The Bank for International Settlements siren calls that central banks around the world should be raising nominal interest rates to choke off an orgy of risk taking grabbed more attention on the chatosphere than I expected, since this is what they always call for, and their reports make for more forecastable reading than the output of lobby groups for pensioners.
I was particularly struck by the pointed remark by the BIS that central banks themselves were not to be trusted to make the right judgement trading off risks to growth and financial stability, since they had failed to predict the 2008 financial crisis. This is a rare personalisation of the issue. Policy committees have turned over substantially since pre-crisis times. Some committees [like the UK’s financial policy committee] didn’t exist at the time they were meant to be foreseeing the crisis. This is a rather lazy remark by the BIS. If one wanted to engage in such public banter, one might draw attention to the fact that, like a stopped clock forecasting midnight, the BIS predicted a financial crisis every quarter for the best part of two decades and were eventually bound to be right. Or, with the rhetorical equivalent of the sliding tackle, we might urge that people ignore the BIS’s interest advice because they have presided over a dilute and inadequate tightening of a capital adequacy regime that was proven and is still too complicated, all without complaint.
As Simon Wren-Lewis points out, the BIS discussion of the issue is extremely one-sided. They fail to appreciate the gravity of the risks of greatly prolonging time spend at the zero bound and an associated period of deflation, or lowflation, especially considering the relative efficacy of instruments for tightening [taxes, interest rates, macro-pru] as against instruments for loosening [forward guidance, almost expended, and QE/credit easing, likewise]. The BIS seem to omit to mention that overly tight policy carries its own financial stability risks. Canadian and Australian banks survived the crisis because their banks were lending into a private sector experiencing windfall booms. A monetary-policy induced recession would increase firm deaths, increase unemployment, and weaken the balance sheets of banks lending to those dying firms and unemployed mortgage holders.
In my opinion they don’t give enough credence to the observation that monetary policy is, fundamentally, a weak tool for dealing with real phenomena, especially those that are slow-burning [highly apt description for financial stability problems] and have real causes [the BIS contest this in this case, with some merit]. A driving force for this argument is the BIS’ intriguing research on the ‘risk taking channel of monetary policy’. This is manifest in a number of micro studies which show how the riskiness of loans correlates with nominal rates. And the theory that credit market institutions mitigate towards what should be real decisions about the risk-return trade-off being affected by nominal, rather than real rates.
These views for me have the status of dissident challenges awaiting further work, rather than new wisdom around which monetary frameworks should be arranged. One way of ensuring that interest rates are high forever would be to announce a permanent increase in the inflation target of 5%, or 10%. Presumably the BIS wouldn’t be in favour of that, and would not argue that ‘risk taking’ would be forever cured by higher steady-state inflation. And if not, what exactly is the argument? Over what horizon, if not the long-run are tightenings effective at curtailing ‘risk-taking’? Interest rates have been at their floor for 20 years in Japan. Do we think that the Japanese economy is suffering from irrationally-exuberant risk-taking?
The correlations in these studies are just that, and not conclusive proof of a risk-taking channel. And if one wants to get serious about pervasive, long run money-illusion, we should be even-handed about it. If we apply the same logic in labour markets, then a tightening that forced down prices, in the presence of unyielding nominal wages, would price workers out of jobs.