Conventional approach to central banking needs revision

Brookings issued a report yesterday, called Rethinking Central Banking, by a group of high-profile economists including Eichengreen, Rajan, Reinhart, Rogoff and Shin. The group – called the Committee on International Economic Policy and Reforms – argues that the conventional approach to central banking needs to be rethought. The neat separation between price stability and other objectives is no longer feasible. The group wants central banks to adopt an explicit financial stability objective, expand their macro-prudential toolkit, and use monetary policy if needed to support financial stability: “If, in the interest of financial stability the central bank sets policies that could result in deviations from its inflation target, then so be it.” (p. 30) They also support the use of capital controls to stem short-term speculative capital flows, and call for more cooperation and coordination between systemically significant central banks.

These policy prescriptions are not radical or new. Much of the ongoing debate in Basel and Washington is focusing on just how to develop these new macro-prudential policies. What is noteworthy with the report, though, is their acknowledgment of weaknesses in the prevailing paradigm. They note that:

• Central banks have allowed credit growth to run free (p. 6)
• International capital markets are destabilizing (p. 21)
• Interest rates affect financial stability and hence real activity (p. 12)

This is significant, since it undermines some of the cornerstones of the current paradigm for (flexible) inflation targeting. As the report notes, “the traditional separation, in which monetary policy targets price stability and regulatory policies target financial stability and the two sets of policies operate independently of each other, is no longer tenable.” This will hopefully lead to more pragmatic and less dogmatic policy making in the future. How the new framework will affect the current preoccupation with DSGE modeling in central banks is, however, not discussed in the report.

Breaking out of the current paradigm will take time, though. The group supports capital controls only on a temporary basis (p. 34) and insists on maintaining the independence of central banks. They even argue for greater independence since “the public and its elected representatives may not be happy if the central bank curbs credit growth in the interest of financial stability.” (p. 31) This is counterintuitive, since the initial call for independent central banks was built on the theoretical premise of monetary neutrality, and therefore a possible delegation of the single task of price stability to central banks. Now, with the border between fiscal and monetary policy even more blurred with huge asset purchases, there should rather be more policy coordination and democratic accountability.

The group acknowledges this dilemma in a separate chapter where they discuss how central banks should best address the current debt overhang. Should central banks support the recovery by purchasing government bonds, or should they stand idly by and potentially force the debt to be restructured, already weak banks to take a haircut, and – in the worst case – witness a financial market meltdown? (p. 25) The group is acutely aware that: “Central bankers face a dilemma. The more they take these competing objectives on board, the more they depart from the intellectual framework that guides their action, and the more complicated their task becomes.” (p. 25)

Which is just another way to say that, as central bankers shift away from their narrow IT mandates, they will have to construct a new theoretical paradigm for pragmatic, stability-oriented central bank policy.

Whether this is the beginning of the end of Woodford’s DSGE monetarism remains to be seen. The report does, however, provides a refreshing look at the challenges facing central banks today and could represent an important basis for the construction of a new paradigm of central banking.