A while ago in internet time, John Cochrane wrote an interesting post called “Policy Penance” where he discusses how academia and central banks are interacting in 2014, at least in the US with the Federal Reserve and macroeconomists from different schools of thought.
The central thrust of the post is that central banks can’t just make speeches and guide expectations, on some level they have to follow rules because the moment they “break their own rules” they incur a credibility cost – it’s more expensive in terms of output or inflation trade-offs – to achieve their inflation target, output or unemployment rate goals.
Time consistency of monetary policy is hard in an environment where central banks are close to academia but not as close to finance as you’d expect. This means that a lot of actors in the markets the Federal Reserve plays in are still fumbling in the dark following the balance sheet expansion of QE and the subsequent, long-awaited and still misunderstood “taper” or reduction in Federal Reserve purchases of MBS, Treasuries and other bonds.
When you then look at the regulatory response to the global financial crisis, and how Dodd-Frank has changed the way that the desks with the largest notional exposure to interest rate sensitive derivatives do business, and how all of these factors are interacting in an environment where to many financial market actors it seems like the central bank is making it up as they go along then you aren’t making the system more stable – you’re making asset prices ever more closely entwined with market participants interpretations of central bank action than they ever have been in history.
If you look at long term interest rates – the US 10 Year at 2.11%, 10 year gilts at 1.83% and German 10 year bunds at 0.63% the conclusion is that market participants expect low interest rates and low inflation for quite some time to come. What academics aren’t getting their heads around fast enough is that in order for the goals of the central bank to be met, capital losses will be imposed on the bondholders.
Forcing interest rates higher is a complete reversal of the “protect the bondholders” mantra from the onset of the global financial crisis. When interest rates rise, bond prices fall. Total returns can still be positive if held to maturity but that’s not guaranteed with changes in how capital flows into and out of the bond markets. The massive expansion of central bank balance sheets has been accompanied by massive increase in outstanding bonds. The New Zealand government has been a major issuer through the crisis for example.
I think that looking at broader labour market indicators as a driver of central bank action is a devil’s bargain. A central bank is about price stability and financial stability, not labour market outcomes or terms of trade. It’s concerning how much attention Janet Yellen is giving to the legitimate issues in the US labour market – this is stuff Congress and the Department of Labour should be sorting out!
We know that a floating currency is essential for New Zealand’s easy access to global capital and far from adding more instruments or targets to the Reserve Bank’s mandate, or indeed any central bank’s mandate, ensuring the correct policy settings are there to achieve the outcomes people want is more important than using the central bank as some enabler of other policy goals far outside their core competency.