Central bankers’ shifting goalposts

The theme of this year’s meeting of the world’s central bankers in Jackson Hole, Wyoming, had little to do with monetary policy. “Fostering a Dynamic Global Economy” is, of course, an important topic. But it is telling that the European Central Bank chose, for its own annual gathering, a similar “non-monetary” topic (“Investment and Growth in Advanced Countries”).
There is nothing wrong with central bankers considering challenges in areas like growth, trade, and investment. But central banks were made independent precisely because it was understood that they would be held accountable for achieving their own objective of maintaining price stability, regardless of the economy’s underlying growth rate. So why is it that central bankers would rather look at external issues than focus on their own area of responsibility?
The answer, it seems, is that they cannot quite explain their current approach.
Conditions today are very favourable for monetary policymaking, particularly for the ECB – as a brief look at history makes clear. Since the creation of the Economic and Monetary Union (EMU) in January 1999, the ECB has been solely responsible for determining the EMU’s monetary policy. (Although national currencies remained in circulation until 2002, exchange rates were “irrevocably” fixed from 1999.)
The ECB’s job was hard from the beginning. After all, when the euro was born, global financial markets were in turmoil, owing to the Asian crisis of 1997 and the Russian default of 1998. The VIX index, which measures stock-market volatility, had hit 44 per cent in August 1998, and during the euro’s first few years, it hovered around 25-30 per cent, compared to around 12 per cent today. While unemployment in the eurozone was declining, the rate was close to 10 per cent, and it remained higher than today’s level, 9.3 per cent, for all of 1999.
From a monetary-policy perspective, there was also a need to cope with the deflationary legacy of financial crisis. Indeed, when the eurozone was established, prices were increasing by less than 2 per cent, and headline inflation was stuck at around 1 per cent. Those two key indicators of monetary policy are at almost exactly the same levels today, but financial markets are significantly more settled now than they were then.
In 1999, despite slightly below-target inflation, high unemployment, and financial-market volatility, the ECB Governing Council did not even consider zero or negative interest rates, much less unconventional policy measures. Instead, its first action, in 1999, was to fix the main policy rate at 2 per cent.
Over the course of that year, the ECB did cut the benchmark rate by 50 basis points, to the then-unprecedented level of 1.5 per cent. But it did so just to give the economy a chance to recover. After a few months, it reversed course, putting the year-end policy rate back at 2 per cent. Over the next year, the rate was raised to 3.75 per cent, even though inflation had not accelerated by more than a few dozen basis points.
Today, the ECB is facing a much more comfortable situation. While inflation is undershooting the 2 per cent target by a similar amount, the labour market appears to be in much better shape.
But is it? It is widely assumed that a deep recession induces many of the unemployed to leave the labour market, because looking for a job seems useless. If many such discouraged workers have left the labor market, a recovery of the unemployment rate to pre-recession levels can be misleading. That is why the unemployment rate needs to be considered in conjunction with the labour-force participation rate.
By that measure, the eurozone is actually doing much better today than in 1999. With the labour-force participation rate five percentage points higher that it was back then, it seems clear that fewer workers have been discouraged from job-seeking today than at the start of the EMU, and thus that there is less underused potential in the economy.
Against this background, it is difficult to explain why the ECB continues to insist that unconventional monetary-policy measures – such as negative rates and continued bond purchases – are needed. The long-term inflation outlook might be somewhat more uncertain today. But can a few dozen basis points in (poorly measured) long-term inflation expectations justify the need for massive quantitative easing and a policy rate 250 points lower than it was at a time of weaker market fundamentals?
This incongruity is not limited to Europe. In the United States, too, one finds a similar combination of inflation and unemployment today and two decades ago. In 1999, a core inflation rate of around 2 per cent, combined with unemployment below 5 per cent, justified a federal funds rate of 5 per cent (and a “normal” balance sheet). Today, the Federal Reserve has kept its benchmark rate below 1.5 per cent – 350 basis points lower than in 1999 – and has postponed any reduction in its bloated balance sheet.
In Japan, inflation is now higher than it was in the wake of the Asian financial crisis; unemployment is at its lowest level in 50 years; and the labour-force participation rate continues to reach record highs. Yet Japan, like the U.S. and Europe, continues to display a quixotic tendency to tilt at deflation windmills, with rock-bottom interest rates and purchases of massive amounts of government debt.
Central bankers surely wish for a dynamic global economy. But that is not something they can influence much. Rather than discussing unrelated issues, they should be focused on explaining why their goalposts have shifted so much – and whether it is time to start moving them back. - Project Syndicate