Please keep “politics” out of the monetary reaction function

During the Great Moderation it was normal to say that the Federal Reserve and the ECB (and many other central banks for that matter) was following a relatively well-defined monetary policy reaction function. It is debatable what these central banks where actually targeting, but there where is no doubt that both the Fed and the ECB overall can be descripted to have conducted monetary policy to minimize some kind of loss function which included both unemployment and inflation.

In a world where the central bank follows a Taylor rule style monetary policy reaction function, targets the NGDP level, do inflation targeting or have pegged the exchange rate the markets will tend to ignore political news. The only important thing will be how the actual economic development is relative to the target and in a situation with a credible nominal target the Chuck Norris effect will ensure that the markets do most of the lifting to achieve the nominal target.  The only things that could change that would be if politicians decided to take away the central bank’s independence and/or change the central bank’s target.

When I 12 years ago joined the financial sector from a job in the public sector I was hugely surprised by how little attention my colleagues in the bank was paying to political developments. I, however, soon learned that both fiscal policy and monetary policy in most developed countries had become highly rule based and therefore there was really no reason to pay too much attention to the nitty-gritty of day-to-day politics. The only thing one should pay attention to was whether or not given monetary targets where on track or not. That was the good old days of the Great Moderation. Monetary policy was rule based and therefore highly predictable and as a result market volatility was very low.

This have all changed in the brave new world of Great Recession (failed) monetary policy and these days it seems like market participants are doing nothing else than trying to forecast what will be the political changes in country X, Y and Z. The reason for that is the sharp increase in the politician of monetary policy.

In the old days – prior to the Great Moderation – market participants were used to have politicians messing up monetary policies. Central banks were rarely independent and did not target clear nominal targets. However, today the situation is different. Gone are the days of rule based monetary policy, but the today it is not the politicians interfering in the conduct of monetary policy, but rather the central bankers interfering in the conduct of other policies.

This particularly is the case in the euro zone where the ECB now openly is “sharing” the central bank’s view on all kind of policy matters – such as fiscal policy, bank regulation, “structural reforms” and even matters of closer European political integration. Furthermore, the ECB has quite openly said that it will make monetary policy decisions conditional on the “right” policies being implemented. It is for example clear that the ECB have indicated that it will not ease monetary policy (enough) unless the Greek government and the Spanish government will “deliver” on certain fiscal targets. So if Spanish fiscal policy is not “tight enough” for the liking of the ECB the ECB will not force down NGDP in the euro zone and as a result increase the funding problems of countries such as Spain. The ECB is open about this. The ECB call it to use “market forces” to convince governments to implement fiscal tightening. It of course has nothing to do with market forces. It is rather about manipulating market expectations to achieve a certain political outcome.

Said in another way the ECB has basically announced that it does not only have an inflation target, but also that certain political outcomes is part of its reaction function. This obviously mean that forward looking financial markets increasingly will act on political news as political news will have an impact of future monetary policy decisions from the ECB.

Any Market Monetarist will tell you that the expectational channel is extremely important for the monetary transmission mechanism and this is particularly important when a central bank start to include political outcomes in it’s reaction function.

Imaging a central bank say that it will triple the money supply if candidate A wins the presidential elections (due to his very sound fiscal policy ideas), but will cut in halve the money supply if candidate B wins (because he is a irresponsible bastard). This will automatically ensure that the opinion polls will determine monetary policy. If the opinion polls shows that candidate A will win then that will effectively be monetary easing as the market will start to price in future monetary policy easing. Hence, by announce that political outcomes is part of its reaction function will politics will make monetary policy endogenous. The ECB of course is operating a less extreme version of this set-up. Hence, it is for example very clear that the ECB’s monetary policy decisions in the coming months will dependent on the outcome of the Greek elections and on the Spanish government’s fiscal policy decisions.

The problem of course is that politics is highly unpredictable and as a result monetary policy becomes highly unpredictable and financial market volatility therefore is likely to increase dramatically. This of course is what has happened over the past year in Europe.

Furthermore, the political outcome also crucially dependents on the economic outcome. It is for example pretty clear that you would not have neo-nazis and Stalinists in the Greek parliament if the economy were doing well. Hence, there is a feedback from monetary policy to politics and back to monetary policy. This makes for a highly volatile financial environment.  In fact it is hard to see how you can achieve any form of financial or economic stability if central banks instead of targeting only nominal variables start to target political outcomes.

So I long for the days when politics was not market moves in the financial markets and I hope central banks around the world would soon learn that it is not part of their mandate to police the political process and punish governments (and voters!) for making the wrong decisions. Central banks should only target nominal targets and nothing else. If they diverge from that then things goes badly wrong and market volatility increases sharply.

Finally I should stress that I am not arguing in anyway that the ECB is wrong to be concerned about fiscal policy being unsustainable in a number of countries. I am deeply concerned about that state of fiscal policy in a number of countries and I think it is pretty clear to my regular readers that I do not favour easier fiscal policy to solve the euro zone crisis. I, however, is extremely sceptical about certain political results being included in the ECB’s reaction function. That is a recipe for increased market volatility.

PS this discussion is of course very similar to what happened during the Great Depression when politics kept slipping into the newspapers’ financial sector (See here and here)

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11 Comments

  1. dwb

     /  June 6, 2012

    excellent observation. central banks that value independence should not get involved in politics. , lest it get turned around and politicians interfere in monetary policy.

    of course, this is the great danger of monetary without political/fiscal union: more LTRO for example adds risk to Germany. so Draghi really needs Merkel to say ok.

    Reply
  2. Mats

     /  June 6, 2012

    As said:

    http://www.ft.com/intl/cms/s/0/b8641ea4-afbf-11e1-a025-00144feabdc0.html#axzz1x1DPO5Ub

    FT: ECB keeps interest rates unchanged
    Decision keeps pressure on politicians to tackle debt crisis

    Reply
  3. Ravi

     /  June 6, 2012

    Lars, this is a terrific post and observation. The ECB’s stance is also very hypocritical. They have claimed for so long to be focused on that narrowest mandate (price stability), but now seem to have taken on the task of forcing political actors to carry out specific actions. Furthermore, Draghi is saying “we won’t do anything now, because Greece may leave the Eurozone”. Isn’t his task to maintain price stability in the *current* Eurozone, and not his imagined Eurozone in the future? Not that price stability is such a wonderful target, but they can’t even do that…

    Reply
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