Central Bankers in a world of uncertainty
People in power have a job to do. They have to lead by example, dispelling the manifest uncertainties that infect all walks of life. It is the same with central bankers. Central bankers have to meet the objectives given to them by their political...
People in power have a job to do. They have to lead by example, dispelling the manifest uncertainties that infect all walks of life. It is the same with central bankers. Central bankers have to meet the objectives given to them by their political leaders and, these days, those objectives typically amount to the deliverance of price stability. What happens, though, if central bankers start to have doubts?
What if they question the wisdom of their inflation-targeting objective? What if they are no longer sure of how to hit their objective? Should they tell the wider world or, instead, should they keep their doubts under wraps, to be discussed with only their closest and most trusted colleagues?
Within the central banking community there appears to be some sort of uncertainty and this has been reflected in recent financial market developments. Of course, knowing that bond yields have spiked up says little about the underlying causes. Among the explanations doing the rounds have been Chinese foreign exchange reserve diversification and the greater-than-expected buoyancy of the global economy.
The really big worry, though, is the possibility that inflation has returned. If so, there are either going to be bigger price increases or it will be necessary to tolerate higher interest rates to prevent those price increases from coming through. Either way, central banks have got their work cut out.
Why should a suspected build-up of inflationary pressures lead to such uncertainty? This reflects three separate sources of central bank tension: Disagreement, dilution and doubt.
Imagine a world with a single central bank. There would be one objective - global price stability - and one instrument - the global short-term interest rate. Now switch back to the real world: Lots of central banks, all of which have their own separate concerns and views of how the world behaves. Disagreements become the norm.
Markets recently breathed a sign of relief because the monthly increase in the US consumer price index, excluding the volatile food and energy components, was only 0.1 per cent, pulling the annual rate down towards two per cent. From the US Federal Reserve's point of view, that is good news as it likes to focus on this "core" measure of inflation. Imagine, though, that the Bank of England was in charge of US monetary policy.
The Monetary Policy Committee would focus on the 0.7 per cent monthly increase in the headline consumer price index, which pushed the annual inflation rate up towards three per cent, and conclude that inflation was a bit too high. Who would be right? A lot depends on the degree to which central banks should take into account "global" inflationary pressures that lie outside their direct control.
Alternatively, think about money supply. The US Federal Reserve argues that money supply these days is unimportant because it is so heavily distorted through offshore holdings and the shift away from bank lending towards securitisation. For the European Central Bank and the Bank of England, however, money supply growth is a potential early warning sign of inflationary dangers ahead. Again, who is right? What is certain, the dispute reveals a schism in central bank thinking and the differences of view threaten disagreements on action.
Dilution comes from the breakdown in linkages between monetary policy and monetary conditions. This, in a nutshell is an issue of control. Economists often give the impression that a given change in policy rates will have a precise impact on the economy. If these linkages are broken or there is difference of opinion of how the transmission mechanism of monetary policy affects the economy, a central bank may be pulling in one direction while other central banks may be pulling in different directions.
Mervyn King, the Governor of the Bank of England, recently gave a speech to the Welsh CBI in which he admitted "our job ... is rather like taking part in a spot-the-ball competition". For the Bank of England, the missing ball is the outlook for inflation and the message seems to be that, like any spot-the-ball competition, the whereabouts of the missing inflationary ball is anybody's guess. Admittedly, some may be more skilled than others in assessing the outlook for inflation but the comparison does not inspire confidence.
In truth, the Governor's comments were made with tongue firmly lodged in cheek, and no doubt he was trying to make inflation targeting sound a bit more interesting than it really is, but his expression of doubt serves to emphasise that central bankers will, from time to time, get things wrong.
However, is it a good idea for central bankers to admit this? Of course they will get things wrong. Of course they will face challenging times.
Yet, it sometimes helps to preserve an aura of invincibility. Why, for example, was the Bundesbank so successful over so many years? How did the Bundesbank pull off the German price stability trick from one year to the next?
Was it control of the money supply, or independence from government interference, or success with the inflation equivalent of spot the ball? Probably it was none of these.
Instead, their pseudo-religious tones encouraged the German public to keep their faith in price stability. A delusion perhaps, but a very useful one nonetheless. Without it, disagreement, dilution and doubt threaten to upset the economic stability we have come to expect over the last few years.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.
What if they question the wisdom of their inflation-targeting objective? What if they are no longer sure of how to hit their objective? Should they tell the wider world or, instead, should they keep their doubts under wraps, to be discussed with only their closest and most trusted colleagues?
Within the central banking community there appears to be some sort of uncertainty and this has been reflected in recent financial market developments. Of course, knowing that bond yields have spiked up says little about the underlying causes. Among the explanations doing the rounds have been Chinese foreign exchange reserve diversification and the greater-than-expected buoyancy of the global economy.
The really big worry, though, is the possibility that inflation has returned. If so, there are either going to be bigger price increases or it will be necessary to tolerate higher interest rates to prevent those price increases from coming through. Either way, central banks have got their work cut out.
Why should a suspected build-up of inflationary pressures lead to such uncertainty? This reflects three separate sources of central bank tension: Disagreement, dilution and doubt.
Imagine a world with a single central bank. There would be one objective - global price stability - and one instrument - the global short-term interest rate. Now switch back to the real world: Lots of central banks, all of which have their own separate concerns and views of how the world behaves. Disagreements become the norm.
Markets recently breathed a sign of relief because the monthly increase in the US consumer price index, excluding the volatile food and energy components, was only 0.1 per cent, pulling the annual rate down towards two per cent. From the US Federal Reserve's point of view, that is good news as it likes to focus on this "core" measure of inflation. Imagine, though, that the Bank of England was in charge of US monetary policy.
The Monetary Policy Committee would focus on the 0.7 per cent monthly increase in the headline consumer price index, which pushed the annual inflation rate up towards three per cent, and conclude that inflation was a bit too high. Who would be right? A lot depends on the degree to which central banks should take into account "global" inflationary pressures that lie outside their direct control.
Alternatively, think about money supply. The US Federal Reserve argues that money supply these days is unimportant because it is so heavily distorted through offshore holdings and the shift away from bank lending towards securitisation. For the European Central Bank and the Bank of England, however, money supply growth is a potential early warning sign of inflationary dangers ahead. Again, who is right? What is certain, the dispute reveals a schism in central bank thinking and the differences of view threaten disagreements on action.
Dilution comes from the breakdown in linkages between monetary policy and monetary conditions. This, in a nutshell is an issue of control. Economists often give the impression that a given change in policy rates will have a precise impact on the economy. If these linkages are broken or there is difference of opinion of how the transmission mechanism of monetary policy affects the economy, a central bank may be pulling in one direction while other central banks may be pulling in different directions.
Mervyn King, the Governor of the Bank of England, recently gave a speech to the Welsh CBI in which he admitted "our job ... is rather like taking part in a spot-the-ball competition". For the Bank of England, the missing ball is the outlook for inflation and the message seems to be that, like any spot-the-ball competition, the whereabouts of the missing inflationary ball is anybody's guess. Admittedly, some may be more skilled than others in assessing the outlook for inflation but the comparison does not inspire confidence.
In truth, the Governor's comments were made with tongue firmly lodged in cheek, and no doubt he was trying to make inflation targeting sound a bit more interesting than it really is, but his expression of doubt serves to emphasise that central bankers will, from time to time, get things wrong.
However, is it a good idea for central bankers to admit this? Of course they will get things wrong. Of course they will face challenging times.
Yet, it sometimes helps to preserve an aura of invincibility. Why, for example, was the Bundesbank so successful over so many years? How did the Bundesbank pull off the German price stability trick from one year to the next?
Was it control of the money supply, or independence from government interference, or success with the inflation equivalent of spot the ball? Probably it was none of these.
Instead, their pseudo-religious tones encouraged the German public to keep their faith in price stability. A delusion perhaps, but a very useful one nonetheless. Without it, disagreement, dilution and doubt threaten to upset the economic stability we have come to expect over the last few years.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.