The Illusion of Control


Exit Strategies and the New Normal

Now comes the ECB testing the water for a possible rate rise, and at the same time the Fed testing the water for a possible stand pat. The interesting thing is that both justify their policy with exactly the same argument—they are both trying to influence long run inflation expectations.

The ECB wants to raise rates in order to send the message that it is prepared to be tough on inflation. Rising commodity prices are seen as a harbinger of future inflation, so it is important to send a contrasting policy message now, as a harbinger of a different future.

Meanwhile, the Fed wants to stand pat in order to send the message that it also is prepared to be tough on inflation. Rising commodity prices are seen as a temporary blip, while the five year ahead break-even inflation rate is seen as a signal that long-run inflation expectations are on track. So it is important to send the reassuring policy message now that policymakers, like the market, are looking through the immediate noise to longer term fundamentals.

Time was, long-run price stability meant defending short-run gold parity, and discount rate changes were seen as operating not on inflation expectations but rather on actual gold flows. If you were losing reserves, then you had to be ready to get them back, either from the market or from the foreign central banks to which the reserves were flowing. Raising the discount rate operated by raising the cost of delaying settlement, so those who could pay today would pay today.

In the years before our own Crisis, so-called “inflation targeting” was all the rage, the idea being that central banks would each direct their efforts toward long run domestic price inflation. If inflation expectations were stabilized, then so too would be exchange rates, at least in the long run since it is in the long run that purchasing power parity holds. The exchange rate, the trading ratio of dollars for euros, should be kept in line by the trading ratio of dollar goods for euro goods.

The whole point of the pre-Crisis consensus was that, under the cover of this long-run expectational stability, individual central banks would have room to maneuver in response to their different short-run circumstances. Policy interest rates could be different, exchange rates could move away from long-run inflation targets, and these price changes would facilitate adjustment to different shocks.

That pre-Crisis consensus is what is actually being tested here. The idea is to maintain long-run expectational stability even while short-run policies push in different directions.

What we are testing, to put it more provocatively, is whether the Crisis is over and, even more, whether the new post-Crisis normal is the same as the old pre-Crisis normal. Personally, I doubt it, and I suspect that a lot of policymakers doubt it also. Perhaps that is why they are just testing waters, not jumping in.

Time was, central bankers thought that discount rate policy was all the control they needed. The Depression shattered that illusion for a generation, only to see it re-emerge in different dress during the Great Moderation.

The Global Financial Crisis has, I think, shattered the illusion of control for the present generation, but without yet giving rise to a believable alternative. Central banks can, as the Crisis has shown, put a floor on financial collapse, but only insofar as they are willing to catch the falling structure on their own balance sheets. It remains to be seen if central banks have the tools to ward off the last resort before it happens; the short term policy interest rate looks once again like offering much less control than is likely to be needed.

We are living in historic times.

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