May 14, 2022
  • May 14, 2022

Central banks are stuck in a “mirror room”

By on November 20, 2021 0

Pharmaceutical companies have patent portfolios, great power navies have aircraft carriers, and central banks have their “canonical” econometric models.

Browned and refined over decades, the canonical models (all quite similar to each other) are proof, especially for central bankers themselves, that their decisions are based on a coherent philosophy.

The profession does not want to appear as driven by a whim, a desire for momentary popularity or political micro-machinations among the members of the board of directors of the central bank. He wants to be seen as encouraging productive investment and equitable economic growth, not speculation.

Twenty years ago, it was generally believed that in the event of a financial crash or economic emergency, central banks would act apolitically and selflessly to keep the system functioning. In the post-bailout world, worsening social inequalities, a bargaining scandal by senior Federal Reserve officials, and the politicization of high-level appointments have all weakened public consensus.

Now there is a lot more cynicism. There is also a deep suspicion that all the post-crash bailouts and “unconventional measures” have done is make the rich richer. Central banks have acquired a lot of financial assets, but are losing public confidence.

When harassed and challenged by politicians or journalists, central bankers step back to recite what the canonical models tell them. The stated purpose of the models is to indicate what short-term interest rates, asset purchase programs, or “directions” through public statements are needed for the economy to meet the “interest rate”. R-star ‘elusive.

R-star is the real short-term interest rate compatible with full employment and a stable long-term inflation rate. In terms of politics, this is the central banker’s nirvana.

Not that R-star is meant to be fixed or stable over long periods of time. The stable interest rate is expected to rise if technological developments or educational levels improve quickly enough for the potential growth rate of the economy to increase. Or, if productivity drops due to a plague or an aging population, R-star will be lowered.

The job of central bankers would be much simpler if the R-star were at all times easily seen, say on a page on a Bloomberg screen. These rates could simply be extracted and entered in the entry fields of the canonical models. Presto: political.

But no. R-star, the key rate, the cornerstone of central bank policy, is unobservable and can only be estimated by economists making an educated guess about what it should be, in the absence of empirical information direct.

The guesses have become rather depressing over the decades. R-star has fallen more than 5 percentage points in advanced economies since the 1980s. And since the 2008 financial crisis, developed-world R-stars have converged at a very low level, as if expecting a economic recovery that will never come.

Are central banks signaling to the private sector that little growth is possible, and is this depressing and misleading belief reflected on central bankers themselves?

Yes, according to Phurichai Rungcharoenkitkul, economist at the Bank for International Settlements in Basel. In an article he co-authored with the Federal Reserve’s Fabian Winkler, the two find that central banks and the private sector “end up mistakenly perceiving the macroeconomic effects of their own actions as real news. They look in a gallery of mirrors.

Rungcharoenkitkul and Winkler modify the Standard Policy Model to prove that, in recent years, “with the Hall of Mirrors effect, an aggressive political strategy may be less effective in boosting spending, and worse yet, could exacerbate the very problem that policymakers are trying to resolve. to resolve”.

In other words, looking at reflections of their own policies of the recent past, central banks have kept official rates too low for too long, and their communication of their expectations has depressed long-term savings and investment. in the private sector.

Unproductive activities were unintentionally encouraged. Setting rates low for too long has led to overpriced housing, insufficient class or labor mobility, and the growth of leveraged speculation.

We have asked central banks to take too much responsibility for the economic recovery. And we mistakenly expected them to be omniscient, even as they look to the private sector for critical clues.

As a result, central bank “signals” and “communications” have arguably caused confusion and undue economic pessimism in the long run. And as the BIS reports put it, “these consequences are all the more serious as the private sector and the central bank mutually overestimate their knowledge of the economy.”