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A wake-up call to the US Federal Reserve from Caruana – Part 1

Monetary policy | A wake-up call to the US Federal Reserve from Caruana – Part 1 Anthony Harrington

In a speech given at the South African Reserve Bank on July 1 2011, Jaime Caruana, the general manager of the Bank of International Settlements, and a central banker’s central banker if ever there was one, itemized the problems with the current approach to fiscal stimulus as a counter to deflationary pressures.

While Caruana did not name names, there can be little doubt that the US Federal Reserve was uppermost in his thoughts as he lectured his audience on what not to do in a post-recession world.


Caruana pointed to four things that central banks should do when confronted with a financial bust. (1) They need to look at things in the round when formulating policy, which means extending policy horizons out beyond the normal two years; (2) they need to find a balanced response to a fiscal crisis, which means not keeping rates artificially low indefinitely; (3) monetary policy needs “to take into account spillover effects across currency areas"; and (4) central banks need to ensure that they remain independent.

Items two and three on this list are almost the mirror reverse of what the Fed has been doing. Here is the actual quote on the “balanced response” theme:

"… the monetary policy responses to financial busts should be more balanced. The currently-prevailing view, which prescribes very aggressive and prolonged monetary easing, underestimates the resulting collateral damage."

What he is getting at is that if a central bank, such as the Fed, engineers a boom as its response to a bust, which is exactly what the Fed did in response to the crash, then it runs the risk that the boom will “raise output growth beyond sustainable rates while masking sectoral distortions and growing vulnerabilities” (which I take to be code for the sub-prime mortgage fiasco, a “sectoral distortion” if ever there was one).

Caruana takes a kind of Austrian position which calls for the malinvestments made through the boom to be allowed to be liquidated so that the system can right itself: “After the bubble bursts, the necessary adjustments can be smoothed, but should not be hindered”, he warns. When a central bank, i.e. the Fed, decides to keep policy rates persistently low, and couples this with generous funding provision, financial institutions involved in the bust feel much less pain and their incentive to adjust diminishes. As he puts it, the actions taken by the central bank “may allow loss recognition and debt repayment to be postponed” or “may encourage renewed risk-taking by removing a source of external discipline.” And worst of all, plenty of cheap money is an excellent way of restarting the hunt for yield, since the risk-free yield is zero or negative. What Caruana wants is for central banks to go ahead and loosen monetary policy aggressively after a crash, just as they did, but then to be prepared to tighten much more aggressively once the immediate impact of the crash has passed. Letting interest rates stay abnormally low is not good monetary policy and leads to distortions, he warns.

Knock-on effect

On point (3), what Caruana actually says is that “in a highly integrated world, purely domestically-oriented policy approaches are bound to be inadequate.” Policy makers need to take a more mature view of things and to get their heads up and look at the impact of their policies outside their own borders. The collective behaviour of nations is a key determinant of the health of the global economy and having the Fed weaken the dollar has huge implications around the world.

In the run-up to the 2008 global crash, one of the biggest distortion mechanisms was the fact that record global growth was accompanied in the core developed markets by what he calls “unusually accommodative global monetary policy” – a reference to the US Fed’s decision to keep rates abnormally low long after the crash had faded into history. This “arguably amplified the global credit and asset price boom, magnifying and extending the damage of the subsequent bust.”

Worse, emerging market central banks in their turn are proving reluctant to risk knocking back strong growth in their own economies by raising rates sufficiently to restore price stability, repeating the Fed’s mistakes in their own countries (Caruana is more diplomatic in his language, but that is the import).

In Part Two (published later today) we look at Caruana’s comments on the relationship between central bank policies and global commodity prices, and his thoughts on central bank independence.

Further reading on central banks, monetary policy and the US Federal Reserve:

Tags: Bank of International Settlements , BIS , Caruana , central banker , central bankers , central banking , central banks , deflation , crash , economic governance , economic policy , financial bust , financial policy , global economy , global financial crisis , global monetary policy , global recession , Jaime Caruana , monetary easing , monetary policy , South African Reserve Bank , US economy , US Fed , US Federal Reserve , US government
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