Andrew Haldane: Halfway up the stairs
Article by Mr Andrew G Haldane, Executive Director of the Bank of England, published in
Central Banking Journal, 5 August 2014.
* * *
"Halfway up the stairs
Isn't up,
And it isn't down.
It isn't in the nursery,
It isn't in the town."
AA Milne, Halfway Down (1924)
It is the 25th anniversary of Central Banking. So it is a good time to be asking some big
questions of central banking. How have central banks evolved over the last quarter of a
century? How has the crisis affected that evolution? And what lies in prospect for them over
the next 25 years?
AA Milne's 1924 poem, Halfway Down, is a fitting description of the position central banks
find themselves in today. During the past 25 years or more, central banks' mandates and
instruments have moved upwards in steps. They have ascended the stairs.
But where this leaves central banks today is not entirely comfortable. Halfway up the stairs is
neither up nor down, neither nursery nor town. That begs a natural question about "where
next" for central banks over the next quarter-century.
Ascending the stairs
History will show the 20th century to have been an unprecedented boom period for central
banking. At the start of that century, central banks were relatively few in number. For those
that did exist, their responsibilities were heavily constrained. Often, their role was to act as no
more than an operational agent for the government of the day, managing money, debt and
foreign exchange markets. They were agents, not principals.
Through the course of the 20th century, central banks' influence began to grow. So too did
their numbers. For some, this evolution began with being granted monopoly rights over
issuing legal tender - fiat money. This gave central banks special status relative to
commercial banks. It underscored their stability role as liquidity provider to the banking
system: stabilising short-term money markets in normal times, acting as lender of last resort
in abnormal ones.
It also secured, by fiat, a demand for central bank liabilities. This meant central bank money
became the natural settlement medium, and central banks the natural clearing house, when
discharging obligations among banks. As the marginal supplier of liquidity, this gave central
banks the ability to set the marginal price of liquidity - the short-term interest rate. In that
way, monetary policy was born and an important central bank step had been taken.
The early phases of monetary control by central banks were often inauspicious, highly
constrained, or both. Monetary regimes during the latter part of the 19th century and the first
part of the 20th were long on rules and short on discretion. The Gold Standard, and later the
Bretton Woods regime, tethered monetary policy to a commodity or dollar anchor, with little
scope for monetary discretion. And where monetary discretion did operate, it was not always
a success. The Federal Reserve's discretionary monetary actions during the Great
Depression were a salutary lesson.
But the breakdown of the Bretton Woods system in the 1970s brought a further sea-change.
Tight international rules gave way to national discretion. With the accompanying rise of
"monetarism", these monetary frameworks were often based around targets for the money
supply. In most cases, the role of central banks was still to act as operational agent. But the
technical nature of these regimes gave central banks a say in their design. A second step
had been taken.
The "great inflation" of the 1970s, together with repeated failures to hit money supply targets,
began to change that picture further during the 1980s. Monetary discretion was found to
have come with costs. In particular, it had given birth to what economists subsequently called
the "time-consistency problem". This problem arose from the temptation to over-supply
money or over-relax regulations today, often to finance wars or to win elections, at the
expense of inflation tomorrow. This problem was thus endemic among elected officials.
The birth of independence
As arm's-length technocrats, without the need to finance wars or win elections, central banks
were seen as a bulwark against these time-consistency concerns. Thus was born central
bank independence. If decision-making power over monetary policy were delegated to
central banks, not as operational agents but as principals, the time-consistency problem
could be curbed at source. With this argument, central bank independence spread rapidly
and globally during the 1980s and 1990s. And with it, central banks had taken another
significant step.
At the same time as monetary policy discretion was being granted, constraints were being
placed around it. These were a necessary part of democratic accountability. These
constraints included government-set success criteria - for example, inflation targets. In the
jargon, many monetary policy regimes became characterised by instrument-independence
but target-dependence. They combined rules with discretion - hence "constrained
discretion".
Yet as significant was the accompanying shift in central bank transparency. This was seen
as a necessary concomitant of delegated power. A century ago, the prevailing central bank
ethos allegedly came from the then-Bank of England (BoE) governor, Montagu Norman:
"never apologise, never explain". Then, secrecy and mystique were believed to be key
weapons in central banks' armoury. Media appearances were rare. Central bank actions
were confined to the back pages of newspapers, if at all. At the BoE, the aim was to keep the
Bank out of the press and the press out of the Bank.
With independence granted, all that changed. Politicians and the public demanded
explanations - and sometimes apologies - for policy choices. Policy meetings were
preannounced and minuted. And regular publications, such as inflation reports and financial
stability reports, set out the analyses underpinning these decisions. Media appearances and
newspaper articles began to appear. Central banks moved from the back to the front pages
of newspapers. Journalists were no longer locked out, but instead ushered in for press
conferences. Another step up the stairs had been taken.
End of the "Great Moderation"
This brave new world looked set to continue indefinitely during the early years of this century.
Inflation was low and output stable, the so-called "great moderation". The Holy Grail of
growth without risk seemed to have been discovered. Yet moderation was sowing the seeds
of its own destruction, dulling the risk senses of central banks, regulators and market
participants. In this vacuum, financial risk-taking rose to Himalayan heights.
The global financial crisis of 2008 brought that decisively to an end. The financial system and
economy tumbled from their Himalayan peaks. Great moderation gave way to "great
recession", the sharpest and longest-lasting since the 1930s. Central banks quickly
acknowledged their pre-crisis blind spot - ballooning debt among both banks and non-banks.
And, not for the first time in their history, they reinvented themselves.
On the monetary policy front, extraordinary times resulted in extraordinary monetary
measures. Interest rates globally were lowered to levels previously never seen, accompanied
in some major advanced countries by purchases of government securities - so-called
quantitative easing (QE). In some countries, central banks in addition purchased private
sector assets, such as mortgage-backed securities and corporate bonds - so-called "credit
easing". Others, including the Federal Reserve and Bank of England, issued forward
guidance to help clarify their future policy intentions and thereby shape the yield curve.
This was terra incognita for central banks. The focus of monetary policy, at least in the
25 years prior to the crisis, had been on controlling the short-term safe rate of interest.
Crisisinduced monetary interventions widened that focus significantly. By pursuing QE and forward
guidance, central banks began to exercise influence beyond overnight rates of interest. And
for those central banks that engaged in credit easing, this influence extended further, from
safe to risky rates of return across a broad spectrum of assets. These were giant steps.
A second aspect of the reinvention was macro-prudential regulation. Inflation-targeting was
necessary but, by itself, insufficient to curb the financial cycle. The response of governments
has been to grant central banks new powers, focused on the needs of the financial system
as a whole and towards the needs of the nonfinancial economy, as much as the financial
sector. That is what the "macro" in macro-prudential meant.
Macro-prudential policy is gaining ground every bit as quickly as central bank independence
did in the 1990s. It has quite radical implications. Pre-crisis credit cycles were allowed to
operate largely unconstrained. Macro-prudential policy overturns that orthodoxy, with policy
instead leaning against the credit cycle to moderate its fluctuations, both during the upswing
and the downswing. It, too, is a big step forward.
A third aspect of the reinvention is in the operations of central banks. During the crisis,
central banks flexed their balance sheets as never before. New facilities were introduced that
extended liquidity for longer durations against expanded sets of collateral (public and private)
to new counterparties (bank and non-bank). This took last-resort lending to a new level.
Some central banks went one step further, becoming effective market-makers of last resort in
some assets to secure market liquidity. These were new and bold steps.
A fourth dimension was transparency. With monetary, regulatory and operational policies all
working in overdrive, central banks have had plenty of explaining to do. During the crisis,
their actions have shaped the behaviour of pretty much every financial market and institution
on the planet. So central banks' words resonate as never previously. Rarely a day passes
without a forensic media and market dissection of some central bank comment. These, too,
are significant steps to have climbed.
Where does this leave central banks today? We are not in Kansas any more. On monetary
policy, we have gone from setting short safe rates to shaping rates of return on longer-term
and wider classes of assets. On regulation, central banks have gone from spectator to
player, with some granted micro-prudential as well as macro-prudential regulatory
responsibilities. On operational matters, central banks have gone from market-watcher to
market-shaper and market-maker across a broad class of assets and counterparties. On
transparency, we have gone from blushing introvert to blooming extrovert. In short, central
banks are essentially unrecognisable from a quarter of a century ago.
Up or down?
The key question, then, is where next? Will the next 25 years see as large a metamorphosis,
from sleepy caterpillar to winged butterfly, as the last? It is impossible to know for sure. But it
is interesting to attempt a bit of futurology and sketch some hypothetical evolutionary central
bank paths. For the sake of illustration, let me consider two - one descending the stairs from
whence central banks came, another ascending them to a whole new level.
One possible future path is that central banks simply retrace their steps, going back to
basics. Extra-ordinary times - from great moderation to great recession - necessitated
extraordinary measures. But extra-ordinary should not become the new ordinary. What might the
new ordinary look like?
For monetary policy, it would probably mean a return to plain-vanilla inflation-targeting using
conventional short-term interest rate tools - the one instrument, one target world. Direct use
of central banks' balance sheets, to affect quantitative or credit easing, would return to being
an emergency room measure, for use only when the zero lower-bound on interest rates bit
tightly. Active monetary policy would mean small, infrequent touches on the tiller, perhaps
accompanied by small, infrequent explanations. Former BoE governor Mervyn King aspired
to make monetary policy "boring". In this scenario, his wish would be granted.
Regulation would follow a similar path. While not returning to their pre-crisis norms,
regulatory rules would move to a more settled pattern. The very definition of a resilient
financial system is one that does not require active intervention. With greater amounts of
capital and liquidity in the financial system, this may be more realistic. There may be less
need to fine-tune the regulatory engine and correspondingly less need for the tug-of-war
between regulator and regulated that has characterised the past few years. A robust banking
system ought also to be less prone to credit booms and busts, thereby reducing the need for
discretionary macro-prudential actions to lean actively against the wind. Regulation would be
handed back to the risk managers.
In this world, the operational activities of central banks could also return to a more even keel.
Wider collateral, longer tenors and new counterparties were necessary ingredients during
crisis. But a return to more conventional operations - short-term lending against government
collateral to banking counterparties - may be sufficient to oil the wheels in normalised market
conditions, as it was for hundreds of years prior to the crisis. Market-making, at least beyond
short-term money markets, would be a last resort.
As for central bank transparency, with monetary, regulatory and operational policy no longer
hyperactive, it is conceivable central banks could retreat from centre stage. Central banks
could migrate to the back pages of newspapers. Like good children, they would be relatively
rarely seen and infrequently heard. Central bank-watchers would find something better to do
with their lives than hang on to every gubernatorial semi-colon.
For a central banker, this sounds like the good life - a low-intervention, low-visibility world. In
some respects, it would be back to the future. The issue is whether this world, however
desirable, is realistic. There are some reasons for doubt.
Financial system reinvention
One of the likely consequences of the crisis, and the resulting regulatory response, is that the
financial system will reinvent itself. Financial activity will migrate outside the banking system.
And with that move, risk may itself change shape and form. What previously had been credit
and maturity mismatch risk on the balance sheet of the banking system may metastasize into
market and illiquidity risk on the balance sheets of non-banks. This could have important
implications for the stability of the financial system and the broader economy.
With more activity outside the banking system, and with the banking system itself better
protected, the financial system and economy may become less prone to the low-frequency,
high-cost banking crises seen in the past. But that is not the end of the story. Risk, like
energy, tends to be conserved not dissipated, to change its composition but not its quantum.
So it is possible the financial system may exhibit a new strain of systemic risk - a greater
number of higher-frequency, higher-amplitude cyclical fluctuations in asset prices and
financial activity, now originating on the balance sheets of mutual funds, insurance
companies and pension funds. These cyclical fluctuations could in turn be transmitted to, and
mirrored, in greater cyclical instabilities in the wider economy.
In this world, it would be very difficult for monetary, regulatory and operational policy to beat
an orderly retreat. It is likely that regulatory policy would need to be in a constant state of
alert for risks emerging in the financial shadows, which could trip up regulators and the
financial system. In other words, regulatory fine-tuning could become the rule, not the
exception.
In this world, macro-prudential policy to lean against the financial cycle could become more,
not less, important over time. With more risk residing on non-bank balance sheets that are
marked-to-market, it is possible that cycles in financial assets would be amplified, not
dampened, relative to the old world. Their transmission to the wider economy may also be
more potent and frequent. The demands on macro-prudential policy, to stabilise these
financial fluctuations and hence the macro-economy, could thereby grow.
In this world, central banks' operational policies would be likely to remain expansive.
Nonbank counterparties would grow in importance, not shrink. So too, potentially, would more
exotic forms of collateral taken in central banks' operations. Market-making, in a wider class
of financial instruments, could become a more standard part of the central bank toolkit, to
mitigate the effects of temporary market illiquidity droughts in the non-bank sector.
In this world, central banks' words and actions would be unlikely to diminish in importance.
Their role in shaping the fortunes of financial markets and financial firms more likely would
rise. Central banks' every word would remain forensically scrutinised. And there would be an
accompanying demand for ever-greater amounts of central bank transparency. Central
banks would rarely be far from the front pages.
Which path?
Which central bank path is the most likely over the next 25 years? Your guess is almost
certainly as good as mine. AA Milne ends his 1924 poem:
"And all sorts of funny thoughts
Run around my head,
It isn't really anywhere
It's somewhere else instead!"
A quarter of a century on, I am confident central banks will be "somewhere else instead". I
am much less confident precisely where, whether upstairs or down. Central banking may
need to await the 50th anniversary of Central Banking to find out.