Crazy aunt on the loose

Central banks

For central bankers in the rich world, unconventional is the new conventional

WASHINGTON, DC

THERE was a time when the Federal Reserve wouldn’t say whether it had changed interest rates. Soon it will say where it thinks rates will be years from now. Beginning with its policy meeting on January 24th-25th, Fed officials will disclose when they expect to start raising their short-term interest-rate target, which is at near-zero now, and what they expect its path to be over the coming years. Behind such radical transparency is a grim fact: at the start of a fourth successive year of extraordinarily low short-term rates and a still-moribund economy, the Fed is desperate for new ways to stimulate demand.

It is not alone. Of the rich world’s four major central banks, Britain’s and Japan’s already have their policy rates stuck near zero and the fourth, the European Central Bank (ECB), is likely to get there this year. Meanwhile, the balance-sheets of all four institutions have ballooned as they expand the volume and range of assets and loans they hold (see charts).
Central banks have never been comfortable with unconventional monetary policies such as verbal interest-rate commitments and quantitative easing (QE), the purchase of assets by printing money. Alan Blinder, a Princeton economist and former Fed official, has likened them to a family that lets its crazy aunt out of the closet only on special occasions. QE is “best kept in the locker marked ‘For Emergency Use Only’”, is how Charlie Bean, the Bank of England’s deputy governor, put it in 2010.
The unconventional, however, is now conventional. In a presentation to this year’s annual meeting of the American Economic Association, Mr Blinder will argue that the circumstances—low inflation and low nominal interest rates, persistent excess capacity, and fiscal policy paralysed by large debts—that have forced central banks to operate through unconventional policy will be a recurring feature of the economic landscape. “We can’t stuff the crazy aunt back in the closet,” he says.
How long could she stay out? In Japan, interest rates have been near zero almost continuously since 1999. Since then the Bank of Japan has bought government and corporate bonds, commercial paper, exchange-traded funds and real-estate investment trusts. Last year it offered targeted loans to spur long-term investment and rebuild areas damaged by the earthquake and tsunami. Such measures have prevented a deeper recession but not deflation or stagnant employment.
That outcome is not yet likely in Western countries. But 2012 will nonetheless require more unconventional policy. The Fed’s decision to include interest rates in its quarterly projections of key economic indicators, announced this week, emulates central banks in New Zealand, Norway and Sweden. But whereas this trio sought transparency for its own sake, the Fed’s main motivation is practical. It has been saying since August that it would hold rates near zero at least until mid-2013. Its new projections should persuade investors to expect no tightening before 2014, thereby nudging down long-term rates.
Whether the stimulative impact will be sufficient is another matter. In November Fed officials thought the economy would grow between 2.5% and 2.9% in 2012. The private sector projects growth of just 2%. The Fed may yet be proven right, given the upbeat tone of recent data. But if it is not, it will probably launch another round of QE, on top of its two previous rounds and “Operation Twist,” under which it swapped short-term for long-term bonds.
A similar sort of dynamic is at work in Britain, where the Bank of England’s most recent forecast was for growth of 1.2% in 2012. As in America, private-sector forecasts are gloomier as recession in Europe and austerity at home bite. The bank is likely soon to resume QE.
Most eyes are on the ECB. It has bought government bonds reluctantly and lent to banks enthusiastically, and portrayed both actions as ways of restoring liquidity to the financial system so that monetary policy can work, not as monetary policy itself. Yet now that it is lending huge sums to euro-zone banks for up to three years, this distinction is becoming meaningless. The idea is for banks to use this money to buy peripheral government debt; to lend more to households and business; or to reduce the amount of debt that they must refinance. In all instances that would raise the price and lower the yields on government or private debt, which is how QE is supposed to work. Asked recently if the ECB was conducting QE, Mario Draghi, the bank’s president, sidestepped the question: “Each jurisdiction has not only its own rules, but also its own vocabulary.”
The ECB could yet explicitly embrace QE if it saw inflation falling short of its goal of just below 2%. Elga Bartsch of Morgan Stanley thinks that could happen this year. The ECB already expects inflation of only 1.5% in 2013 and that number could drop as the bank brings its growth projections into line with the gloomier private consensus. Ms Bartsch thinks the ECB will cut its policy rate to 0.5% from 1% now in the first half of the year, about as low as it can go for technical reasons. Asset purchases would be the next logical step.
The question is: which assets? Mr Blinder notes QE can work by narrowing the spread between long-term and short-term rates or between private and government rates. The first is best conducted by purchasing government debt, the second by purchasing private debt. The Bank of England has stuck firmly to the first route, leaving it to the Treasury to extend credit to the private sector. The Fed has done a bit of both by purchasing federally-backed mortgage bonds as well as Treasuries, but avoided purchases of private assets because of legal and political constraints.
The ECB is in the opposite position to the Fed: circumscribed in its ability to fund governments but at liberty to buy private debt. Although expanded purchases of peripheral government bonds would be more effective, Ms Bartsch therefore reckons the bank is likely first to conduct QE through expanded purchases of private debt such as bank and corporate bonds (assuming its three-year loans to banks prove ineffective at expanding credit). It could also purchase bonds of all euro-zone governments, in the process relieving pressure on struggling peripheral sovereigns.
Whatever central bankers do, they cannot repair problems best fixed by politicians, such as America’s incoherent fiscal policy or Europe’s fractured institutions. Asked about the ECB’s aggressive new lending to banks, Masaaki Shirakawa, the governor of the Bank of Japan, said it could “buy time”. But he warned it could backfire if politicians fritter away whatever time the central bank has bought. Unfortunately, that risk is never low.