Boring Bankers

9^th November 2007
The Malta Independent - Friday Wisdom

Central Bankers are generally very boring people. They have more independence than most other national organisations, an independence almost at par with that of judiciary outside Pakistan. They are tasked to keep the value of money stable but the only tool they have to do so is a very blunt one. Central banks are in charge of monetary policy which in simple language seeks to control the level of interest rates in the economy.

As the theory goes, if an economy is growing more than its potential, the excess demand will translate itself into rising prices so the Central Bank tightens monetary policy by raising interest rates to convince people to consume less and save more and thus bring back demand to within the economy’s potential. If on the other hand the economy is growing very slowly and below its potential causing excessive price stability or deflation through price reductions, central banks tend to lower interest rates to stimulate demand and kick start the economy.

Central banks get into a quagmire when they are faced with an economy with low real growth and high inflation as any attempt to stimulate the economy by lowering interest rates to stimulate demand could complicate an existing inflation problem. On the other hand, if they raise interest rates to address inflation they could throw a low growth economy into an outright recession.

When faced with such stark choices of conflicting objectives, central banks in developed economies that enjoy true independence from the executive are generally expected to give priority to the inflation objective. Quite often this would irk politicians whose objective time frames are generally as short as the date of the next elections. This is the reason why central banks cherish their independence which is the corner stone of the euro monetary system.

Changes in interest rates, unless of a draconian nature in the Paul Volcker style in the early 1980s, would only have an effect on the real economy with substantial time lag and this is why central bankers, boring as they may be, are expected to stay ahead of the economic curve and model their interest rates decisions to pre-empt problems rather than to address them. Otherwise interest rate changes decided today will have their real effect in 12 or 18 months down the road when the problems may have changed. So unless central banks stay ahead of the curve they could be prescribing a medicine unsuitable for the malady.

This could explain why for example presently there are people who query whether the US Federal Reserve is fuelling inflation by cutting interest rates too soon and by too much while others are arguing whether the European Central Bank is asphyxiating growth in Europe by not cutting interest rates and letting the Euro appreciate too much.

If central bankers are boring people, Maltese central bankers should be doubly so. They will no longer have monetary policy to administer as of 1 January and given that they have already lost banking regulation to the MFSA and exchange control to history, I sympathise with those who might think that our central bankers will be quite relaxed, outside their economic research department, as from next year and hard put to justify the use of their current resources, both human and physical.

So it is quite amazing that on the eve of joining the euro our Central Bank seems to have entered into an argument with the government about release of excessive foreign reserves to pay off part of the national debt. What’s more funny is that this duel is being made with the Times of Malta who are acting as an unofficial proxy for the government so that the latter avoids giving the impression that it is challenging the independence of the central bank.

Leaving technical issues aside, as these could be quite complicated, the crux is whether the excess reserves that are not required to cover the currency in circulation component under the new euro regime should continue to be administered by the Central Bank or released to government to pay off the national debt.

Those who argue that this will save us millions in interest servicing costs of the public debt seem to forget that this will be neutralised by lower profits by the central bank which in the end would flow back to the public exchequer. So we will lose on the swings what we gain on the roundabout.

Personally I would prefer to see these reserves stay with the Central Bank if for nothing for the avoidance of the possibility of giving this and future governments capacity to rebuild the public debt and still stay within the euro rules. On the other hand the Central Bank has to start practicing what they preach and explain what measures they would be taking to improve their efficiency given their reduced workload. They should also be more transparent about their performance in the management of foreign reserves.

Small fry investment services operators entrusted by their clients with portfolio management are under the new MiFID regime expected to report performance every quarter against a declared benchmark. Why should our professionals at the Central Bank avoid measuring their performance publicly against a benchmark given they are handling pretty high figures with several zeros behind the digits?

There is another enigma with the business of central banking. When things are going well central banks target their monetary policy to keep retail prices under control but take very little interest in asset price inflation. For example the Central Bank never pitched their interest rate policy to control the real estate price explosion of recent years. When things turn bad, as is happening presently in the US housing market which inevitably spills itself into the financial markets and possibly on the general economy, central banks start cutting interest rates aggressively in order to stabilise the economy and create a cushion for a soft landing.

But something is wrong somewhere. What applies to the downside should also apply to the upside which can only be done if central banks include asset price inflation in their monetary policy stance and if they have direct regulatory control over the markets not only in the banking sector but also on its periphery that contribute to asset price inflation or outright asset price bubbles. The whole regulatory regime needs to be re-engineered in the light of the 2007 experience.