Oh Dear, Central Banks Are Going to Evaluate Themselves

December 5 2018

What will your modos operandi be when, as a central bank, you want to expand your discretionary powers to conduct monetary policy that will be ever more harmful to ordinary citizens and has more severe consequences for financial markets, without setting off the public’s alarm bells? First of all, whatever the case, you of course do not admit that your aim is to obtain more discretion.

What you might do instead, is package the changes you want to make in something that sounds as innocent as possible and, whenever feasible, could even be interpreted by outsiders as some type of repentance. Last, you pore an academic sauce over the proposal, by publishing lofty scientific papers, preferably written by well-known academics (who are often eager to collaborate as we have seen earlier in the collapse of Iceland’s financial system). This is exactly what some central banks have recently done. Personally, I am greatly concerned about the (near) future because of this most recent move by the Fed.

What is at stake? The Fed, the American central bank, recently announced to evaluate its own monetary policy in 2019. “Could monetary policy improve?”, “Could we better explain monetary decisions?”, and similar types of questions. This does not only sound reassuring, but also as if the central bank is crying mea culpa and is willing to subject itself to self-criticism, right? Well, appearances can be deceiving. The Fed alleges, as part of this internal evaluation, to also reconsider the central bank’s dual mandate. And that is when things become dubious.

Over the past few years, the central bank hardly succeeded in bringing inflation to a level close to their 2 percent target. After pulling out all the stops they finally pulled it off. But then another issue arose. Inflation was beginning to rise fast, and a result the central bank was forced to raise interest rates. The Fed has been raising rates for quite a while, but to be completely honest this could have been done a bit faster, given the outlook for inflation.

How convenient would it be if the Fed’s inflation target would have a lot in common with the monthly cell phone plans of the past. Do you still remember that there used to exist plans that would offer, say, 100 minutes a month, but you could carry any unused minutes over to the next month?

Something similar would suit the Fed, and other central banks, extremely well. If, for instance, aiming for an annual inflation rate of two percent, inflation would have been 0 percent in 2015 and, likewise, in 2016, while inflation would have reached 1.5 percent in 2017 and 2018, you could argue that you are now allowed to have a 3 to 4 percent inflation in 2019 and 2020. Why so much? Well, because you are allowed to carry over metaphorical unused inflation minutes, accumulated in 2015, 2016, 2017 and 2018, to next year and the year after. If this would have been the rule, the Fed could easily take it a notch down and postpone raising rates or raise rates at a slower pace.

The bad news is that the current Federal Reserve Act does not work that way. The good news is that this might change. They call it “nominal GDP targeting”. If the central bank is mandated to target a nominal GDP growth of five percent, they will be able to fulfill that wish. Nominal GDP is the product of real GDP growth, which is what you will come across in newspapers whenever a news item declares that economic growth has been X percent, and the inflation rate.

Now assume that central banks will no longer target an inflation rate of two percent, but nominal GDP growth of five percent. This means that whenever economic growth is one percent, the central bank is allowed to do whatever it takes to raise the price level by 4 percent! This “whatever it takes” does not only imply keeping interest rates at zero percent (which pushes yields on savings accounts down), but also to buy on a massive scale bonds, with bubbles in those markets as a consequence. Financial bubbles that sooner or later burst, with all the negative consequences that this entails.

“But would this really have such a significant impact?”, you might think. “I mean, the Federal Reserve Act is slightly modified by give and take a handful of words, is that truly as bad as you say it is?” To address this doubt, an experience from the Eurozone will speak volumes.

When the European Central Bank (ECB) was founded, the bank was given the task to assure price stability. The ECB defined price stability as “inflation, in the medium term, below two percent.” The act indicated that the European central bankers had to base their interest rate policy on two pillars: an economic pillar, namely on an analysis of economic developments, and a monetary pillar, because history teaches that whenever a central bank allows money supply growth to spin out of control, high inflation becomes inevitable.

In 2003, the ECB began to evaluate its monetary strategy. Ever since, the monetary pillar has largely disappeared, and as a result, the ECB allowed the money supply to increase manifold. But the most important consequence of this internal evaluation, was a modification of the definition of price stability. Since 2003, the ECB no longer defines price stability as “inflation below two percent,” but “inflation below, but close to two percent.” Those few extra words, “close to”, made an incredible difference. When inflation in the Eurozone, during its most recent crisis, dropped to 1 percent, the ECB was quick to slash interest rates and buy government debt at a rate of €80 billion euros a month. The reason? Inflation was too low. One percent was, after all, less than but not close enough to its two percent target. If the definition of price stability had not been changed in 2003, the central bank would have had a more difficult time to defend its zero-interest rate policy which persisted over the years.

If the announced evaluations will give central banks more leeway than they currently have (read: if they are allowed to leave inflation higher than currently is the case), this would be favorable rather than unfavorable for precious metals prices in the medium term.

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