After Bernanke, Make Unconventional Policy the Norm
Op-ed in the Financial Times
© Financial Times
Discussion of Ben Bernanke's possible successor has focused on who could best manage the US Federal Reserve's eventual exit from its multiyear monetary expansion. While President Barack Obama should take that into account, what he should really be looking for in the next chairman is someone who can institutionalize a new policy approach at the central bank and get congressional agreement for doing so.
Like it or not, when Bernanke steps down in January, his replacement will have to make unconventional monetary policy conventional, and establish a viable oversight framework for doing so.
The great lesson of the financial crisis for monetary policy is that there is no one interest rate that determines or even represents credit conditions in the modern economy. For the past 30 years, both monetary economics and policymaking have made the comforting assumption that movements in the central bank's main policy interest rate would affect the whole economy in a predictable way. This allowed academic and market analysts to try to explain central bank behavior in terms of simple rules.
More important, it allowed central bankers to maintain the fiction that—because decisions were cast in terms of a public sector interest rate, and the whole economy rather than specific sectors—their policies did not have different impacts on different groups, such as bondholders and the unemployed. Combined with the lucky outcomes of the Great Moderation—that quarter-century of reasonable growth and low inflation starting in 1984—this gave the illusion of relatively precise control of inflation and growth outcomes through monetary policy.
Recent events show the more complex reality of how monetary policy is transmitted to the whole economy, as opposed to just bond markets. In the euro area, low interest rates and commitments to government bond market intervention are failing to improve credit conditions for small and medium-sized businesses across southern Europe. In China, Hong Kong, and Turkey, attempts to constrain property lending booms have required targeted measures as well as rate rises. In the United States, the Fed's purchases of mortgage-backed securities have done more to promote a housing-led recovery than buying long-dated Treasuries could ever have done.
At the same time, increased market volatility has been attributed successively to the Bank of Japan, the Fed and the People's Bank of China. This reveals the coarseness of central bank control of economic outcomes, or even the direct effects of monetary policy. If you want to start raising inflation expectations, as is necessary in Japan, you have to accept volatility at the short end of the yield curve. If you want to cut off property speculation, as is necessary in China, you have to accept that doing so requires disrupting cozy lending relationships.
If America's rate-setting Federal Open Market Committee (FOMC) wants to use its main rate instrument to prevent bubbles—and therefore take into account factors beyond inflation and unemployment, which is all it is mandated to do—it has to accept there will be tighter monetary conditions more generally. These limitations and trade-offs are not a temporary result of quantitative easing; they are the economic reality, and will persist. Even though they are motivated by the benefits to the overall economy, these policy decisions do affect different economic interests in society differentially, as monetary policy has always done—though not so visibly.
So perhaps the new Fed chief's main challenge will be to design and institutionalize a set of tools for more targeted interventions in public and private credit markets.
This will be intellectually and operationally difficult, as it is for all central banks. We know the need for such tools but do not yet know what works. For the Fed, the additional challenge is that Congress has been busy limiting its powers since the crisis began, particularly regarding which assets the bank may purchase. It is sheer luck that purchases of mortgage-backed securities were still allowed and happened to be the right thing to buy to deal with the mortgage crisis. If the next crisis comes in money market mutual funds or local banks' capital, the US economy may not be so fortunate.
Public debate has also been allowed for too long to stigmatize "unconventional" monetary policy, and wax nostalgic for the days of a simpler Fed mission. The Fed has, perhaps understandably, let this happen for fear of provoking further political interference. But such defensiveness and self-limitation is based on a mischaracterization of the past and creates a dangerous vulnerability for the US economy.
For centuries, central banks bought and sold private sector assets. Even when they did so less, in the past couple of decades, their monetary policies had distributive effects. The next Fed chair has to confront this reality rather than run from it, and win powers that other central banks rightly exercise today.