Central bankers go through the looking glass

What is going on in this topsy-turvy world? Could it be that inflation is like a compass with a broken needle? That would be a dreadful prospect - central bankers’ worst nightmare. And what would be the broader implications for central banking?

These troubling questions were raised by Claudio Borio, a top economist at the Bank for International Settlements (BIS), at a conference held in London on Friday night.

“Central banks must feel like they have stepped through a looking glass and who can blame them? They used to struggle to bring inflation down or keep it under control; now they toil to push it up," he said.

“They used to fear wage increases; now they urge them on. They used to dread fiscal expansion; now they sometimes invoke it. Fighting inflation defined a generation of post-war central bankers; encouraging it could define the current one.

“Controlling inflation is the bread and butter of modern central banking – it has been so for at least half a century. Yet if history is anything to go by our profession has always struggled to understand inflation.”

Long-standing sceptic

Borio, one of the world’s most senior central banking officials, urged his audience not to take even their strongest-held beliefs for granted.

First, he warned we may be underestimating the influence that real factors have on inflation, even over long horizons.

“Put differently, Milton Friedman’s famous saying that 'inflation is always and everywhere a monetary phenomenon' requires nuancing. Looking back, I will focus mainly on the role of globalisation; but, looking forward, technology could have an even larger impact."

Second, the long-standing sceptic of ultra-easy policies warned his audience that we might be underestimating the influence that monetary policy has on real (inflation- adjusted) interest rates over long horizons.

“This, in fact, is the mirror image of the previous statement: at the limit, if inflation were entirely unresponsive to monetary policy, changes in nominal rates, over which central banks have a strong influence, would translate one-to-one into changes in real rates," he said.

“And it raises questions about the idea that central banks passively follow some natural real interest rate determined exclusively by real factors, embodied in the familiar statement that interest rates are historically low because the natural rate has fallen a lot."

Here, Borio referred to the prevailing view which is that deep-seated forces, unrelated to monetary policy, have affected the balance between desired saving and investment – factors such as productivity growth, demographics, income distribution, the relative price of capital, and the like.

Back to basics

Through this logic, Borio argued that he had reached the conclusion that market real interest rates tend to track the natural rate, cyclical variations aside. The view is so ingrained that, in discussions, the argument is often short-circuited: it is simply stated that saving-investment balances determine real interest rates.

“In fact, saving and investment balances do not influence market real rates directly; they affect those rates only in so far as they affect inflation (and expectations thereof) or the setting of the nominal rates by central banks and market participants," he said.

Finally, Borio went on to say, if he is right we may need to adjust monetary policy frameworks accordingly.

“As I shall explain, that would mean putting less weight on inflation and more weight on the longer-term real effects of monetary policy through its impact on financial stability."

Incidentally, he added, the stronger focus on financial stability would bring central banking closer to its origins.

Borio concluded that if monetary policy has a very long-lasting impact on real interest rates, then we may need to adjust monetary policy frameworks accordingly.

“My remarks have been intentionally provocative. But I do believe that, while the answers we may give can be very different, the future of central banking, and monetary policy more specifically, depends on them.”

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