As the coronavirus pandemic recedes in the advanced economies, their central banks increasingly resemble the proverbial ass who, equally hungry and thirsty, succumbs to both hunger and thirst because it could not choose between hay and water.
Torn between inflationary jitters and fear of deflation, policymakers are taking a potentially costly wait-and-see approach. Only a progressive rethink of their tools and aims can help them play a socially useful post-pandemic role.
Central bankers once had a single policy lever: interest rates. Push down to revitalise a flagging economy; push up to rein in inflation (often at the expense of triggering a recession). Timing these moves, and deciding by how much to move the lever, was never easy, but at least there was only one move to make: push the lever up or down. Today, central bankers’ work is twice as complicated, because, since 2009, they have had two levers to manipulate.
Following the 2008 global financial crisis, a second lever became necessary, because the original one got jammed: Even though it had been pushed down as far as possible, driving interest rates to zero and often forcing them into negative territory, the economy continued to stagnate. Taking a page from the Bank of Japan, major central banks (led by the US Federal Reserve and the Bank of England) created a second lever, known as quantitative easing (QE). Pushing it up created money to purchase paper assets from commercial banks in the hope that the banks would inject the new money directly into the real economy. If inflation appeared, all they need do was push down on the lever and taper the asset purchases.
That was the theory. Now that inflation is in the air, central banks are nervous. Should they tighten policy?
If they don’t, they can expect the ignominy suffered by their 1970s predecessors, who allowed inflation to become embedded in the price-wage dynamic. But if they follow their instincts and shift their two levers, tapering QE and modestly raising interest rates, they run the risk of triggering two crises at once: A jobs bonfire, as increasing interest rates reduce aggregate demand and dampen investment, and a financial crash, as markets and corporations, addicted to free QE money and over-extended, panic at the prospect of withdrawal. The 2013 “taper tantrum,” which occurred after the Fed merely suggested that it would rein in QE, would pale in comparison.
Central banks are terrified of this scenario because it would render both their levers useless. Though interest rates would have risen, there would still be little room to reduce them. And politically prohibitive amounts of QE would be necessary to reflate submerged financial markets. So, policymakers sit on their hands, emulating the hapless ass who could not work out which of its two needs was weightier.
But, by presupposing that the two levers must be moved sequentially and in tandem, central banks’ conundrum assumes a past that need not be repeated. Historically, sure, the second lever, QE, was invented only after the first, interest rates, had stopped working. But why should we assume that with inflation rising again, the sequence must now be reversed by eliminating QE first and then raising interest rates? Why can’t the two levers be moved simultaneously and in the same direction, implying a two-prong monetary policy that hikes interest rates and QE (albeit a different form)?
Interest rates should indeed be raised. Lest we forget, even in times of zero official interest rates, the bottom 50 per cent of the income distribution are ineligible for cheap credit and end up borrowing at usurious rates via payday loans, credit cards, and unsecured private loans. It is only the rich that benefit from ultra-low interest rates. As for governments, while low official interest rates allow them to roll over their debt cheaply, their fiscal constraints seem impossible to loosen, so much so that public investment is constantly lacking. For these two reasons, 13 years of ultra-low interest rates have contributed to massive inequality.
Copyright: Project Syndicate, 2021
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