COMMENT: Rewriting the monetary-policy script

For now, the US Federal Reserve has the most flexible toolkit among the major central banks. In addition to inflationary pressure, the Fed’s monetary policy must also take into account employment statistics, growth data, and the stability of financial markets. But even the Fed’s flexibility is under siege. Republican lawmakers are discussing how to bind the Fed to more scripted policy rules to manage inflation (using a formula known as the Taylor rule, which predetermines changes in the federal funds rate in relation to inflation and an output gap). Needless to say, such a move would be a mistake.

Central banks (not to mention lawmakers), with their strong attachment to neo-Keynesian theory, are ignoring a major lesson from decades of monetary-policy experimentation: the impact of monetary policy cannot be predicted with a high degree of certainty or accuracy. But the belief that it can is essential to the credibility of the now-standard inflation targets. If central banks keep missing these rather narrow marks (“below, but close to 2%”), they end up in an expectations trap, whereby markets expect them to dispense ever higher doses of monetary medicine in a frantic attempt to reach their target.

Clearly, such monetary policies create soaring costs and risks for the economy. And central banks themselves are coming dangerously close to looking like fiscal agents, which could undermine their legitimacy.

A new and more realistic monetary paradigm would discard overly rigid rules that embody the fallacy that monetary policy is always effective. It would give central banks more room to incorporate the risks and costs of monetary policies. With such a paradigm, central banks could move away from negative interest rates and large-scale asset purchases. They would define their inflation targets more flexibly, to avoid being forced into action whenever “uncertainties” such as declining oil prices or required wage adjustments cause inflation to move above or below 2%.

Perhaps most important, a new paradigm would acknowledge the limits of central banks’ power and foresight. That would remove an alibi that governments too often hide behind to avoid introducing the structural reforms that really matter for long-term growth.

Michael Heise is Chief Economist of Allianz SE and the author of Emerging From the Euro Debt Crisis: Making the Single Currency Work.

****

Copyright: Project Syndicate, 2017.

www.project-syndicate.org