Central banks are at their best when they have a correct and clear vision of economic developments and prospects, as well as the tools to deliver good outcomes, whether they are acting alone or with other policy makers. The congressional testimony delivered by Fed Chair Janet Yellen last week suggests that these qualities may currently elude the U.S. central bank. Worse, the policy challenges facing Fed officials pale in comparison with those of their colleagues in Europe.
For the Bank of England and the European Central Bank, significant structural uncertainties have suddenly been added to the complications presented by fluid economies and peculiar financial conditions. This unusual combination undermines the effectiveness of central banks and, as the experience of the Bank of Japan proves, could get them closer to the line that separates effective measures from ineffective or even counterproductive ones.
In her semi-annual testimony on monetary policy, Yellen stressed that the U.S. economy must contend with “considerable uncertainty.” The reasons are both domestic and international, and aren't limited to short-term surprises such as the Brexit referendum and the disappointing U.S. jobs report for May. She also pointed to structural issues including sluggish productivity growth and business investment.
Similar forces are at play in Europe, and to a much greater degree. The structural headwinds have been amplified in the last week by genuine uncertainties in the aftermath of the Brexit referendum -- specifically, the unclear future of the economic and financial relationships between the European Union, the world’s largest economic area, and Britain, the fifth-biggest economy.
This state of affairs has made it enormously difficult for central banks (and others) to come up with an economic vision that commands sufficient conviction and foundation, leaving their policy approach without a solid secular anchoring. As a result, these institutions inevitably become more “data dependent,” which, in turn, adds to their communication challenges. The resulting fluctuations in their market signals expose the central banks to accusations of damaging inconsistency.
This is occurring at a particularly challenging time for global central banking. As I detailed in “The Only Game in Town,” central banks have taken on unprecedented policy responsibilities in recent years. This wasn't done by choice but by necessity, as other national economic policy-making institutions have been sidelined by political polarization. Repeatedly, and excessively, the banks have felt compelled to venture deeper in uncharted policy terrain, using a range of unconventional -- and untested -- measures to buttress economic growth and avoid disruptive deflation.
In the aftermath of Brexit, we should expect the BOE and the ECB to be under pressure to do even more. They will loosen monetary policy further, including through lower interest rates for the BOE, more quantitative easing for the ECB as well as pro-market forward guidance from both. Their objective will be to counter a post-referendum slowdown in economic activity, particularly business investment, and a higher risk of recession.
In the short term, the additional measures would be reflected in financial markets through more liquidity support for equities and in depreciation pressures on the pound and the euro. However, the impact on the real economy, the intended ultimate beneficiary of this additional policy activism, would be much more limited. The reason is understandable: There isn’t much that either central bank can do to compensate for the structural uncertainties associated with the outcome of the referendum. Moreover, their attempts at action will be neither cost-nor risk-free.
Without the additional support of politicians for a a more comprehensive policy approach -- one that deals with exhausted engines of genuine growth (as opposed to relying on the artificial stimulus from added liquidity), deficient aggregate demand, overhangs of excessive indebtedness and incomplete regional and global policy architectures -- the additional monetary policy activism would take the central banks, and particularly the ECB, closer to the point of policy ineffectiveness. That could risk repeating the unfortunate experience of the Bank of Japan, which has already gotten very close to -- and perhaps even crossed -- the threshold between being not just ineffective but counterproductive.
In a better political context, the U.K. vote -- particularly the message it sends about the loss of trust in the political and business elites, along with “expert opinion" – would be the catalyst for the comprehensive policy response that the world economy needs, and that policy makers have the technical ability -- though not the political enablers -- to provide. Regrettably, national politics continue to hinder such a response and global policy coordination remains inadequate, so central banks may instead be forced to try to do even more with already stretched and almost exhausted tools that are ill-equipped for the task at hand. In the process, global central banks, which have been the only part of the policy apparatus able and willing to respond, would risk taking an unfortunate step closer to ineffectiveness.