Before the global financial crisis monetary policy seemed to be the only game in town. Central bank independence and transparency appeared to contribute to creating an environment of stable inflation and adequate economic growth. No wonder some central bankers, most notably Ben Bernanke, declared the era to be one of the ‘Great Moderation’.
Of course, events since 2008 have changed all that although it took some time for observers to realize that a fundamental shift was taking place. While major central banks around the world responded with ultra-low interest rates, many even hitting and remaining at the so-called ‘zero lower bound’, others also rushed to reduce their policy rates in order to prevent their currencies from appreciating too quickly. The policy did not always work as several policy makers, such as in Brazil, felt that a ‘currency war’ was at hand. Indeed, many emerging markets' economies were continuing to grow quickly while advanced industrials economies were mired in recession and slow growth.
Now that slower economic growth is spreading to some emerging markets economies the pressure on their currencies has begun to evaporate. Instead, beginning earlier this year, markets began to fret over whether and when the US Federal Reserve might abandon its aggressive program of quantitative easing. Yesterday’s announcement by the US Federal Reserve suggests that the era of ultra-low interest rates will likely persist for some time to come, perhaps even into 2016. And why not? For while the Fed has repeatedly asserted that the US economy is recovering slowly (too slowly of course for many), the elephant in the room continues to be a dysfunctional fiscal policy.
There is simply no chance that the US Congress will cease to play a game of chicken with the Obama Administration until the President’s term ends in January 2017 unless somehow the Congress reverts back to a Democratic majority in the mid-term elections next year. As a result, the threat of more budget cuts and votes to stop raising the debt limit ceiling that has marked US fiscal policy since 2009 will continue. The fact that the Fed apparently surprised markets by removing the threat of tapering suggests that the US central bank has given in to fiscal dominance. This implies an inability, other than through moral suasion, to persuade politicians that fiscal and monetary policy must work together. Clearly, this is not the case at the moment. The last financial crisis, which many central banks dealt with reasonably well, may well be followed by a looming debt crisis. The Eurozone and China also figure prominently in this scenario with debt problems of their own that are currently being kept out of the public eye.
Low interest rates and quantitative easing may well have helped to soften the blow of the last financial crisis but policies to deal with excessive sovereign debts and the cumulative distortionary effects of ultra-low interest rates may well require more unpleasant policies in future. It remains to be seen whether central banks can weather that storm since this will test their mandate of keeping inflation low and stable while conducting policy in an autonomous manner. As has happened in the past, fiscal dominance may well place central banks into the position of reluctantly following the demands of the fiscal authorities.
The most recent decision of the Fed also tests the effectiveness of central bank communication. As it happens, the Viessmann European Research Centre, with funding from a CIGI-INET grant, as well as a grant from the Laurier Centre for Economic Research and Policy Analysis, recently held a 2 day conference on the topic. The papers are available here.