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Central banks
Jan 7th 2012 | WASHINGTON, DC | from the print edition
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.
from the print edition | Finance and economics