Back to the Drawing Board

by Inya Ivkovic, MA

Central bankers and many economists thought they had finally found an adequate weapon to fight the swings of the business cycle — short-term interest rates. They firmly believed that, by increasing and reducing interest rates at a pre-calculated pace, they could counteract various degrees of cyclical booms and busts. Monetary policy became much more appealing compared to the gold standard and targeted money supply, if for no other reason than it brought simplicity and a reasonable amount of certainty with respect to inflation.

As predicting inflation became a more exact science, at least in theory, the stage was set for economic growth, because investing became more predictable, too. When calculating an investment’s future value, most calculations are discounting its present value for the effect of inflation, thus allowing companies to make better educated decisions on where to put their capital. As a result, the GDP rate during the decade between 1997 and 2007 held at an average of 4.3%, which compares favorably to the 3.4% rate held the previous decade.

This kind of monetary policy even got a new name. Before Ben Bernanke took the post of Fed chairman, he declared himself infatuated with such an inflation-focused monetary policy by calling it “The Great Moderation.” But, as the beauty of hindsight will advise, it sounded too good to be true probably because it was exactly that — too good to be true!

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After the meltdown in financial and credit markets, proponents of inflation-focused monetary policy have been forced to rethink their assumptions and had been sent back to the drawing board with one common thought — economic crises are more than by-products of unfortunate sets of circumstances. Assumptions about inflation-targeting have come under scrutiny, with most policy makers now agreeing that the old regime of manipulating short-term interest rates to keep inflation in check is no longer sufficient. In fact, many now
consider inflation-targeted monetary policy sadly lacking during
times of huge cycle swings.

The most blame for the Great Recession of 2008/2009 appears to have been allocated to central bankers, who, almost without exception, failed to see the dangers of allowing asset bubbles to perpetuate themselves. Actually, it seems to me that the most weight has been placed on one particular central banker, the Fed’s former chairman, Alan Greenspan, who led the pack, almost vehemently objecting to popping asset bubbles by raising overnight lending rates just because he didn’t want to put a damper on stock prices. Instead, his signature move was to reduce interest rates as a bubble would emerge to ease the repercussions of it bursting on the rest of the economy. Greenspan was so confident that this was the way to conquer business cycle “mood swings” that he imposed his preaching on the rest of the world and even boasted that his views were in synch with many of his counterparts.

Unfortunately for Greenspan’s legacy and reputation, the one asset bubble he shouldn’t have left unattended was the housing bubble in the U.S. As foreclosures spiked up while house prices were still at their peak, the limitations of inflation-centered monetary policy showed their true colors. Even as interest rates hit rock-bottom, the crisis failed to abate. Things have gotten so bad that venerable institutions, such as the Federal Reserve, Bank of England and Bank of Japan, had to become buyers of last resort of those toxic assets. At that point it became crystal clear that lowering or increasing borrowing costs does not have enough of a ripple effect in the global financial markets environment.

So now what? It seems that a global regulatory overhaul is in the works. The Group of 20 managed to agree last month in London that current regulatory frameworks are inefficient and that central banks should be given an even larger role in regulating financial markets. Opponents to such views say, on the other hand, that central banks (with only very few notable exceptions) had been given that role once, which they chose to over-simplify by reducing it to interest-rate fiddling, thus signaling that they don’t have what it takes to curb asset and other financial market excesses. Additionally, considering that inflation-centered monetary policy is the most effective when an economy is on the path of recovery, perhaps that’s where central banks should switch their focus, and leave managing the global financial markets to industry regulators. Oh, yes, and a politician or two with a big stick could come in handy, too.