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Mark Carney tries on his new hats

What lessons can we draw from the Mais Lecture?



As predicted in The Money Trap, central banks are in process of ditching inflation targeting as a monetary rule.  Needless to say, this is not how they see it. At the Bank of England, Mark Carney thinks he looks fancy wearing the new hats George Osborne has given him.  He tried them on in last week’s Mais Lecture. Here is a summary and comment:


The fight against inflation in the 1970s and 1980s culminated in the adoption of an inflation target, which, said Mr Carney, helped secure 15 years of price stability and sustained economic growth. (I would agree with that.) However, with time, a healthy focus became, he said, a dangerous distraction. Indeed, it was “fatally flawed”. He came near to admitting the pursuit of inflation targets had caused the build up of imbalances that led to the crisis:

“The period of low and predictable interest rates before the financial crisis helped drive a ‘search for yield’ and leverage cycle, even with inflation subdued”

He added: It doesn’t take a genius to see that similar risks exist today.

The inflation targeting regime failed to recognise that financial stability is as important an objective of macroeconomic policy as price stability, and it downplayed the interrelationships between the two. In pursuing price stability, monetary policy can contribute to the gradual build-up of financial vulnerabilities through its effect on the degree of risk-taking in the economy.

He recognised a “tension” between monetary and financial stability. The solution is for the tension to be “managed” in a coordinated way by the central bank. The use of macroprudential tools can decrease the need for monetary policy to be “diverted” from managing the business cycle towards managing the credit cycle. This , Mr Carney argued, enhanced the credibility of the inflation target.

But notice how the aim of monetary policy has been re-defined. It is also a ‘last line of defence in reducing financial stability risks”. But also, it should aim to “manage the business cycle”. Really? It’s like watching a magician – now you see it, now you don’t. What happened to the inflation target? “Oh its still here, look”. It’s just dressed differently.

That sounds very much like a plea for a more flexible, dual – or triple – mandate. Indeed, the case for a more flexible central bank mandate to replace inflagtion targeting has been well put by Professor David Cobham here. But that’s not what Mr Carney has in mind.

What Mr Carney, other central bankers – and David Cobham – fail to recognise is this: globalisation and the domination of cross-border capital flows by financial factors under a  regime of flexible exchange rates have changed the environment for monetary policy out of all recognition. Even with modifications, the old policy-making model will not work.

Mr Carney rightly recognised that globalisation requires policy to have “more than a purely domestic focus”, but he did not explain how international influences would be taken into account, still less raise the possibility that they could throw any policy within the current framework into disarray. This is the same dilemma as Mrs Yellen faces when the Fed is criticized by emerging markets.


So what is the policy framework now?

It has two key elements: “discretion” and “flexible exchange rates”. Although there is no evidence it knows how to use them to good effect, the Bank is asking us to trust it with the far-ranging new powers it has acquired as a result of the crisis caused partly by its previous mismanagement of money and credit.


In my “conversation” with Paul Volcker at Central Banking’s Awards dinner he said that in the US, public confidence in the Fed, though it still ranked high compared with other public bodies, had fallen; it seems likely that the same applies to the Bank of England. Is it right to expect the public’s trust? More widely, is it right to trust it – to trust any official body – with such enormous discretionary powers?


Abuse of power unavoidable

It is not. All experience shows that giving any official body excessive, discretionary regulatory powers leads to problems. This is not crudely a case of safeguarding public policy from corruption by the financial sector lobbyists – although crony capitalism is, sadly, the dominating force in the emerging globalised society. (This used to be regarded as a Third World problem, but   as Luigi Zingales and Simon Johnson have shown applies to developed countries like the United States as well). 

It is rather that they will be tempted to use powers of direction over banking and credit for objectives prompted more by political influences than the requirements of economic or financial stability.

Inflation targeting no longer provides an anchor to prices. There is no monetary rule:  the “fatally flawed” aim of keeping inflation under control can at any time be set aside for broader reasons to do with “managing the business cycle” or “as a last line of defence” against financial stability risks. A rule is worthless unless it disciplines players at all times.

Raising false hopes

Does macro-prudential policy offer a way to manage the tension, or bridge the gap, and enable simultaneous achievement of multiple goals? Not to judge by expeience. There is a market for money. Whatever controls are placed on credit, or capital ratios, or LTVs in some sectors will affect the flow of funds and interest rates throughout the system. Macro-prudential tools might “work” to restrain a boom, for example; but unless you have a monopolized market they will only do so by raising interest rates throughout the system – otherwise, funds will simply find alternative channels to satisfy unmet demands for credit. In other words, they do not provide an additional macro-economic policy instrument. The attempt to use prudential means to meet macro-economic ends raises false hopes that will end in tears.

Can you imagine the Oversight Commmittee criticising Mr Carney?

Then there is the new Oversight Committee (OC) of 8 non-executives (who are “in” the Bank but not “of” the Bank, whatever that means). Anthony Habgood, a veteran of numerous company boards with, it seems, no background in banking or finance, is to lead the Bank’s Court of Directors and the Oversight Committee. Mr Carney said – apparently in the belief that this was a matter of pride – that the OC has been modelled on the Independent Evaluation Office of the IMF.

What he did not say was that the IMF’s IEO has been completely ineffective in getting the IMF to change its  mentality and become a stronger institution. These weaknesses stem from such factors as  “cognitive biases” such as groupthink, intellectual capture, blind spots and listening to what they want to hear –  and  the fact that it naturally falls under the influence of major shareholders, notably the US. Pre crisis, the US discouraged the IMF from making an assessment of its financial system or financial innovations such CDOs. Is Mr Carney aware that the IEO has conducted evaluations of the IMF’s role – and its failings – after every single recent crisis and that they have all come to broadly the same conclusions? And that these have all been ignored? The IMF of course says it has “taken steps” to address the weaknesses identified by the IEO – notably by strengthening “governance” and “surveillance” (big words), and allowing countries more time for adjustment, etc. But the historical evidence such steps will do nothing to make it  a more effective watchdog of the system as a whole. 


It is also highly dangerous that two of the new crop of top central bankers, Janet Yellen and Mark Carney, remain wedded to the bad idea of forward guidance. As we found out in the build up to the crisis, this is a sure way of stoking speculative bibbles. The Fed has not proposed a proper framework for exiting from QE – hence the market is vulnerable to wild speculative fever on every chance remark made by Mrs Yellen. Meanwhile, Carney repeated that “low for long interest rate environment” will “likely be with us for some time”; and any adjustments in rates will be limited and gradual. As he said, this puts a tremendous burden on both microprudential supervision and macroprudential management. It is not a role they are well fitted to assume.

So we have no anchor to prices; and a central bank with dangerously far-reaching powers over financial institutions and the system as a whole and the allocation of credit in the economy; and a central bank claiming direct accountability to the general public. It can in effect direct banks to lend more here, or less there, just as in the war and immediate post-war years. Meanwhile, interest rates continue to be manipulated and remain far from market clearing levels. This set-up makes a mockery of the proper role of finance in a market economy.

There is no way out of this trap under the current international monetary system.