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Central banks are stuck in a ‘hall of mirrors’


Drug companies have patent portfolios, great power navies have aircraft carriers and central banks have their “canonical” econometric models.

Burnished and tweaked over the decades, the canonical models (all rather similar to one another) are proof, not least to the central bankers themselves, that their decisions are based on a coherent philosophy.

The profession does not want to appear driven by whim, a desire for momentary popularity or micro political scheming among the central bank’s board members. It wants to be seen to encourage productive investment and equitable economic growth, not speculation.

Two decades ago there was a general belief that in the event of a financial crash or economic emergency, central banks would act in an apolitical and disinterested manner to keep the system functioning. In the post-bailout world, worsening social inequalities, a scandal over trading by top Federal Reserve officials, and the politicisation of high-level appointments have all weakened the public consensus.

Now, there is a lot more cynicism. There is also a deep suspicion that all the post-crash bailouts and “unconventional measures” have done is make the rich richer. Central banks have acquired a lot of financial assets, but are losing the public’s trust.

When badgered and challenged by politicians or journalists, the central bankers retreat to reciting what the canonical models tell them. The professed goal of the models is to indicate what short-term interest rates, asset purchase programmes, or “guidance” through public statements are necessary for the economy to reach the elusive “R-star” interest rate.

R-star is the real short-term interest rate consistent with full employment and a stable inflation rate in the long run. In policy terms, that is the central banker’s nirvana.

Not that R-star is supposed to be fixed or stable over long periods of time. The stable interest rate should rise if technological developments or education levels improve quickly enough so that the economy’s potential growth rate increases. Or, if productivity falls due to a plague or ageing population, R-star will be lowered.

The central bankers’ task would be much simpler if the R-star at any moment were readily observable, say on a page on a Bloomberg screen. Those rates could just be plucked and entered into input fields for the canonical models. Presto: policy.

But no. R-star, the key rate, the lodestone for central bank policy, is unobservable, and can only be estimated by the economists making an informed guess on what it should be, in the absence of direct empirical information.

The guesses have become rather depressing over the decades. R-star has fallen by more than 5 percentage points in advanced economies since the 1980s. And since the financial crisis of 2008, R-stars throughout the developed world have converged to a very low level, as if waiting for an economic recovery that never comes.

Are the central banks signalling to the private sector that little growth is possible, and is that depressing and misleading conviction reflected back to the central bankers themselves?

Yes, according to Phurichai Rungcharoenkitkul, a staff economist at the Bank for International Settlements in Basel. In a paper he co-authored with Fabian Winkler of the Federal Reserve Board, the two find central banks and the private sector “end up misperceiving the macroeconomic effects of their own actions as genuine information. They are staring into a hall of mirrors.”

Rungcharoenkitkul and Winkler tweak the standard policy model to prove that, in recent years, “with the hall-of-mirrors effect operating, an aggressive policy strategy may be less effective in reviving spending, and worse could even exacerbate the very problem policymakers are trying to solve”.

In other words, by staring at the reflections of their own policies of the recent past, the central banks have kept official rates too low for too long, and their communication of their expectations has depressed long-term saving and investment in the private sector.

Unproductive activity was unintentionally encouraged. Setting low rates for too long led to overpriced housing, too little class or labour mobility and the growth of leveraged speculation.

We have been asking central banks to take on too much of the responsibility for economic recoveries. And we have mistakenly expected them to be all-knowing, even as they look to the private sector to provide essential cues.

Consequently, central banks’ “signals” and “communications” arguably have caused confusion and excessive long-term economic pessimism. And as the BIS reports says, “these consequences are more severe the more the private sector and the central bank overestimate each other’s knowledge of the economy”.

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