The new crisis of central banking

By Mario I.Blejer and Piroska Nagy-Mohacsi 

LONDON — As veterans of past inflation battles know, central bankers must never lower their guard, because the monster is always there, stubbornly waiting for an opening. If central bankers ever think that they have finally prevailed over the problem — that they have a full understanding of all the factors underlying it — they will learn the hard way about inflation’s ability to reinvent itself. Too often, inflation finds allies, like the COVID-19 pandemic that facilitate its return and confuse policymakers with complicated trade-offs.

That is why the credo of central banking is: Never belittle the inflation risk. To combat it, you must not only be decisive in response to changing circumstances; you also must be well ahead of the game. As Mohamed A. El-Erian of Queens’ College, Cambridge, rightly stresses, if you are saving your best options for a better day, you may already be behind. You cannot postpone a fight against inflation, because the problem is highly visible and creates contagious expectations that can quickly become entrenched. Hesitate and you run the risk of losing credibility, which will invariably make the fight longer and much costlier to wage.

Gradualism simply is not an option. If you have experienced high inflation, as one of us (Blejer) did as the president of the Central Bank of Argentina, you know that early inflationary symptoms cannot be ignored or dealt with later. The longer it takes to address the root cause (or causes) of inflation, the longer and more difficult the struggle becomes.

Central banking in the time of COVID

With this lesson in mind, consider the economic strategy adopted by larger developed countries in response to the pandemic. All deployed a scaled-up version of the ultra-expansionary policies used to combat the 2008-09 financial crisis, but with the addition of a huge fiscal component. This approach generally succeeded in preventing a major economic collapse worldwide and in facilitating recovery.

Emerging markets also were able to mount a robust countercyclical response over the course of 2020-21 (many for the first time in their recent economic histories). They could do so because of the positive spillovers from expansionary policies in advanced economies, and because of the availability of currency swaps from major central banks, especially the US Federal Reserve (Fed) and the European Central Bank (ECB). Although emerging-market governments’ more limited fiscal space and credibility meant that these policy responses were naturally smaller, they significantly mitigated the economic damage from the pandemic.

But as the recovery got under way, most advanced-economy central banks appear to have read inflation wrong. With inflation muted for so long before the pandemic, policymakers were confident that upward pressure on price would be transitory, arising solely from pandemic-related disruptions. These issues would be resolved and fade away, and did not justify jeopardising the recovery by reining in the monetary and fiscal expansions. But as the inflation figures continued to break decades-long records, central banks finally were forced to shift to the more aggressive path that they had rejected just a few months earlier.

Acknowledging the magnitude and the speed of the recent inflationary surge, on January 26 the Fed signalled that it will wind down its asset purchases (so-called quantitative easing, or QE) and prepare for interest-rate hikes as soon as March. Having changed its policy stance, the Fed will manage to regain control over the situation eventually. But it and other major central banks have already lost some credibility, owing to their failure to anticipate inflation and their lack of determination to contain it early on.

Confidence won and lost

Making matters worse, evidence from the aftermath of the 2008-09 crisis shows that exiting QE will be politically difficult. The Fed, like other major central banks, needs to restore public confidence and to do that, it must take bold, decisive and immediate action, even overshooting its targets if it comes to that. If it responds with more gradualism, it could end up even further behind the curve, implying the need for an even sharper correction in the future. That would strike another, even greater blow to its credibility.

The Fed must continue to control inflation, support the recovery, and deal with an immense and unheard-of macroeconomic disequilibrium. To do this, it must produce a specific programme to normalise its monetary policies. A credible programme will need to be tough but realistic. Given the uncertainties of inflation, the Fed should ignore those who are calling for it to set concrete, time-bound quantitative objectives, such as a precise number of interest-rates hikes. At the same time, it must stop its monthly asset purchases immediately.

Moreover, the Fed now must acknowledge that its new monetary framework of “average inflation targeting” — which allows for a degree of above-target inflation after a period of below-target inflation — has failed its first major test. The above-target price growth experienced in 2021 appears to have de-anchored inflation expectations.

Equally important, monetary tightening will require supportive fiscal policies to limit the costs to the real economy. Expansionary fiscal and quasi-fiscal policies should be scaled back, and non-crisis-related policy priorities will need to be pursued through more sustainable budgetary channels. Hard political trade-offs will come back into play. If fiscal policies remain expansionary to deal with deep-seated but non-crisis-related issues, central banks will have to tighten monetary policy even more sharply to curb inflation and scale back inflation expectations.

Unlike major advanced economies, most emerging markets spotted the risk of rising inflation earlier, owing to their longer memories of price volatility. Many started to raise interest rates and abandon their (more modest) asset purchases in the summer of 2021. Yet, as in the past, the mere prospect of policy tightening in advanced economies created negative spillover effects. Capital inflows are coming to a halt, and exchange rates are under growing pressure, even in the “well-behaved” emerging markets.

The Fed and the ECB could help to limit volatility in foreign-exchange markets by keeping their highly effective currency swaps in place (with policy oversight, if needed, from the International Monetary Fund or the Bank for International Settlements).

Nonetheless, the situation presents a daunting challenge. The extraordinary expansion of monetary and fiscal policies has been instrumental in averting deep worldwide recession, but it has also created the largest-ever peacetime imbalances. These include massive fiscal deficits, higher public and private debt burdens and enormous expansions of central banks’ balance sheets (the Fed alone almost tripled its holdings).These indicators, along with those arising from operations designed to facilitate market liquidity, will make it more difficult to implement interest-rate changes. And central banks’ limited room for maneuver is not even the most important additional cost of the pandemic policy response.

Moral hazard run amok

For the past few decades, central banks have been at the vanguard of a successful campaign to ward off recessions. But even when effective, such efforts frequently involve new and untested instruments with unwanted side effects and hidden costs, some of which could be significant and long-lasting. One well-known casualty is lost productivity, a problem that has probably recurred in the current crisis, as large-scale asset purchases and government subsidies and guarantees propped up companies that otherwise would have failed.

But an even bigger issue is the major central banks’ commitment to do “whatever it takes” to support markets, a popular stance after the 2008 crisis that was put on steroids during the pandemic. And an unintended (though not unforeseeable) consequence of this approach was to create rampant moral hazard — and thus encourage increased risk-taking — throughout the global economic system.

Global-level risks today are historically high, and they stem largely from macro policies that continue to flood markets with liquidity, inflating bubbles and driving up the valuations of securities and of other real and financial assets, including cryptocurrencies. Notwithstanding recent equity-market fluctuations — which reflect investors’ expectations of more rapid policy tightening by the Fed — portfolios everywhere seem to be overweighted with riskier assets, leaving the entire global financial structure more exposed to systemic accidents and sharp adjustments.

Only moral hazard can explain investors’ baffling behavior as they shift their allocations towards risky assets without being compensated by greater expected returns. Ultra-low interest rates and more than a decade of QE have delinked the normal trade-off between risk and rewards. Investors no longer anticipate bearing all the risk that they are taking, and many are ignoring risk altogether, because they are counting on policymakers to safeguard the price of their holdings forever. In other words, they believe that there is a trustable “Fed put” on asset markets.

When moral hazard becomes so widespread, magical thinking inevitably follows, because market participants no longer believe that they are responsible for their commitments, or that calculated risks are genuine. This general mood not only distorts the trade-offs between risks and returns, but also prevents major markets from providing the right signals to investors and government decision-makers. If left unchecked, moral hazard will inflict high social costs through long-run efficiency losses, misallocated investment and higher systemic risk (and thus vulnerability to crises).

While markets have assumed more risk, so, too, has the Fed’s balance sheet. In 2020, when the Fed took the unprecedented step of buying low-rated bonds and exchange-traded funds of junk debt, markets naturally celebrated. The message was as clear as it was astonishing: The market will be rescued again, no matter what. Worse, the primary beneficiaries of the Fed’s junk-bond purchases are not forward-looking value-driven investors but over-leveraged private investment groups and financially unstable borrowers. Worryingly, previously cautious institutional investors such as pension funds have gotten in on the action.

The Fed has also taken on more risk in other ways, such as by purchasing the bonds of struggling enterprises. In other words, the Fed’s balance sheet could complicate the corporate debt-restructuring process and introduce a political dynamic to bankruptcy procedures.

Elsewhere, too, central banks have gone from being the “lender of last resort”, backstopping the financial system, to being the “market maker of last resort” — and on an unprecedented scale. This is reflected in their vastly different operations today.

A pandemic of risk

Others have followed central banks’ lead. At all levels of government in the United States and Europe, a wide range of additional measures have also created moral hazard. The highest incidence is probably in financial markets, where there are many signs of increasing fragility and distorted incentives. Such incentives are clearly at work in credit card markets, state-federal financial relations, commercial and residential construction and housing, sovereign debt, student loans and moratoria on mortgage and rent payments.

Many commentators argue that moral hazard is not a relevant concept when it comes to government interventions in response to crises. In a life-threatening pandemic, everything should be subordinated to the fight against the virus. During periods of high uncertainty, when the normal flow of finance is disrupted, government intervention is warranted, within limits, to prevent paralysis. According to this view, the moral hazard associated with “whatever it takes” should be regarded as a lesser nuisance — something to deal with later.

In September 2007, for example, Lawrence Summers (then an economist at Harvard University) argued that in formulating a response to a crisis, “moral hazard fundamentalism” should not come at the expense of confidence building. In extreme situations, governments must complete the market and provide a minimum level of assurance to potential investors and households.

We do not question the validity of massive government and central bank interventions to save the system during an acute crisis. Our point is that this has come at an underappreciated price: A massive build-up of moral hazard. What is critical now is that crisis-response policies must not be allowed to perpetuate the problem after the crisis has passed (as we believe they have). It is in the post-crisis phase that the costs of moral hazard start to balloon, as expectations of bailouts — even in normal times — become entrenched.

One could argue that these are political judgments that should reflect people’s choices and preferences. But those choices should be made with full knowledge of the potentially high costs that will inevitably be paid in the form of lower efficiency, foregone future growth and reduced policy space for handling future crises.

Central banking itself is now in crisis. The Fed has bruised its credibility with a miscall on inflation, and it is still sitting on a massive balance sheet in a risky, bubble-ridden market largely of its own making. It will have to overdo its tapering to regain confidence. And even then, it will remain to be seen if fiscal policymakers will support it in the process.

Under these circumstances, moral hazard may seem like an abstract, inconsequential issue. In fact, it has become the central problem. The effects of perverse incentives on long-term growth and development patterns could be immense. Like the specter of inflation, they must never be ignored or underestimated.

Mario I. Blejer, a former president of the Central Bank of Argentina, is a former director of the Centre for Central Banking Studies at the Bank of England. Piroska Nagy-Mohacsi is visiting professor in Practice at the London School of Economics and Political Science. Copyright: Project Syndicate, 2021. 

www.project-syndicate.org