There is an ongoing debate about when (not whether) the Federal Reserve in the United States and the Bank of England will raise interest rates. Opponents of such a move acknowledge that interest rates have to go up some time but argue that the ongoing weakness in Europe, the slowdown in emerging market economies, and the turmoil in China are all good reasons to wait as long as possible. Proponents of an early rise worry about the distortions caused by prolonged ultra-low interest rates. They also want to bring interest rates up again so that they will have something to cut should they run into trouble in the future.
This debate may seem like the usual macroeconomic conversation you would expect to hear among central bankers and yet it is not. There is an underlying political controversy around central banking that creates an incentive for central bankers to move more quickly in raising interest rates than economic conditions might warrant. This controversy takes place any time central bankers approach the frontier between ‘conventional’ and ‘unconventional’ monetary policy; it gets stronger and more intense once they crossover and start using unconventional monetary policy instruments; and it lasts until central bankers find a way to return to normal.
Under ‘normal’ conditions, central bankers conduct monetary policy by making marginal adjustments in short term interest rates or ‘policy rates’. A typical move would be to raise or lower policy rates by one quarter of one percent or ‘twenty-five basis points’, where each ‘basis point’ is one one-hundredth of one percent. I am using a lot of quotation marks because few people outside of the finance community know any of these terms – and that is precisely the point. These are small changes in short-term interest rates that have subtle and complex impact on economic performance over time. Moreover, the net effects of these changes on real people are hard to untangle.
Of course everyone knows that borrowers benefit from lower interest rates and creditors benefit from higher interest rates. They also know that a fall in interest rates can lower your monthly mortgage payment and a rise in interests can pull it back up again. But in a complex economy, most people are creditors and well as debtors because they have pensions (or college funds, etc.) as well as mortgages. Hence, the effect of any monetary policy change should be considered in the broader context of how interest rate movements influence prices and employment (not to mention exchange rates or pension performance) before dividing up the population into winners and losers.
Under normal conditions, who wins and who loses from a shift in monetary policy is ambiguous. People may worry about whether interest rates are going up or down, just like they worry about whether the economy is doing better or worse, but knowing the precise details (or mechanisms or jargon) is not going to provide much reassurance.
This ambiguity insulates central bankers from day-to-day politics. So long as most people do not know whether they are winning or losing from the various interest-rate adjustments, they are likely to grant central bankers autonomy in making policy decisions. They may insist that politicians provide some periodic oversight on the broad outlines of central banking practice, but they are going to be more interested in long-term economic performance than in the precise conduct of central banking.
The ambiguity about the short-term effects of monetary policy dissipates when economic conditions become more challenging. People are quick to figure out who wins and who loses from large fluctuations in short-term interest rates. The economy is no less complex in such conditions but the priorities for individuals become clearer: You are less likely to worry about your future pension pay-out when you cannot meet your monthly mortgage payment. This is not an immediate threat to the insulation around central bankers, particularly when people recognize that something must be done now to make things better – a realization that the Polish economist and central banker Leszek Balcerowicz described as ‘extraordinary politics’ – but any patience with short-term losses for long-term gains is likely to be short-lived.
There is little ambiguity about who wins and who loses when central bankers have to turn to ‘unconventional’ monetary policy actions like very low or even negative interest rates (which are essentially taxes on savings) or large asset purchasing programs (called ‘quantitative easing’ in Britain and the United States). The short term effects of such policies are easy to characterize because of the effect they have on the return to savings and on asset prices. Savers lose and existing asset-holders benefit – as does anyone who can make money by borrowing money and then taking on risk. This clarity fosters almost immediate controversy among those who see themselves as the ‘losers’. You just have to look at the pages of the Frankfurter Allgemeine Zeitung to see what I mean.
The fact that losers from unconventional monetary policy actions are complaining is not politically fatal for central bankers. Very low interest rates and large asset purchasing programs are controversial but they are better than the alternative of doing nothing, particularly in the short-term. Over the longer-term, however, unconventional monetary policies raise big questions about long-term consequences for ever broader groups of society – such as how to save for a pension without the benefit of compound interest or what will happen when central banks try to sell the assets they purchased back onto the markets (or when they allow those assets to mature without rolling over the credit to the governments that issued the bonds in the first place).
If we add the short- and longer term effects together, we end up in a situation very different from what central bankers would regard as ‘normal’. Normal central banking has ambiguous effects in the short term while promising greater stability and predictability in the longer term. The kind of central banking we have seen during the crisis does exactly the opposite: it offers clear short term effects but creates uncertainty about the future. This reverse formula invites controversy because the losers from unconventional monetary policy actions know who they are and why they are suffering; it also ensures that this controversy will strengthen over time because just about anyone can be convinced to worry about an uncertain future.
Central bankers know that they are under the spotlight and they also know that their political independence is under increasing scrutiny. Witness, for example, European Central Bank (ECB) executive board member Peter Praet’s recent speech on the impact of unconventional monetary policy on the insurance industry. Such knowledge is not enough to convince them to do harm through their economic policy choices but it does strengthen the urge to move beyond these extraordinary circumstances. If they could reset the policy framework to something that is more ‘normal’, they could strengthen their control over economic performance while reinforcing the ambiguity that insulates them from day-to-day politics.
That political dynamic creates an incentive for central bankers to act sooner rather than later to move away from unconventional monetary policies. The danger is that they may act sooner than economic conditions will warrant. The ECB has done this twice already, with premature interest rate rises in July 2008 and April and July 2011. The question now is whether the U.S. Federal Reserve and the Bank of England will follow the same pattern. The economic arguments are finely balanced; the politics point in only one direction.Follow @Erik_Jones_SAIS