The writer is the author of ‘The Price of Time: The Real Story of Interest’
A great experiment in monetary policy is drawing to a close. Last week, the European Central Bank announced its largest rate hike in two decades, taking its benchmark rate back to just zero per cent. Never before, over the course of some 5,000 years of lending, have interest rates sunk so low. Those who rue the consequences of easy money are quick to blame central bankers. But the problem originates with the strict inflation mandates they are required to follow.
In 1990, the Reserve Bank of New Zealand became the first central bank to adopt a formal target. In 1997 a newly independent Bank of England was also given a target, as was the ECB when it opened for business a year later. After the global financial crisis, both the Federal Reserve and Bank of Japan jumped on board. What BOJ governor Haruhiko Kuroda called the “global standard” — an inflation target in the range of 2 per cent — performed several functions: providing central banks with a clearly defined benchmark, anchoring inflation expectations and relieving politicians of responsibility for monetary policy.
The trouble is that whenever an institution is guided by a specific target, critical judgment tends to be suspended. As the late political scientist Donald Campbell wrote, “the more any quantitative social indicator is used for social decision-making”, the higher the risk it will distort and corrupt the processes involved. This problem is well known in monetary policymaking circles. In the 1970s Charles Goodhart of the London School of Economics noted that whenever the BoE targeted a specific measure of the money supply, this measure’s earlier relationship to inflation broke down. Goodhart’s Law states that any measure used for control is unreliable.
Inflation-targeting runs true to form. Thanks in large measure to globalisation and technological advances, inflationary pressures abated in the 1990s, allowing central bankers to lower interest rates. After the dotcom bust at the turn of the century, fears of deflation induced the Federal Reserve to set its Fed funds rate at a postwar low of 1 per cent. A global credit boom followed. The ensuing bust unleashed even stronger deflationary pressures. The Fed proceeded to cut its policy rate to zero. In Europe and Japan, rates turned negative for the first time in history.
Throughout the following decade, central bankers justified their actions by reference to their inflation targets. Yet these targets produced a number of corruptions and distortions. Ultra-low interest rates pushed the US stock market to near record valuations and provided the impetus for the “everything bubble” in a wide variety of assets ranging from cryptocurrencies to vintage cars. Forced to “chase yield”, investors assumed more risk. The fall in long-term rates hurt savings and triggered a massive increase in pension deficits. Easy money kept zombie businesses afloat and swamped Silicon Valley with blind capital. Companies and governments availed themselves of cheap credit to take on more debt.
Most economists assume that interest rates simply reflect what’s going on in what they call the “real economy”. But, as Claudio Borio at the Bank for International Settlements argues, the cost of borrowing both reflects and, in turn, influences economic activity. In Borio’s view, the era of ultra-low interest rates pushed the global economy far from equilibrium. As he puts it, low rates begot even lower rates.
During the pandemic central bankers were still striving to meet their inflation targets when they lowered interest rates and printed trillions of dollars, much of which was used by their governments to meet the extraordinary costs of lockdowns. Now, inflation is back and central banks are scrambling to regain control without crashing the economy or inducing yet another financial crisis. The fact that policy rates trail far below inflation, on both sides of the Atlantic, suggests that monetary policymakers are no longer blindly following their inflation targets to the exclusion of all other considerations.
This is welcome. But elected politicians cannot continue to shirk responsibility. They need to reconsider central banks’ mandates, taking into account the impact of monetary policy not just on near-term inflation, but on asset valuations (especially real estate), leverage, financial stability and investment. The experiment with zero and negative rates has done considerable harm. It must never be repeated. As Mervyn King, the former BoE governor, says: “We have not targeted those things which we ought to have targeted and we have targeted those things which we ought not to have targeted, and there is no health in the economy.”