After years of strong and steady economic and credit expansion, all of a sudden financial markets virtually ceased to function. As if this wasn’t enough, policymakers are now facing a new type of danger: inflation. In the 1920s the policy authorities faced the strongest financial crises ever and eventually the Great Depression; in the 1970s they had to deal with the Great Inflation. With bad luck, today we may end up having both! We are not quite there yet, but few doubt that we are facing a very delicate situation, in which monetary policy strategies need to be careful designed to avoid disaster. Lets’ examine the situation in more detail by tracing a picture that can be used as background to evaluate the future monetary policy conduct. Specifically let’s try to compare the combination of economic signals and monetary policy strategies nowadays with the one faced in those two important episodes of the past.
In the 1920s monetary policies where constrained by the Gold Standard and supervisory policies were still rudimentary and looser than they are today. The result: the bank system took on too much risk in financing mostly business in the rising industrial sectors and monetary policy reacted to bank panics by adopting a restrictive stance. By refusing liquidity even to banks with sound collaterals the monetary policy had fuelled bank panics. After the crises two cures were indicated: better banking supervision and reserve requirements.
In the 1970s the Great Inflation was the result of three interrelated factors. Cost push shocks, due to rising oil prices, the vast use of indexed contracts which prevented downward wage flexibility and the lack of sound and credible monetary policy frameworks. The cure indicated at the time was a mixture of containing indexations and appointing credible and accountable central bankers. Nowadays monetary policy strategies (inflation targeting or price stability) are indeed the heritage of that period: the message was monetary policy should be credible enough to target future inflation expectations.
Where do we stand nowadays? Let’s start by examining possible causes and consequences of the financial crises. The crisis has been ignited by excessive risk taking in the real estate business, fuelled by overly expansionary monetary policy and compounded by a dangerous mix of mortgage lending and securitisation. The ‘’originate to distribute’’ model induced banks to weaken their traditional screening and monitoring function, thereby artificially inflating house price expectations. As the Fed pointed out, the market has become less transparent hence creating room for inefficiencies. Some see the cure in a more stringent regulatory system, preventing banks from engaging in excessive lending without paying a fair price for their mistakes. However, regardless of the degree of regulatory sophistication it is hard to believe that bank awash with liquidity for so many years would not have been able, eventually, one way or another, to assume the (excessive) volume of risk they wanted. For this reason, it seems reasonable to attribute the present financial crises to an excess of global liquidity.
The recent rise in inflation is perhaps even more surprising, considering that inflation targeting strategies recently adopted by all central banks were widely acclaimed by academics and practitioners as the best recipe for durable price stability. Wage pressures were not among the early causes of rising inflation: core inflation has been rather stable so far, and due to fierce competition by workers from emerging markets the global level labour costs has generally been kept low. The energy price increase also played a minor role, as many empirical analyses showed. We are left with excess liquidity: targeting inflation expectations at short-medium horizons, did not prevent over-expansionary monetary policies that fuelled demand in the recent years.
Both phenomena we are looking at, financial crises and raising in inflation, can be seen as long term implications of expansionary monetary policies and, in particular, of the lack of a well defined nominal anchor in the policy strategies conducted by most central banks.
How about the future orientation of monetary policies? Apart from the ECB, which is rightly keeping nominal interest rate stable, The Fed and the Bank of England attempt to contain the financial crises by providing credit to illiquid banks, and to this aim have expanded the range of collateral they are willing to accept. The classic theory of ‘’lender of last resort’’ tells us that monetary authorities should lend to illiquid banks to avoid panics, but against sound collateral. To avoid moral hazard, lending should be given to illiquid banks not to insolvent ones. Now, shall we consider a security containing dubious asset-backed components as sound collaterals? And, how can a bank in a world with so much liquidity be unable to obtain credit in the interbank market, unless the market judges it to be an insolvent bank? Overall recent interventions by the Fed and the Bank of England might amplify moral hazard problems. Most of all those same interventions are harming central bank credibility which is the main pillar of inflation targeting/price stability strategies.