The Fourth Generation of Central Banking

Article in Euromoney

September 1, 2004



Central bankers have been the financial market heroes of the past two decades,
for asserting independence from profligate politicians, conquering inflation and resolving financial crises not of their own making. But they have managed themselves out of a job. And what lies ahead for the next generation is frustration and loss of influence.

THE 1990s WERE a golden age for central bankers, if not for central banking. The vast majority of central banks gained independence to set monetary policy, and in some cases the goals of monetary policy, free from political control. The priority of maintaining price stability attracted widespread support and the disinflation of the 1980s was largely consolidated.

With a nearly global movement towards efforts at fiscal consolidation, monetary policy became the primary instrument of economic stabilization. As increasing numbers of currencies floated, albeit often in managed fashion, room for the exercise of discretionary monetary policy increased. Central banks like the Bank of England, once deemed servants of inflationary politicians, became seen as bedrocks of stability-even the Banque de France became known as a Franc Fort.

Between the 1987 US stock market crash and the 1997-98 Asian financial crisis, Alan Greenspan went from being the new kid on the central banking block to the chairman not only of the Federal Reserve, but of the Committee to Save the World.

This era of good feelings towards central bankers could not last indefinitely, and it is now coming to a close.

We stand at the beginning of a new era of lower expectations for central banking and lesser impact from it, though central bankers will remain primus inter pares among economic policymakers.

Greater politicization

It is worthwhile to review what challenges central banks have faced in the past, and how they have responded to them. Starting with the birth of modern monetary policy at the end of the Bretton Woods fixed exchange rate system, I would identify four generations of central banking, defined by their primary economic motive forces:

First generation - stagflation 1970-79

Second generation - disinflation 1979-87

Third generation - financial liberalization 1987-99

Fourth generation - globalized production 1999-?

The fourth generation we are now entering will be characterized by greater politicization and a less predictable impact of monetary policy, with the economy driven by disputes over the international integration of what economists call the real economies.

The first three generations

The breakdown of the Bretton Woods fixed-exchange rate system, which freed major central banks to set monetary policy, was followed in short-order by the first oil shock, and by the still unexplained sharp drop in productivity growth in most of the industrial nations.

The stagflation that emerged defined the first generation of central banking, through the second oil shock of 1979.

The central bankers' target to watch was the nominal short-term interest rate, the canonical central banking instrument, and whether it was adjusting to inflation.

The key policy question for central bankers, and for macroeconomists more generally, was where does stagflation, the combination of rising inflation and unemployment, come from?

The link to exchange rates from monetary policy was one of relative credibility - those countries (Germany, Japan, Switzerland) that maintained relatively low inflation rates as a result of more aggressively counter-inflationary policies had more solid currencies. The difficulty for central bankers in most other countries (including the US and the UK) was that their politically mandated, and to some degree considered achievable, policy goal was the maintenance of full employment.

The market response to the divergence of monetary policy between central banks and of policy challenge and goal was distrust and distortion. The feeling of confusion for much of the time on the part of all intellectually honest central bankers fed that distrust.

The second generation of central banking was intellectually much clearer. With the emergence of price and expectation driven inflation by the end of the 1970s, most central banks converged in their commitment to disinflation.

The target to watch shifted to the slope of the yield curve, capturing the degree of monetary tightening and the effect on long-run inflation expectations. The key policy question became the functional one, does money (ie, the growth rate of monetary aggregates) matter? While appeal to monetary aggregates proved politically useful in the hands of such masters as Paul Volcker, they turned out to be unimportant economically.

Exchange rates tended to follow budget trends, driven by the fiscal-monetary policy mix, as seen in the run-up of the dollar in the mid-1980s. With a clear monetary policy goal of getting inflation down, market response was one of initial disbelief, and then catch-up with reality as central banks saw disinflation through with varying speed. With clarity, central bankers were defined by their determination.

The success of the disinflationary effort brought the second generation to a rapid end. The forces of financial adaptation set in motion by 15 years of inflation, and the obvious failures of partial deregulation (as amply demonstrated by the US savings and loan crisis), led to a wave of financial liberalization that defined the third generation of central banking.

From 1987 until the resolution of the Asian and Russian financial crises of 1997-98, the target to watch was productivity growth - because perceptions of productivity from Bangkok and Buenos Aires to Silicon Valley and Tokyo motivated waves of expansion and contraction in investment.

The central concomitant question for monetary policymakers was determining actual potential output in their economies.

Exchange rates were driven in turn by these investment flows, with increasing volatility as a result. The policy goal of central bankers became avoiding and, where necessary, resolving financial crises.

Arguably, the taking for granted of the primacy and attainment of price stability led to a more reactive stance by central bankers, waiting for crises to emerge before responding with interest rates. As long as the financial crises could be blamed on poor policy, or even better on structural failures outside central banks' control, the market response was deification of the Greenspans, Tietmeyers, Fragas, and the like. The central bankers themselves felt a deep sense of satisfaction with success over what they arguably could control (inflation) and no scapegoating for what they apparently could not (absence of structural reform).

The fourth generation

Moving into the fourth generation of central banking, satisfaction both of and about central bankers is in decline.

Already by 1998, with the response to the Asian financial crisis, the Russian GKO default, and the collapse of Long-Term Capital Management, it was clear that achievement of essential price stability alone was insufficient to establish economic stability - and that even central bankers perceived to be powerful were unable to constrain the sometimes destabiliz-ing behaviour of politicians, financiers, and the occasional combination of the two.

The 1999-2002 debate over whether monetary policy could be effective in ending deflation in Japan, and the frightening brushes with deflation risk in the US and Germany that followed, further emphasized the limits of central banks' power.

The weak, export-dependent, recovery of 2003-04 in the eurozone also displayed the extremely modest direct benefits of European monetary unification for the member states' real economies. A similar story could be told about the failure of the Argentine currency board, or the deflation-encouraging policies of the Bank of Japan under governor Masaru Hayami, to induce structural change or faster growth.

The shortfall of central bankers' ability to affect economic outcomes from their previously perceived control is perhaps most evident in the long misalignments of G3 exchange rates.

In terms of the six key challenges common to all central banking, the outlook for the fourth generation is only partly clear. The first three are determined by structural developments, and trends are clearly discernible; the remaining three are more open in outcome and more troubling.

First, what is the target for central banks and markets to watch?

Inflation variability has diminished, and long-term interest rates are more responsive to events and policy moves than in prior generations of central banking. Monetary aggregates have been correctly abandoned as major sources of guidance. The productivity growth shifts that characterized the 1990s appear to have stabilized. Thus, the policy variable of greatest uncertainty and impact today is fiscal receipts of the national governments.

Since the only source for sustained inflation today would be fiscal dominance-that is, the Argentina-esque expansion of government outlays irrespective of monetary tightening or taxation limits - that overwhelms the central bank, the gap between public income and expenditure is a key determinant of short-term economic performance and monetary policy response.

The key policy question

Unfortunately, given both the dependence of tax authorities on revenue from capital gains and the political uncertainties about various forms of capital taxation, this variable is likely to become increasingly volatile. It is also by definition outside the realm of central bank control.

Second, will central banks be able to move growing financial markets with their limited policy instruments?

This is the key policy question of the fourth generation. It is well-known that government debt and foreign exchange markets have grown by orders of magnitude in recent years, far more quickly than the real economy or even world trade. As the Harvard economist Benjamin Friedman points out, we are already in a world in which the ability of central banks to affect interest rates is based on open market operations of vanishingly trivial size compared with daily private transactions. And the share of credit and investment directly responsive to the transmission of those interest rate movements through the banking system grows even smaller in turn.

International economists have made similar observations about the scale of foreign exchange interventions as compared to that of forex markets. Continuing financial innovation will erode both the predictability and magnitude of the impact of central banks' policy measures.

Third, what will drive exchange rate movements?

Following logically on the crucial importance of fiscal receipts to the business cycle and to monetary policymaking, the trends in exchange rates will increasingly be affected by demo-graphics and political developments. Demographic shifts, noticeably aging of populations in some of the wealthiest economies such as Germany and Japan, are accelerating and beginning to determine capital flows and returns.

Political decisions affecting which leading industries will thrive where and how capital is taxed are also playing larger roles in investment decision-making, given integrated capital markets. Both of these drivers are beyond the capacity of central banks to influence in a sustained manner.

Turning to the three more open questions, the focus remains on factors external to central banks' own control, but those whose development is less predictable.

Fourth, what will be the next major policy challenge for central banks?

The attempts to maintain full employment of the first generation of central banking, the reduction of inflation of the second generation, and the resolution of financial crises in the third all gave central banks the chance to prove themselves (or not) by their performance. In the fourth generation, however, the focus of monetary policy goals is likely to shift to the accountability of the central banks themselves.

If central banks define ever more narrowly what they are responsible for (price stability), if what they can and do deliver does not satisfy political demands for economic performance, and if the forces limiting that performance are those that the central bank can only address by intervention in public debate (be that the Fed on US fiscal policy, the Bundesbank on German labour market reform, or the Bank of Japan on corporate restructuring), central banks will likely find maintaining their autonomy to be their major policy challenge.

This has already begun to occur. When the majority of the large eurozone economies fell foul of the Stability and Growth Pact in the past two years, and found neither help from the ECB forthcoming nor the obvious growth benefits from European monetary unification that had been foretold, to alleviate their situation, their politicians understandably began to question the mandate of the ECB.

Fifth, what will be the market response to these fourth generation developments?

The overwhelming response will be disengagement of the market decision-makers from monetary policy.

Of course, there always will be bond and FX traders making money off individual central
bank announcements, and therefore following them with great interest.

Overall, however, central bank decision-making will have less and less to do with market movements. As noted above, the sheer scale of market transactions is far outstripping central bank interventions, making the interventions at a minimum less predictable if not indeterminate in effect; more and more investment decisions are made on the basis of longer-term real factors (like demographics and productivity growth) as well as of political decisions (like tax policy) rather than monetary policy; and the significance of monetary policy has become in a sense a victim of its global success in establishing price stability, now that policy structures and outcomes have converged, at least in the major economies.

So, sixth, the overwhelming feeling for central bankers in the fourth generation will be frustration.

Frustration that their instruments will not be as effective as they once were, that their success in maintaining price stability will not translate into influence on other policy issues, that their contributions to debate over these non-monetary issues will likely be responded to with political scrutiny on central bank autonomy, and that the deification they enjoyed during the third generation of central banking will be replaced by being taken for granted if not disregarded.

Implications for exchange rates

The shortfall of central bankers' ability to affect economic outcomes from their perceived control is perhaps most evident in the movement of exchange rates.

It is well known that econometric studies of short-term to medium-term (out to three years) exchange rate movements demonstrate that a random-walk beats all theoretically grounded forecast models. What is insufficiently appreciated is what that failure of prediction indicates about our lack of understanding.

Ultimately, inflation and productivity differentials between countries should determine exchange rate trends, and monetary policy should determine inflation levels. Yet, we cannot say with any precision when these underlying factors will dominate over temporary shocks.

We cannot even say consistently how a currency will respond to a conflict between mon-etary and fiscal policy: a loose fiscal policy countered by monetary tightening seems to drive up interest rates and then the value of the currency (eg, Volcker-Reagan policy mix) yet a fiscal consolidation balanced by relative monetary ease seems to drive down interest rates, and then increases the value of the currency, too (eg, Greenspan-Clinton policy mix).

The rise in the volatility of major exchange rates is even more intellectually troubling. Milton Friedman and other monetarists believed that monetary activism was the source of ex-change rate instability. So greater commitment to price stability by central banks should have been stabilizing. Yet while that commitment has undeniably deepened and strength-ened, exchange rates have become more volatile.

Rudiger Dornbusch and his followers believed the faster response of financial markets to shocks than the real economy (eg, labour contracts) was the cause of exchange rate overshooting. So the liberalization, deregulation, and increases in flexibility that have occurred in the past 20 years should have been stabilizing, but, as noted, exchange rates have become more volatile. And no-one can explain well why the real costs to businesses and the economy of the increase in exchange rate volatility appear to be minimal (hedging remains too expensive and limited in use to fully explain this outcome).

In short, at present central banks are not consistently affecting, let alone driving, exchange rate movements.

Thus, to forecast the implications for foreign exchange markets of the fourth generation of central banking, two questions require answers. First, say five years from today, will the major central banks' policies be more or less important to exchange rates? They will likely be less important than today, perhaps far less important.

Central banks' information advantage over markets will continue to decline-while central banks' teams of economists tend to remain better forecasters of their domestic economies' performance than their private-sector counterparts, as the source of fluctuation in the economies shifts to the real economy and fiscal politics, that gap will shrink.

As central banks become more transparent, to promote stability and meet demands for accountability, their private information advantage about their own preferences and monetary policy moves will shrink as well. This equalization of information will remove the one alterna-tive source of leverage central banks have over markets and the economy, just as the direct impact of their market interventions shrinks.

Meanwhile, the policy challenge of defining a role for central banks in foreign exchange markets will become even greater, when for the major economies neither foreign exchange rates nor their stability will be a declared priority, nor could it credibly become one given the focus on domestic price stability.

If anything, current trends in both financial markets and the real economy-including the globalization of production that characterizes the fourth generation of central banking-will continue to weaken the link between exchange rates and domestic policy goals, making it all the more difficult to justify taking exchange rates into account in monetary policymaking.

So, five years from today, will exchange rate intervention by major central banks be more or less common than today? Clearly, it will be less common. First and foremost, the major central banks consider exchange rate intervention to be largely ineffective, especially when undertaken unilaterally.

The seeming successes of Chinese and Japanese exchange rate intervention resisting appreciation against the dollar in 2003 and early 2004 is more apparent than real, and is ultimately a political accident that will soon come to an end. In China's case, it is only the combination of draconian measures to resist capital outflows and the willingness to suffer a significant domestic credit market overheating that maintain the yuan peg - these are not sustainable.

In Japan's case, the massive scale of the interventions undertaken was only politically possible in the shadow of China's resistance to revaluation, and even then it is unclear that interventions delivered value (in terms of economic impact) for the money spent (in excess of 6% of GDP on US treasuries likely to decline in value). Meanwhile, coordinated intervention among the major central banks, like that undertaken to help the euro find a bottom against the dollar in 2000, will be all the more effective the more coordinated and rare it is, which should make such coordination rarer still.

Finally, since exchange rate policy remains in the purview of finance ministries controlled by elected officials, rather than in that of central banks-and as noted above central banks will be under increasing political pressure during the current fourth generation-this is likely to make central bank resistance to finance ministry initiatives on exchange rates even more likely.

A version of this argument was presented as the opening keynote speech at the Fourth Annual Euromoney Foreign Exchange Conference, May 19, 2004, in London.