Perils of central banks as policymakers of last resort

Refet Gürkaynak, Troy Davig 25 November 2015

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Central banks around the world are shouldering ever-increasing policy burdens without an accompanying expansion of their policy tools. They have become policymakers of last resort, residual claimants of macroeconomic policy. As central banks take on the duty of addressing policy concerns other than inflation – and consequently take the blame for not completely solving those problems – other policymakers get a free hand in pursuing alternative goals, which may not be aligned with social welfare. The end result is that tools available to the central bank may be used excessively but ineffectively. Witness negative shorter-term interest rates in ever more countries and still growing balance sheets in many advanced economies. Our concern is that placing the burden on central banks of achieving not only stable prices, but also implicitly other objectives, worsens the trade-offs faced by central banks and produces suboptimal outcomes by distorting the incentives of other policymakers.

As Orphanides (2013) highlights, the increase in central banks’ implicit mandates is widely visible. In the developed economies, this is most clearly manifested in central banks’ attempts to compensate for fiscal tightening after the Great Recession. More recently, attention has turned to using interest rate policy to promote financial stability.  In developing and emerging market economies, central banks carry out policies to affect a long list of macroeconomic outcomes, including capital flows, exchange rates, bank loan growth rates, housing prices and the like, as well as keeping an eye on inflation. An implicit expectation that central banks will take on these objectives, along with their willingness to do so, runs the risk of producing inferior outcomes compared to when central banks mind their core business of fostering price stability.

There is a large literature on optimal policy, which asks what central banks should be doing given the constraints they face. Almost all of this literature treats the world as having a single policymaker (i.e. the central bank) facing multiple inefficiencies. Indeed, optimal policy is often used synonymously with optimal monetary policy. As a result, the interest rate responds to all welfare-relevant variables in the model. Hence, the literature finds that optimal monetary policy is to set interest rates to control a combination of inflation and the output gap (Rotemberg and Woodford 1997)  as well as exchange rates (Corsetti et al 2010), house prices (Adam and Woodford 2013), asset prices (Gali 2014), address macroprudential concerns (Smets 2014), and so on. These papers are correct – if the only available policy tool is the interest rate, it should be set to maximise social welfare and will therefore respond to all distortions that are affected by monetary policy.

But monetary policy is not the only available policy. Instead, the world is best characterised as an environment in which multiple policymakers try to address multiple inefficiencies. In recent research, we note that such an environment entails interaction between policymakers, where outcomes depend on the preferences and mandates of those policymakers, as well as how their policies interact (Davig and Gürkaynak 2015). These interactions can have important implications for the design of monetary policy when non-monetary policymakers have idiosyncratic objectives – that is, projects that are important to them but may not enter the social welfare objective.

As an example, consider fiscal policy that resists countercyclical measures to stabilise output, perhaps due to preferences to keep tax rates at some particular level. That is, there may be resistance to cutting taxes in the face of a downturn or raising taxes in a boom. While the fiscal authority may still place weight on socially desirable mandates, such as keeping output close to potential, it balances this objective with the idiosyncratic goal of keeping tax rates close to its desired level. However, if it is understood that monetary policy places sufficient weight on stabilising output, then this provides scope for fiscal policy to focus on its idiosyncratic goal.

To illustrate these interactions, we use a New Keynesian setting with a value added tax rate and show that as monetary policy increases weight on stabilising output, the fiscal authority will respond by using tax policy less in response to output fluctuations. That is, if monetary policy adopts the social welfare function by caring about output stabilisation, fiscal policy will let it take on this burden and pursue its own goal of setting taxes at its desired rate.  In this setting, we ask whether it is possible that the central bank may increase public welfare by not adopting the social loss function as its mandate, but focusing only on inflation? We show that the answer is yes, given the fiscal policymaker puts some – but not too much – weight on their private concern.1 The central bank only minding inflation makes the welfare loss from output gap deviations sizable for the fiscal policymaker, resulting in a loss that dominates her idiosyncratic objective. The result is a fiscal policymaker taking socially desirable policy actions. Conversely, if the central bank places too much emphasis on the output gap by shifting focus away from its inflation goal, the fiscal policymaker maximises her own welfare by pursuing her private goals.

The model and examples in Davig and Gürkaynak (2015) suggest that a natural division of policy duties is for the central bank to care about inflation, leaving the other policy authorities to focus on objectives well-suited to their instruments. Key to our argument is that if the central bank takes on additional mandates, other policymakers may face incentives not in line with social welfare. As a result, central bank ‘mandate creep’ may be welfare detrimental.

The lesson to remember is that there are many policymakers, so central banks need not internalise all economic concerns even if there is a sense that monetary policy can ‘do something’ because it is more nimble. Doing so effectively turns the central banks into policymakers of last resort – that is, the residual claimants of economic policy. This changes the incentives of other policymakers and potentially worsens the trade-offs central banks face. And one should not forget that nimbleness is endogenous, that we observe equilibrium outcomes. Monetary policy has to be more nimble because it is used for cyclical purposes, while other policies can be slow because no one questions why they are not designed and implemented faster.

Unfortunately, in a world where central banks have already taken on additional mandates, even implicitly, and other policymakers are behaving socially suboptimally, it would likely entail a large welfare cost to move to an equilibrium where policymaking tools and objectives are appropriately aligned. This is a general problem in ‘too-big-to-fail’ situations, where the problem is best solved before it arises. Policy options are limited once the choice is between allowing catastrophe now and providing bad incentives for the future.

In this vein, it is worth evaluating whether any policy actions would have differed over the past several years if central banks had focused primarily on inflation. For example, would fiscal policy have been more expansionary in the US and in Europe if output and unemployment were not seen as at least partly the central banks’ responsibility? Would the government of Turkey have pursued expansionary policies long after the output gap was closed if the Central Bank of Turkey were not taking the blame for all the resulting imbalances? These counterfactuals are hard to evaluate, but the aggressive actions of central banks, along with the lack of action from other policymakers in many countries, suggest these types of interactions are part of the fabric of modern macroeconomic policy.

While transitioning to a smooth path, one that better allocates mandates across policymakers, poses significant challenges, we think it is important to be aware of the various potential costs of treating central banks as public agents responsible for ‘the economy,’ rather than for inflation, especially when their instruments remain relatively limited.

References

Adam, K and M Woodford (2013) “Housing prices and robustly optimal monetary policy”, Working Paper (June).

Corsetti, G, L Dedola and S Leduc (2010) “Optimal monetary policy in open economies”, in B M Friedman and M Woodford, eds, Handbook of Monetary Economics, Volume III, Amsterdam: Elsevier Science Publishers, 861–933.

Davig, T and R Gürkaynak (2015) “Is optimal monetary policy always optimal?”, International Journal of Central Banking, 11: 353-384.

Gali, J (2014) “Monetary policy and rational asset price bubbles”, American Economic Review, 104 (3): 721–52.

Orphanides, A (2013) “Is monetary policy overburdened?”, BIS Working Paper No. 435.

Rotemberg, J J and M Woodford (1997) “An optimization-based econometric framework for the evaluation of monetary policy”, in B S Bernanke and J J Rotemberg, eds, NBER Macroeconomics Annual, Cambridge, MA: MIT Press, 12: 297–346..

Smets, F (2014) “Financial stability and monetary policy: How closely interlinked?”, International Journal of Central Banking, 10(2): 263–300.

Footnote

1 This would not be the case for a fiscal policymaker who puts too much weight on her private concern. Such a policymaker will pursue policies effectively disregarding the public mandate regardless of what the central bank is doing. In that case the central bank is really the only policymaker and should treat the social loss function as its mandate.   

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Topics:  Macroeconomic policy Monetary policy

Tags:  central bank, Central Banks, mandate creep, policymakers, policymaker of last resort, inflation, price stability, social welfare, fiscal tightening, Great Recession, macroeconomics, monetary policy

Professor and Department Chair at the Department of Economics, Bilkent University; and CEPR Research Fellow

Senior Vice President and Director of Research, Federal Reserve Bank of Kansas City

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