Drug corporations have patent portfolios, big power navies have aircraft carriers and central banks have their “canonical” econometric models.
Burnished and altered throughout the decades, the canonical models (all very similar to one another) provide proof, not least to the central bankers themselves, that their judgments are based on a cohesive ideology.
The profession does not want to appear motivated by whim, a desire for ephemeral popularity or petty political manoeuvring among the central bank’s board members. It wants to be seen to foster productive investment and equitable economic progress, not speculation.
Two decades ago there was a broad notion that in the case of a financial catastrophe or economic crises, central banks would operate in an apolitical and disinterested manner to keep the system working. In the post-bailout environment, rising social inequities, a controversy over trading by top Federal Reserve officials, and the politicization of high-level appointments have all damaged the public consensus.
Now, there is a lot more cynicism. There is also a profound perception that all the post-crash bailouts and “unconventional measures” have done is make the rich richer. Central banks have gained a lot of financial assets, but are losing the public’s faith.
When badgered and challenged by politicians or media, the central bankers revert to reciting what the canonical models tell them. The declared goal of the models is to show what short-term interest rates, asset purchase programmes, or “guidance” through public pronouncements 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 words, that is the central banker’s utopia.
Not that R-star is expected to be fixed or steady over long periods of time. The steady interest rate should rise if technical developments or education levels improve quickly enough so that the economy’s potential growth rate increases. Or, if productivity diminishes owing to a pandemic or ageing population, R-star will be decreased.
The central bankers’ duty would be much simpler if the R-star at any point were readily observable, say on a page on a Bloomberg screen. Those rates could merely be plucked and inserted into input areas 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 judgment on what it should be, in the lack of direct empirical knowledge.
The guesses have become very gloomy throughout the decades. R-star has declined by more than 5 percentage points in industrialized economies during the 1980s. And since the financial crisis of 2008, R-stars around the industrialized world have converged to a very low level, as if waiting for an economic rebound that never comes.
Are the central banks indicating to the private sector that little growth is likely, and is that gloomy and false notion mirrored back to the central bankers themselves?
Yes, according to Phurichai Rungcharoenkitkul, a staff economist at the Bank for International Settlements in Basel. In a report he co-authored with Fabian Winkler of the Federal Reserve Board, the two found central banks and the private sector “end up misperceiving the macroeconomic impacts of their own actions as true information. They are peering at a hall of mirrors.”
Rungcharoenkitkul and Winkler adapt the usual policy model to establish that, in recent years, “with the hall-of-mirrors effect operating, an aggressive policy strategy may be less effective in reviving spending, and worse may even exacerbate the same problem policymakers are seeking to solve”.
In other words, by staring at the reflections of their own policies of the recent past, the central banks have maintained official rates too low for too long, and their transmission of their expectations has dampened long-term saving and investment in the private sector.
Unproductive activity was unwittingly encouraged. Setting low rates for too long led to unaffordable housing, too little class or labor mobility and the emergence of leveraged speculation.
We have been asking central banks to take on too much of the burden for economic recoveries. And we have incorrectly expected them to be all-knowing, even while they look to the private sector to offer important indications.
Consequently, central banks’ “signals” and “communications” possibly have generated uncertainty and disproportionate long-term economic pessimism. And as the BIS analysis explains, “these repercussions are more severe the more the private sector and the central bank overestimate each other’s expertise of the economy”.
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