The Post Lockdown Phase Also Applies to Central BanksAS HAS OCCURRED FOR MORE THAN A DECADE NOW, THE FED AND THE ECB WILL CONTINUE TO RESORT TO UNCONVENTIONAL MONETARY POLICY IN THE COMING MONTHS. AND CENTRAL BANK INDEPENDENCE WILL HAVE TO BE DEFENDED
by Donato Masciandaro, Intesa Sanpaolo chair in Economics of Financial Regulation, Universita' Bocconi
Translated by Alex Foti
The two most important central banks in the world, the Fed and the ECB, must also prepare for the Phase 2 of the pandemic. They have only one certainty: for months to come, monetary policy will have to be conducted by unconventional means. So what are the main points? In normal times - which date back to 2008 - there were at least four fixed points: the central bank must be independent; monetary stability must be a relevant target; policy instruments must be neutral, in the sense of minimizing the fiscal and banking effects of monetary policy; finally, the only instrument of monetary policy was changes in nominal short-term interest rates.
The discount-rate instrument maximized the neutrality of monetary policy, because it minimized its potential redistributional effects, which act through three possible channels, concerning redistribution between citizens, between sectors, and between generations, respectively. When nominal interest rates change, citizens can be divided into borrowers and savers, with the one group happy when the other is not. But for some time these two categories have cut across the traditional distinction between households and businesses, so that distributional effects have traditionally been scarcely felt. Furthermore, in normal times, with relatively small central banks' balance sheets, and assets mostly composed of short-term government bonds, the sectoral effects also seemed negligible. Finally, low inflation minimized intergenerational transfers.
From 2008 onward, the monetary policies of the Fed and the ECB have become unconventional in three different ways. First, short-term nominal interest rates have kept on decreasing, reaching zero in the United States and going into negative territory in the European Union. Secondly, the action of central banks to purchase financial assets to inject liquidity into the economy and also affect long-term interest rates has taken extraordinary proportions. The size of purchases has grown enormously, while the type of assets purchased has changed profoundly, to include public and private securities, with increasing risk for the lender of last resort. Finally, the central banks have adopted the policy of binding announcements, seeking to influence future interest rates, through the mechanism of expectations.
The automatic reflex of the massive adoption of unconventional policy tools has caused the exponential emergence of redistributional effects. The more redistribution effects increase, the more politics wants to - and must, we would add - deal with central banks. Since both the Fed and the ECB will continue to pursue heterodox policies, it is in the interest of American and European citizens that the effectiveness of monetary policy be protected by strengthening two other safeguards: central bank independence and consistency in monetary policy objectives.
The independence of the central bank is predicated on the assumption that having a stable currency is functional to the long-term welfare of citizens and such an aim can only be successfully pursued by entrusting the task to an independent bureaucracy. Thus the defense of the independence of central banks from politics and high finance must continue. Rather, the two central banks should reconsider the appropriateness of equating monetary stability with controlling variations in consumer prices. Such an identity is risky for a number of reasons, of which I should mention at least two. First, an objective is credible if it is attainable. If you think changes in consumer prices do not depend solely on monetary policy, then it would be more prudent to consider the inflation variable a compass rather than a target. Secondly, an objectively punctual and asymmetrical value can be more risky than definitions based on time intervals, or on the price level. Without changing the definition of monetary stability, the work of the Fed and ECB will become much more complex. The sword of Damocles will continue to hang over the heads of central bankers. Courageous decisions are needed. Let's hope it will be enough.