Stephen King: A crisis of faith among central bankers
Stephen King: A crisis of faith among central bankers
Published: 18 June 2007 http://news.independent.co.uk/business/comment/article2670015.ece
I'll begin with a statement of the bleeding obvious. There are lots of things we simply don't know. Those, in turn, can be split into the known unknowns and the unknown unknowns, to use the terminology famously employed by Donald Rumsfeld. Although he was ridiculed for his apparently unusual take on epistemology, his comments were, philosophically, perfectly sensible. Perhaps, though, the context was wrong. He seemed to be using a general point about epistemological uncertainties to provide a specific excuse about policy failure in Iraq.
This raises a more practical issue. To what extent should our leaders admit to their all-too-human frailties? Should they show humility or be resolute in their actions? Should they wear their doubts on their sleeves or, instead, stride confidently forward, heroically brushing aside the countless objections about a given course of action while reading the collected works of Friedrich Nietzsche?
Those who admit to their uncertainties are all too often given a bit of a hard time. You may recall the furore in the 1980s over the then Bishop of Durham's doubts about the virgin birth and his - so it seems - misquoted comments about the resurrection being not much more than a conjuring trick with bones. I'm sure there are plenty of ecclesiastically minded people who, like the Right Rev David Jenkins, doubt the literal truth of the Gospels, but whether they're wise to air their doubts in public is another thing altogether. People in power have a job to do. They have to lead by example, dispelling the manifest uncertainties that infect all walks of life.
So it is with central bankers. Central bankers have to meet the objectives given to them by their political leaders and, these days, those objectives typically amount to the deliverance of price stability. What happens, though, if central bankers start to have doubts? What if they question the wisdom of their inflation-targeting objective? What if they are no longer sure of how to hit their objective? Should they, like the Bishop of Durham, tell the wider world or, instead, should they keep their doubts under wraps, to be discussed with only their closest and most trusted colleagues?
I raise these questions because, within the central banking community, there appears to be some sort of crisis of faith, a crisis that has been reflected in financial market developments in recent weeks. Of course, knowing that bond yields have spiked up says little about the underlying causes. Among the explanations doing the rounds have been Chinese foreign exchange reserve diversification and the greater-than-expected buoyancy of the global economy. The really big worry, though, is the possibility that inflation has returned. If so, either we're about to see bigger price increases or, instead, we're going to have to tolerate higher interest rates to prevent those price increases from coming through. Either way, central banks have got their work cut out.
Why, though, should a suspected build-up of inflationary pressures lead to a crisis of faith? The crisis reflects three separate sources of central bank tension: disagreement, dilution and doubt.
Imagine a world with a single central bank. There would be one objective - global price stability - and one instrument - the global short-term interest rate. Now switch back to the real world: lots of central banks, all of whom have their own separate concerns and views of how the world behaves. Disagreements become the norm.
At the end of last week, markets breathed a sign of relief because the monthly increase in the US consumer price index, excluding the volatile food and energy components, was only 0.1 per cent, pulling the annual rate down towards 2 per cent. From the Federal Reserve's point of view, that's good news because Ben Bernanke and his colleagues like to focus on this "core" measure of inflation. Imagine, though, that the Bank of England was in charge of US monetary policy. The Monetary Policy Committee would focus on the 0.7 per cent monthly increase in the headline consumer price index, which pushed the annual inflation rate up towards 3 per cent, and conclude that inflation was a bit too high. Who's right? A lot depends on the degree to which central banks should take into account "global" inflationary pressures that lie outside their direct control.
Alternatively, think about money supply. The Federal Reserve argues that money supply these days is unimportant because it's so heavily distorted through offshore holdings and the shift away from bank lending towards securitisation. For the European Central Bank and the Bank of England, however, money supply growth is a potential early warning sign of inflationary dangers ahead. Again, who's right? I think the Europeans have got a point, but the dispute reveals a schism in central bank thinking. There may be no nailing of 95 Theses on the Wittenberg church door, but the differences of view threaten disagreements on action.
Dilution comes from the breakdown in linkages between monetary policy and monetary conditions. This, if you like, is an issue of control. Economists often give the impression that a given change in policy rates will have a precise impact on the economy - a bit like shifting the thermostat on your central heating system. Suppose, though, you then discover that only some of the radiators in your house are connected to the boiler and that some malevolent force - perhaps one of your children - keeps opening the doors and windows. Under those circumstances, your chances of reaching the desired ambient temperature are rather low. The same applies to central banks. Their efforts are diluted because other central banks are pulling in different directions.
And, then, finally, there's doubt. Mervyn King, the Governor of the Bank of England, is in danger of becoming a monetary equivalent of the Bishop of Durham. Last week, Mr King gave a speech to the Welsh CBI in which he admitted "our job ... is rather like taking part in a spot-the-ball competition". For the Bank of England, the missing ball is the outlook for inflation and the message seems to be that, like any spot-the-ball competition, the whereabouts of the missing inflationary ball is anybody's guess. Admittedly, some may be more skilled than others in assessing the outlook for inflation but the comparison does not inspire confidence.
In truth, the Governor's comments were made with tongue firmly lodged in cheek, and no doubt he was trying to make inflation targeting sound a bit more interesting than it really is, but his expression of doubt serves to emphasise that central bankers will, from time to time, get things wrong.
But do we want our central bankers to admit this? Of course they'll get things wrong. Of course they'll face challenging times. But it sometimes helps to preserve an aura of invincibility. Why, for example, was the Bundesbank so successful over so many years? How did Messrs Pöhl, Schlesinger and Tietmeyer pull off the German price stability trick from one year to the next? Was it control of the money supply, or independence from government interference, or success with the inflation equivalent of spot the ball? I suspect it was none of these. Instead, their pseudo-religious tones encouraged the German public to keep their faith in price stability. A delusion perhaps, but a jolly useful one nonetheless. Without it, disagreement, dilution and doubt threaten to upset the economic stability we've come to expect over the last few years.
Stephen King is managing director of economics at HSBC