LONDON (Reuters Breakingviews) - Sometime between fighting the global financial crisis and averting the breakup of the euro zone, central bankers began to be viewed as superheroes. They are in danger of becoming victims of their own success.
Global rate-setters’ omnipotent status has less to do with fire-fighting and more to do with conquering the soaring inflation of the 1970s and 1980s. Granted, luck as well as skill had something to do with annual price increases falling towards the 2 percent that most of them target.
Globalisation and technological advances have been pushing down prices in past three decades. But central banks received – and took – most of the credit for the achievement. In doing so, they also cemented their position as elite technocrats, protected from meddling politicians. But that status is increasingly in doubt. At a Bank of England conference to mark two decades of monetary policy independence last week, participants fretted over the risks posed by unrealistic expectations.
(Graphic: G7 inflation over the decades: tmsnrt.rs/2yRWI8D)
First, rate-setters may have built up too much inflation-fighting credibility for their own good, as Christina Romer, an academic at the University of California, Berkeley pointed out. Workers will be less apt to push for higher pay if they are convinced any price spikes will prove temporary. That’s a huge problem when inflation is too low, as is the case now in some countries. European Central Bank President Mario Draghi or his Bank of Japan counterpart Haruhiko Kuroda would dearly love wage demands to start the sort of inflationary spiral that their predecessors once feared.
Second, there is a risk political and popular support for central bank independence will fade along with memories of the damage that high inflation inflicted in the past. The more that stable prices are taken for granted, the less monetary policymakers can expect to be insulated from political attacks when they venture into politically-sensitive debates.
Take the backlash that BoE Governor Mark Carney faced when he issued pre-referendum warnings about the potentially damaging economic consequences of Britain leaving the European Union. Or the acerbic criticism that Gordon Brown, a former British prime minister and finance minister, directed at former UK central bank officials at last week’s conference for commenting on fiscal policy. The attack was all the more pointed for being delivered by the architect of the BoE’s modern independence.
Clashes between politicians and central bankers may become the norm, Charles Goodhart, an LSE academic and a former UK rate-setter, told the attendees. Politicians championed central bank independence and inflation targeting during decades when government debt as a proportion of GDP and inflation were both falling. They could well become less supportive in a low-inflation, high-debt era. Though the risk of prices galloping higher appears remote, the impact of higher policy rates on governments’ borrowing costs will be all too real.
The breakdown in old economic relationships makes central banks even more vulnerable. Contrary to textbook economic theory, unemployment has been falling without inflation flaring up. Monetary policymakers and other economics experts are hard pressed to explain why. The longer the phenomenon persists, the more doubts will be cast on the necessity and wisdom of continuing to target inflation, either of 2 percent or at all.
These questions are all the more likely to surface in an era where inflation is no longer viewed as the main threat to growth or equality. Rate-setters are the first to admit that monetary policy cannot tackle some of the causes of sluggish economic and wage growth, such as low productivity. Faced with restive voters, politicians will inevitably wonder whether fixing these issues wouldn’t be easier if they took back control of policy rates, or gave central banks a different mandate altogether.
Another big financial crisis would make demands for an overhaul even harder to resist. The last crisis that started a decade ago forced monetary policymakers to stop focusing too narrowly on just fighting inflation. Some, such as the BoE, were officially tasked with supervising banks. Others including the U.S. Federal Reserve expanded the scope of issues they weighed when setting policy, taking into account the potential for bubbles developing in financial markets and asset prices.
Set up to fail
But financial stability is, as Carney termed it last week, “an orphan child”. There’s little certainty about who is ultimately responsible for maintaining stability, and it’s even harder to judge whether policymakers are doing enough to preserve it. Unlike inflation, there are no simple and permanent benchmarks against which progress towards financial stability can be measured. Its absence is more evident. When things inevitably go wrong, central bankers will take their share of the blame. That too could stoke demands for a broader review of central bankers’ remit - and their autonomy.
The tenor of the BoE’s conference showed policymakers are well aware of such dangers. What they might do to mitigate the risks is less clear. It would help if they could ferret out what is driving inflation and discover whether economies have undergone a structural change that warrants a new approach to policy. Conducting regular reviews of their mandates, say every decade or so, may also help. When superheroes begin to lose their powers, it makes sense to ask for help.
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