The Federal Reserve’s challenge of communicating effectively to markets has rarely been greater than during the past few months, as Chairman Ben Bernanke has to telegraph the exit route away from the unconventional monetary policies implemented since the 2008 crisis. His nominated successor, Fed Vice Chairwoman Janet Yellen, summed this up aptly in a speech last April, when she drew out the contrast between the practices of today and those of previous eras, and argued that central banks have gone from a stance of “never explain” to one embracing transparency.
No matter how transparent, however, central bankers in both the U.S. and Europe are running up against a problem that escapes the reach of any one particular individual or team in charge of monetary policy. The challenge is that they lost a considerable weapon in their arsenal – namely, robust discretionary control over interest rates – as they pursued the extraordinary measures of quantitative easing, or QE, in recent years. This was a response to the lack of credit demand as the private sector has kept on shedding its own debt, known as deleveraging. Yet many economies remain burdened with high public debt and sluggish growth. This leaves fiscal policy as the only effective lever that a government can use, but this, too, is limited in its reach due to the constraints of high debt.
It is worth noting the Fed has purchased 95 percent of net U.S. government debt issuance in the last six months. Accordingly, any exit from current monetary policy cannot be independent from the fiscal situation as the government’s financing is largely reliant on the central bank’s stance. Accordingly, Bernanke has backtracked from the Fed’s once-expected intention to reduce the pace of QE this autumn, likely amid concerns over fiscal policy uncertainty. We ended up in a world of fiscal dominance of monetary policy. How did central banks fall into this trap?
To understand this story, it is first important to explain the basic principles that underlie the imperative of central bank communication. The first is that transparency and communication are not the same thing. For example, former Fed Chairman Alan Greenspan duly communicated Fed policy to markets as the law required, but that did not stop him from taking the occasional recourse to studied ambiguity. In contrast, Yellen defines transparency as ensuring that all the information held by the central bank is communicated to the public.
The second principle concerning Fed communication has to do with the nature of money today — namely, that a currency is worth what policymakers promise it to be. So for such “fiat” money to hold value, it has to be credible. When it is not credible — in, say, a crisis-stricken country – it collapses as people flock to the dollar instead. In other words, the promise of purchasing power that currency embodies must be trusted. So to build as much trust as possible, policymakers typically commit themselves to making low inflation the primary objective of monetary policy.
To undergird this promise, central banks are increasingly replacing their discretionary decisions on interest rates with a more rule-based framework for monetary policy that emphasizes credibility, transparency and accountability. This development, which became ever more widespread around the world since the inflation crisis of the 1970s, bases monetary policy around a transparent program rather than leaving policy to be buffeted by calculations of short term trade-offs between unemployment and inflation. This rule-based framework is sometimes called “constrained discretion,” which means that a central bank mainly focuses on stabilizing inflation and inflation expectations. However, it sometimes deviates from this course to accommodate shocks in output and unemployment. As long as these deviations from “sound” monetary policy are short term, inflation expectations remain muted. The market only becomes concerned when these deviations are seen as lasting too long.
Credibility is usually measured by inflation expectations. Before the response to the 2008 crisis, the job of a central banker seemed simple: as long as you communicated with the public and used some kind of peg to anchor inflation expectations such as inflation targeting, all you had to do was ensure that the interest rate fell when inflation expectations were low and rose when they were high. But the major tool that is the interest rate became less and less robust as central bankers kept pushing down interest rates during the 2008 crisis – and they discovered a problem that continues to this day: monetary policy is now constrained by the fact that once nominal interest rates have been brought down to zero, they can fall no further (known as the “zero lower bound”). And this is no longer enough to boost credit demand of households and corporations, which is limited as they keep on deleveraging. The standard monetary policy toolkit is therefore obsolete when severe credit frictions occur. At the same time, post-crisis demand stimulus has also come through fiscal policy, namely higher government spending, with the obvious consequence of rapidly escalating levels of public debt.
On the monetary side, it soon became clear that reducing interest rates to close to zero would not suffice to kick-start the battered U.S. economy after the financial crash. As a result, policymakers supplanted the use of traditional interest rate settings and instruments such as discount windows and open market operations by a plethora of extraordinary facilities to provide reserves, guarantees and short-term credits to banks. Unconventional monetary policy under the general label of QE aimed to overcome the zero bound of nominal interest rates with the central bank directly purchasing the domestic government’s bonds and other domestic securities. This, in turn, aimed to bypass the banking sector rather than rely on what we term the “broken credit channel” of monetary transmission. The fiscal stimulus was therefore partly financed by the expansion of the Fed’s balance sheet.
The aim of QE is to raise inflationary expectations, thereby inducing people to borrow and spend to drive up demand (say, by injecting funds into banks to finance domestic loans and refinance mortgages). But it needs to stimulate domestic demand without undermining confidence in the future value of money or in the sustainability of public finances and debt. And indeed, interest rates have stayed at historic lows, which has helped the U.S. economy in some sectors, such as housing. More broadly, however, the sheer overhang of debt built up before the crisis continues to keep people reluctant to borrow.
While this reluctance to spend has contained real inflation risk, it has not stopped the fiscal deterioration. The crisis generated huge budget deficits and public debt through a combination of discretionary fiscal stimulus; lower tax revenues on the back of slow growth; reduced spending by the private sector as it deleveraged; and the socialization of bank losses through programs like the Troubled Assets Relief Program. Fiscal constraints in the U.S. and other mature economies have therefore built up very sharply.
Another assumption needed to make QE work is a certain “Keynesian myopia.” As the economists Daniel Benjamin and Levis Kochin have defined it, QE’s desired effect requires convincing the public that near-term tax increases are not coming, so that consumer spending continues as normal rather than contract. This only works if you can persuade the public that payback time will never come in the form of higher taxes. In more formal terms, this means that the real value of outstanding debt will indefinitely exceed future primary surpluses, which are the positive balance of government revenues over spending, leaving aside spending on debt service. To be effective, fiscal and monetary policy need to be coordinated when private-sector balance sheets heal and credit demand for quantitative easing ceases.
But as we know, many fiscally troubled developed countries did become concerned about staving off the threat of national insolvency, and accordingly, they launched austerity programs. This was most pronounced in Europe, especially in the troubled periphery, but government spending fell in the U.S. as well, starting in 2011, and since then has caused substantial fiscal drag. Given Washington’s current fiscal impasse, the full effect of unconventional monetary policy cannot be achieved. As for the broader austerity experiment – U.S. and Europe — the results were mixed, depending on how far the public tolerated the hardship stemming from higher taxes and decreased spending. If these countries escape from their fiscal predicament and return to solid economic growth in the longer run, their public finances will improve without the need for a retrenchment so painful as to undermine the government’s credibility.
But what if a country cannot sustain reasonable growth? In that case, bond markets may doubt whether debt sustainability could be restored, and they could start dumping government debt – causing interest rates to jump. All of a sudden, governments would find it difficult to service their debt, or, at least, to service their bond payments without falling ever more deeply into debt. This danger is captured by the budget crunch that occurs when real interest rates exceed the growth rate, unless primary surpluses are kept large enough, which is something that becomes ever more painful in an environment of low or negative growth. In that case, a country’s public debt becomes unsustainable.
In these circumstances, one way to stave off default would be to press the central bank to take QE a step further by cancelling some or all of the government bonds purchased by the central bank or undertaking direct central bank financing of government spending, for example. Such options are made all the more tempting by the illusion that monetary policy can single-handedly restore growth and thereby dig the government out of its fiscal hole. But here we see the risks generated by central-bank discretion replacing the traditional rules in monetary policy. These risks lie in the uncertainties generated by large and snowballing levels of public debt resulting sooner or later (the exact timing driven by political expediency) as the central bank is forced to act as the banker of the government. There is nothing new here: in times of profound crisis, central banks are called to the rescue.
Central banks can always try to head off any such crunch by reversing QE once inflationary pressures start to be felt. That process may be fraught – as the central bank would be selling government bonds into a falling market – but it could at least make the attempt. (And, in any case, the bonds could simply be held to maturity, at which point the government would have to repay without any central bank refinancing). Put another way, QE in its initial form represented only a temporary increase in the monetary base. But what if it becomes a permanent increase – if, for example, central banks continued to purchase government paper even against the background of rising inflation? Then they will have definitively crossed their Rubicon. In that case, the unanchoring of inflationary expectations would only be a matter of “when,” not “if.”
The common thread running through these various dangers is the inextricable links between monetary and fiscal policy. These two planks of macroeconomic management become even more closely intertwined under QE. One way or the other, excessive public debt threatens monetary stability. Either inflationary expectations generated by monetary stimulus cause government bond yields to rise, in turn making public debt look unsustainable, or QE’s effect in disguising the underlying weakness of the public finances proves short-lived. When the reality of the fiscal emergency becomes impossible to ignore, the response with the least political resistance is to inflate the debt away. In other words, the fiscal limit to monetary policy – that is, the maximum government debt-GDP ratio that can be sustained without risking default of rampant inflation — would have been reached. (For more, read here.)
These realities bring home the limits of what central banks can achieve on the communication front. However skillful the messaging designed to shore up public confidence in a central bank’s ability to control inflation, it cannot escape the constraints set by time and consistency: the public understands that the central bank may be inconsistent over time, so it distrusts declarations by those authorities. Even if the central bank itself remains trusted, such trust becomes less relevant as the reality dawns that the problem’s source lies in the public finances – which are not under the control of the monetary authorities.
To be sure, central bank governors in their public remarks regularly express their concerns about the weakness of fiscal policy. By this means, they communicate a desired message – for example, that a government’s failure to carry out a necessary tightening of fiscal policy will result in higher interest rates. While such a statement might help create the intended expectations, however, the central bank can never back this up through actions under its control. And if higher interest rates do result, they could simply make the government appear to be heading for insolvency, rather than prompt policymakers to cut government spending.
There is also the issue of how effective communication can be when a central bank cites multiple targets. In the past, central bankers simply announced inflation forecasts and thereby implied the direction of interest rates by enabling market participants to see whether those forecasts were above or below the mandated target for inflation. But today, many central bankers are indulging in a variation of traditional communication known as “forward guidance.” The difference here is that the central bank makes its interest rate policy conditional on a key indicator – typically unemployment falling to a declared level. In addition to the difficulty created by targeting several different indicators rather than inflation alone, such multiple targets could all too easily be derailed by unpredictable actions (or inaction) by governments in the fiscal sphere. In that case, higher public debt can seriously increase inflation expectations, and against this threat, no amount of “communication” can be sure to prevail. Furthermore, multiple policy targets confuse the formation of inflation expectations, leading to unpredictable consequences for central bank credibility.
Even though the debates on forward guidance, alternative and multiple policy targets and the level of transparency are worthwhile, none of these measures are able to deal with the fiscal challenges a number of developed economies are facing. No matter how dove-ish Yellen turns out to be, monetary policy effectiveness is greatly reduced when credible coordination between fiscal-monetary is lacking and fiscal-policy uncertainty prevails. So the idea of transparency that Yellen very properly champions as a point of principle will become less and less applicable by any central banks that have also gone down the road of unconventional monetary policies. Under present circumstances, it will not be enough to ensure certainty and confidence if the Fed just declares a priority target of reduced unemployment (that is, the dove-ish position that Yellen favors). Market participants are bound to wonder when the risk of unemployment deemed excessively high becomes less pressing than the risk of inflation linked to excessive public debt. And the Fed will not singlehandedly be in a position to communicate credibly when that point will have been reached. That judgment depends on players in the government and the legislature.
This story was updated on Oct. 9, 2013, to reflect Janet Yellen’s nomination.