed for dollars (supplied via swap lines with local central banks) and on the ECB for six-month euro funds.
A tepid recovery will make central banks reluctant to withdraw support from critical markets, especially if business or politicians protest. In 1942 the Fed agreed to hold down long-term interest rates to help the Treasury finance the war; it did not extract itself from the commitment until 1951. When the time comes to sell its large holdings of mortgage debt, it may face resistance from America’s housing lobby.
Central banks may not just have to rethink their tools. They may also have to rethink their goals. Governments and central banks had come to agree that they should focus only on achieving low and stable inflation. The Fed by law must emphasise employment and inflation equally, but in practice it, too, targets inflation. This consensus was forged in central banks’ research departments and universities, and its adoption paralleled a rise by academics to the top ranks of central banks: among the leading lights are not only Ben Bernanke, chairman of the Fed, and Mr King but also Lucas Papademos, vice-president of the ECB, and Lars Svensson, a deputy governor of Sweden’s Riksbank.
cont'd
http://www.economist.com/displayStory.cfm?story_id=13527329