The leading central banks in the advanced economies insist their policies are guided by targets, usually expressed in terms of the annual increase in a relevant consumer price index (CPI).  For the ECB, the target is annual CPI inflation below, but close to, 2%.  For the Bank of England (BoE) it is an annual rise in CPI of 2%, while for the Bank of Japan (BoJ) it is, for the moment, also 2% CPI inflation.  The US Federal Reserve operates under a dual mandate, seeking not only a 2% annual rate of increase in the personal consumption deflator but also maximum employment, vaguely defined.  All these central banks, then, manage monetary policy, to a large degree, by reference to inflation targets.  They argue that any prolonged deviation in actual inflation from the target would run the risk of undermining confidence in their ability to maintain stability in consumer prices and, by extension, stability in economic activity.

There are several contentious assumptions underlying this approach.  First of all, there is the assumption that the central banks enjoy a large measure of credibility in the first place.  That is questionable after the global crisis of 2008, which could be attributed, in large part, to prior mistakes in monetary policy.  However, they might contend that the subsequent avoidance of a 1930s-style economic collapse served to rebuild their reputations.  Then again, central banks appear to be assuming that households and companies are highly intolerant of temporary deviations in inflation from the target rate.  There is no clear evidence to support this. The most important assumption they make, though, is that, by their monetary actions, they are able to fine-tune inflation rates to the degree needed to avoid the kind of fluctuations that might threaten confidence.

Academic analysis has been deeply concerned with the links between inflation, inflation expectations and economic activity, but rather less so with how monetary policy adjustments influence inflation.  This is not to say that the judgments of academics on how inflation expectations affect demand in the economy and output are always soundly-based. The point is, rather, that monetary policy’s channels of influence on consumer price inflation remain subterranean.  There is no satisfactory and widely-accepted explanation of this influence.  Some would deny there is any appreciable direct influence on the prices of goods and services.  This view is more widely-held after six years of ultra-accommodative monetary policies ended, earlier this year, not in rising CPI inflation, but in a deflation scare. Yet, intuitively, it seems an easy monetary stance must boost prices somewhere.  Hence, it is now widely assumed that monetary policy has its chief effect, not on the markets for goods and services, but on asset prices.  It is through the effect on asset prices that central banks are
able to influence conditions in the economy and ultimately the CPI.  Yet, this route is so circuitous as to deprive central banks of the close control over their target-variable they would need, if they were to feel sure of maintaining confidence in their targeting ability.

Instead of asking how inflation is influenced by monetary policy, a more fruitful line of inquiry might start with the central banks’ monetary policy actions and seek to trace their effects on the broader aggregates.  Prior to the financial crisis, central banks used to ease policy in order to stimulate credit growth and tighten it to discourage the further expansion
of lending in the economy. In the post-crisis situation, however, the attitude of central bankers to credit growth is ambivalent.  On the one hand, they regard a robust demand for credit and the willingness of financial intermediaries to meet it as the mark of a healthy economy.  This association is ingrained in their thinking.  On the other, the proliferation of credit has come to be seen as problematic.  There is a presumption, in official circles as more widely, that excessive credit growth contributed hugely to the disorder that overtook the financial system from 2007 onwards. Ratios of debt to GDP and to sector incomes in many instances had reached historical ‘highs’.  Then again, for banks, balance sheet expansion, resulting from resumption in lending, puts strain on the more demanding capital ratios which regulators have insisted should be met since the crisis.  Yet it was only through much effort that banks built up their capital to meet these more stringent requirements; they might be hard-pressed to increase their capital still further.  There is, therefore, a clear downside to credit expansion, from the central banks’ point of view. It has not been unusual, in recent times, for central bank committees charged with meeting economic objectives to hail signs of an upturn in credit expansion while their colleagues concerned with financial stability warn of the potentially dire consequences if indebtedness in the economy resumes its rise.

In fact, the growth in credit granted by commercial banks in the USA in the year to March was almost 8%.  From this, it might look as though the Fed’s ultra-easy policy has had its normal effect in boosting bank lending.  If so, the effects of monetary policy have not been uniform across countries. The BoE, for example, reported that lending by monetary institutions contributing to the M4 statistics contracted by 3.9% in the twelve months to February, the latest period for which figures have been published.  This was despite the BoE having conducted QE buying of bonds on a comparable scale (relative to GDP) to the Fed.  Bank lending in Japan, it was reported last week, rose by 2.6% in the year to March.  That appears a brisk rate of growth, especially when viewed in real terms.  However, bank lending in Japan was already growing at an annual 1.2% rate in December 2012, before the BoJ indicated it would greatly expand its asset purchases.  The BoJ’s extremely aggressive monetary stimulation seems to have made only a marginal difference to the trend in bank lending growth, if indeed the small pick-up in pace is attributable to the BoJ’s actions.  It is too early to judge what impact the ECB’s QE is having.  But in the year to February, credit extended by monetary institutions to non-government euro zone residents contracted by 0.4%.  Admittedly, the short-term growth trend in private credit turned gently upwards in November but that may have reflected demand for credit associated with a falling euro exchange rate. The ECB’s previous non-conventional monetary actions had failed to induce positive growth in lending.  Probably the bank lending data fail to give the full picture of credit developments.  The operations of the ‘shadow banking’ sector may also have reflected some of the effects of ultra-accommodative monetary policies. It is hard to quantify these operations, however, and we should not assume they make a substantial difference to the scale of policy effects, simply on the grounds that policy has been very expansive.  Such an argument would be circular.

We should bear in mind that boosting credit growth may have been, in the past, the most obvious result of an easy monetary stance.  But this is not the only means by which central banks, in setting ultra-low short rates, might affect the economy.  These low rates can also reduce the burden of borrowers’ existing loans.  Funds previously earmarked for debt service can be diverted to other uses, possibly including expenditure on goods and services.  This process is facilitated to the extent that debt in the economy is short-term or readily refinanceable.  QE programmes extend the downward pressure on interest rates to the longer maturities, thereby reducing the cost of capital market fund-raising.  In their defence of QE, central bankers have come to regard this as the most powerful argument in its favour.  The pace of capital issuance has been strong, initially in the US dollar sector but latterly picking up also in the euro.  What is lacking is evidence that all this fund-raising is boosting spending on goods and services.  At first glance, much of it appears to relate to financial engineering   All the same, balance sheet reconstruction should, at one or several removes, leave extra funds available for spending.  If a central bank engages in QE, providing funds to take up a corporate bond issue, the issuing company should make an addition to spending power in the economy, even if it uses the proceeds in buying back its own shares.  At the end of this chain, those who had owned the shares should wind up with cash which they would then be able to spend.  In practice, though, it seems those who, at the end of this process, end up holding the cash that QE has created have a low propensity to spend.

Consequently, it would be fair to say that, ever since the financial crisis, economic growth has tended to fall short of central bankers’ expectations At first, the central banks could explain this away, arguing that the situation would have been much worse in the absence of the accommodative measures they were taking.  But this line loses its plausibility the longer it is trotted out. After six years, the shock from the 2007-09 crisis should surely be less than it was in the immediate aftermath of the financial troubles, yet with monetary policy-settings even more expansive than in the crisis years, economic growth is still sub-optimal.  The conclusion is increasingly hard to avoid that the instruments of monetary policy are less effective than central bankers, and for that matter financial markets too, had supposed.

Latterly, the central banks have come to see currency depreciation as a short cut towards lifting obstinately low inflation towards their respective targets.  They even threw a cloak over what they were doing, contending that exchange rate movements that were the product of domestic monetary policy measures should not be regarded as hostile acts in a currency war.  Even so, it is obvious that not all central banks could raise inflation rates through this means, seeing that depreciation in some currencies must be matched by appreciation in others.  The danger in this situation is that agreement to turn a blind eye to the exchange rate consequences of monetary policy breaks down, as appeared to be happening in Europe earlier this year when central banks in several non-euro countries took defensive action against the ECB’s euro-weakening strategy.

Japan’s recent economic history well illustrates the limits to monetary policy’s effectiveness.  While academics in Japan and elsewhere have long maintained the BoJ could achieve a significantly positive inflation rate, if only it was vigorous enough in delivering stimulus, this is not working out in practice.  The BoJ’s pump-priming is more than twice as vigorous as the Fed’s ever was, relative to GDP, but Japan’s economy is hardly growing at all.  Initially, the BoJ’s aggressive asset-buying weakened the yen and pushed inflation up towards the 2% target.  But there was no commensurate increase in wages.  A squeeze on real household incomes was the result.  The BoJ’s actions may, indeed, have had the perverse effect of weakening growth through constraining consumption, even before the Abe Government’s sales tax hike took further toll.  This week, Mr Hamada, a close adviser of Mr Abe and initial enthusiast for an ultra-accommodative BoJ policy, made comments suggesting an important change of strategy may be in the works.  He declared the neutral level for the yen/US dollar exchange rate was 105, though the recent range slightly under 120 was ‘acceptable’.  He said, further, that it was reasonable for the BoJ to set its inflation target at 1%, ex oil.  Since the current 2% target was adopted before there was any thought of future oil price fluctuations, this looks like acceptance that the BoJ’s inflation target is, in current circumstances, too ambitious.  While the large companies that are members of Keidanren seem set to raise their workers’ wages as the Government wishes, smaller companies remain financially hard-pressed, not least by the impact on their costs of the weaker yen the BoJ’s policy has delivered.  It appears Japanese policymakers are now giving serious thought to the practical implications of BoJ policy-actions.  They may be less inclined to accept unquestioningly the assurance of Western economists that monetary policy offers a panacea.  This is likely to be the beginning of a global debate on the efficacy of monetary measures, with ECB experience also figuring largely in the discussion.

Stephen Lewis

Stephen Lewis is a highly respected and experienced economist and is currently employed as the Chief Economist at ADM Investor Services International. He also serves as Treasurer of the Forum for European Philosophy and was five years ago elected to the Royal Institute of Philosophy.