Plosser: Restoring Central Banks After the Crisis

 Excerpts from speech of Charles Plosser, March 26 2012 . Link

...many countries around the world responded with a significant increase in government spending.

For example, in a world of fiat currency, central banks are generally assigned the responsibility for establishing and maintaining the value or purchasing power of the nation’s unit of account. Yet, that task can be undermined, or completely subverted, if fiscal authorities set their budgets in a manner that ultimately requires the central bank to finance government expenditures with significant amounts of seigniorage in lieu of current or future tax revenue.

The ability of a central bank to maintain price stability can also be undermined when the central bank itself ventures into the realm of fiscal policy. History teaches us that unless governments are constrained institutionally or constitutionally, they often resort to the printing press to try to escape what appear to be intractable budget problems. And the budget problems faced by many governments today are, indeed, challenging. But history also teaches us that resorting to the printing press in lieu of making tough fiscal choices is a recipe for creating substantial inflation and, in some cases, hyperinflation.

In other words, with independence comes responsibility and accountability. Central banks that breach their boundaries risk their legitimacy, credibility, and ultimately, their independence. Given the benefits of central bank independence, that could prove costly to society in the long run.

There are a number of approaches to placing limits on independent central banks so that the boundaries between monetary policy and fiscal policy remain clear.

First, the central bank can be given a narrow mandate. Second, the central bank can be restricted as to the type of assets it can hold on its balance sheet. And third, the central bank can conduct monetary policy in a systematic or rule-like manner, which limits the scope of discretionary actions that might cross the boundaries between monetary and fiscal policies.

Unfortunately, over the past few years, the combination of a financial crisis and sustained fiscal imbalances has led to a breakdown in the institutional framework and the previously accepted barriers between monetary and fiscal policies. The pressure has come from both sides. Governments are pushing central banks to exceed their monetary boundaries, and central banks are stepping into areas not previously viewed as appropriate for an independent central bank.

Let me offer a couple of examples to illustrate these pressures. First, despite the well-known benefits of price stability, there are calls in many countries to abandon this commitment and create higher inflation to devalue outstanding nominal government and private debt. That is, some suggest that we should attempt to use inflation to solve the debt overhang problem. Such policies are intended to redistribute losses on nominal debt from the borrowers to the lenders. Using inflation as a backdoor to such fiscal choices is bad policy, in my view.

Breaching the boundaries is not confined to the fiscal authorities asking central banks to do their heavy lifting. The Fed and other central banks have undertaken other actions that have blurred the distinction between monetary policy and fiscal policy, such as adopting credit policies that favor some industries or asset classes relative to others. Such steps were taken with the sincere belief that they were absolutely necessary to address the challenges posed by the financial crisis.

The clearest examples can be seen when the Federal Reserve established credit facilities to support markets for commercial paper and asset-backed securities. Most notable has been the effort by the Fed to support the housing market through its purchases of mortgage-backed securities. These credit allocations have not only breached the traditional boundaries between fiscal and monetary policy, they have generated pointed public criticisms of the Fed.

The Central Bank’s Balance-Sheet Policy

In the U.S., for example, the balance sheet of the Federal Reserve has changed from one made up almost entirely of short-term U.S. Treasury securities to one that is mostly long-term Treasuries, plus significant quantities of long-term mortgage-backed securities. This concentration of housing-related securities is problematic because it is a form of credit allocation and thus violates the monetary/fiscal policy boundaries I just mentioned.

Many central banks expanded their balance sheets in an effort to ease monetary policy after their usual policy instrument — an interest rate — had reached the zero lower bound. Do central bankers anticipate that their balance sheets will shrink to more normal levels as they move away from the zero lower bound? Is it desirable to do so? Or should monetary policy now be seen as having another tool, even in normal times? Some have suggested that central banks adopt a regime in which the monetary policy rate is the interest rate on reserves rather than a market interest rate, such as the federal funds rate. This would then permit the central bank to manage its balance sheet separately from its monetary instrument, freeing it to respond to liquidity demands of the financial system without altering the stance of monetary policy. In principle, this would take pressure off central banks to shrink their balance sheets from the current high levels and simply rely on raising the interest rate on reserves to tighten monetary policy.

I am very skeptical of an operating regime that gives central banks a new tool without boundaries or constraints. Without an understanding, or even a theory, as to how the balance sheet should or can be manipulated, we open the door to giving vast new discretionary abilities to our central banks. This violates the principle of drawing clear boundaries between monetary policy and fiscal policy. When markets or governments come to believe that a central bank can freely expand its balance sheet without directly impacting the stance of monetary policy, I believe that various political and private interests will come forward with a long list of good causes, or rescues, for which such funds could or should be used.

In June, the Federal Reserve’s Open Market Committee outlined some principles that would guide its exit from this period of extraordinary monetary accommodation. In particular, the FOMC clearly stated its desire to return to an operating environment in which the federal funds rate is the primary instrument of monetary policy. To achieve that objective, the Fed will have to shrink its balance sheet to a more normal level. I interpret this as saying that our balance sheet should not be viewed as a new independent instrument of monetary policy in normal times. The exit principles also indicated the Committee’s desire to return the Fed’s balance sheet to an all-Treasuries portfolio. This re-establishes the idea that the Fed should not use its balance sheet to actively engage in credit allocations.

To summarize, it is important for governments to maintain independent central banks so that they are better able to achieve their mandates. It is also sound policy to limit the discretionary ability of central banks to engage in policies that fundamentally belong to fiscal authorities or private markets. Establishing and maintaining clear boundaries between monetary and fiscal policies protects the independence of the central bank and its ability to carry out its core mandate — maintaining price stability. Clear boundaries and resisting the use of the balance sheet as a new policy tool would also improve fiscal discipline by making it more difficult for the fiscal authorities to resort to the printing press as a solution to unsustainable budget policies.