Central Banks of the World Flying By the Seat of Their Pants

Mohamed A. El-Erian


Central Banks’ “Responsible Irresponsibility”?

Many monetary policy purists will not recognize what central banks in Europe and the United States are up to these days. And those that do are likely to express outrage at how far these traditional guardians of monetary stability have ventured into unfamiliar territory — a situation they undoubtedly regard as inadvisable, if not dangerous.

Such reactions are understandable. Yet confusion and outrage are not the right responses for the rest of us. Whether you are a government, an investor or a concerned citizen — and whether you live in the west or in an emerging economy such as Brazil — it is important to understand why both the European Central Bank and the US Federal Reserve are so far adrift from conventional central banking; and what this means for the global economy as a whole, and for individual countries.

Like fiscal agencies, central bankers responded aggressively to the calamity of the 2008 global financial crisis. Eager to avoid an economic depression, they slashed interest rates, opened all sorts of emergency financing windows to keep banks alive, and also injected liquidity into the economy through whatever avenue they could think of.

From the very beginning, the intention was for this unusual policy activism to be both temporary and reversible. Indeed, much time and effort were devoted to designing “exit strategies” that allow central banks to return to “normalcy” in an orderly and timely fashion.

Yet there has been no exiting. Instead, central bankers have found themselves drawn deeper — much deeper — into experimental mode.

With ultra-low interest rates proving insufficient to deal with the economic malaise, the Federal Reserve has felt compelled to provide unprecedented “forward policy guidance.” It signaled its strong expectation that rates would remain floored at zero until at least the end of 2014. And by claiming that it could see that far into the future, it essentially challenged the time-tested view that monetary policy acts with “long and variable lags.”

This was not the only unthinkable. The Federal Reserve has aggressively bought US government and mortgage securities. On the other side of the Atlantic ocean, the ECB has acquired trillions of bonds issued by struggling members of the Eurozone; and it has even found a back door to get money to the Greek government in order for it to meet its debt obligations to the ECB.

The numbers are getting very large; especially as both central banks have signaled their intention to do more (including last Thursday’s ECB announcement). Already, the ECB has ballooned its balance sheet to over 30 percent of GDP and the Federal Reserve to 20 percent of GDP. (Note that the Bank of England and the bank of Japan are in the same ballpark).

Through their ever-larger presence in markets, central banks have inevitably influenced liquidity, price signals and information content. In some cases, even the provision of financial services to the public has been impacted (including money market saving instruments, pensions and life insurance).

Imagine if this were attempted by central banks elsewhere. It would be met in the west by cries of irresponsibility. Yet, ironically — and using a formulation adopted by economists such as Paul Krugman and Paul McCulley — central bankers in Europe and the U.S. have felt that it is in fact responsible for them to be irresponsible.

Central bankers will tell you that they have had no choice but to operate increasingly in unfamiliar and unconventional policy territory. After all, despite massive monetary (and fiscal) stimulus, the US economy has remained sluggish and unemployment is still way too high. Meanwhile, Europe continues to struggle with a debt crisis that started in Greece in 2009 and has spread wide and far. Even Germany, the continent’s powerhouse and the country that has undertaken the deepest structural reforms, is now slowing markedly.

Due to political paralysis and polarization, central bankers seem to be the only policymakers both willing and able to respond to these unusual challenges. Yes they are using imperfect tools. Yes the outcomes of their actions involve collateral damage and unintended consequences. But they see all this as preferable to the alternative of doing nothing.

I suspect that central bankers, whether in Europe or the U.S., realize that — acting by themselves — they cannot deliver the much-needed outcomes of growth, jobs and financial stability. Rather than guarantee the destination, they are helping to define the journey. They are building bridges, hoping to buy time for politicians and other policymaking entities to overcome their bickering and dithering.

Time will tell whether this strategy will work. In the meantime, the rest of the world has no choice but to adapt to this “responsible irresponsibility.”

The more western central banks inject liquidity into their economies, the greater the splash for other countries. The result is something that has been experienced by countries such as Brazil: significantly greater exchange rate volatility, disruptive flows of capital, and higher tensions between domestic and external realities.

Brazil and other responsive emerging countries have responded by re-caliberating their macroeconomic policy mix. They have aggressively cut interest rates while tightening fiscal policy; and they are looking to revamp structural reforms.

It is still early days though. Further policy adjustments will be required in the months and years ahead as western central banks implement additional unconventional policies, and as the longer-term effects become more visible. And it will not be easy. Policy responses will be analytically hard to calibrate precisely, especially as all this is happening with virtually no global policy coordination to speak of.

Have no doubt. While most countries would prefer to be just observers, they are in fact reluctant participants in one of the biggest monetary policy experiments of all time. The entire world shares an interest in the success of this unprecedented endeavor — after all Europe and the United States anchor today’s international monetary system and will do so for quite awhile. Yet in hoping for success, we are all well advised to also think of the range of contingency steps to deal with the collateral damage and the unintended consequences.

This article was originally published in Portuguese in Brazil’s Estado de Sao Paulo.

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