Why central banks need to change

Never before have economists been so baffled. Their world has been turned upside down because these days all what should happen doesn't, and what shouldn't does.

So it was entirely appropriate that Rakesh Mohan, deputy governor of the Reserve Bank of India, should have chosen to ponder the myriad monetary and other mysteries in the world. It is impossible to do justice to the discourse which is one of the best I have ever seen and which should become a required reading in colleges.

In a masterful dinner lecture delivered in Beijing in October 2005* (which has become available only now in the November Bulletin of the RBI published a week ago) and mindful of the venue, Mohan says: "We are living through interesting times."

Indeed, we are. The essence of the puzzle is that although most economic indicators suggest that the world economy should be contracting, it is actually expanding.

So Mohan poses the following six sub-puzzles:

• The US dollar appreciating despite increasing US twin deficits.
• Soaring oil prices accompanied by strong global growth.
• Long-term bond yields falling in the presence of Fed Fund rate hikes.
• Low consumer inflation in the presence of abundant liquidity and increasing asset prices.
• Strong global growth accompanied by slowdown in global saving and investment rates, and;
• The phenomenon of low inflation despite currency depreciation.

One explanation he offers for monetary stability is "reforms in the manner in which monetary policy is set currently, and the institutional changes that have occurred in the 1990s… The institutional strengthening of central banks has coincided with the worldwide thrust on fiscal consolidation and structural reforms in the labour and product markets, which have also worked towards attaining price stability."

Another factor is the hugely enhanced flexibilities in all markets because of greater competition both domestically and internationally. "This has reduced the incentive for monetary authorities to raise output above the potential."

And then there is productivity growth. Every unit of currency gives a bigger bang now.

There is also the famous Balassa-Samuelson theorem at work. "The inflow of migrant labour both in the US and UK has arguably led to a diminution of inflationary pressure in the labour market."

Also, "even substantial increases in input prices no longer lead to corresponding increases in output prices and are further muted by the forces of global competition."

Then he makes a disarming admission. "The persistence of low and stable inflation worldwide… can be explained by invoking these developments in the real economy. The role of central banks in the recent containment of inflation can, at best, be seen to have limited applicability."

Mohan's message is thus that there has been a reduction in risks across the board, both spatially and temporally. The net effect is that "Paradoxically the central banks' own success could have blunted the efficacy of their most powerful policy instrument: the short-term interest rate."

About rising oil prices and the lack of impact on growth he makes an important distinction. "Unlike in the past when oil price surges were driven by supply shocks, the current bull market in oil is mainly the result of a perceived secular increase in demand emanating from accelerated growth"

So, what next? Here we get a rough idea of why the RBI has been raising rates contrary to all expectation. "As with traditional inflation, the surging asset prices distort relative prices and cause a misallocation of resources. For instance, since households think they are wealthier, they spend more and save and invest less."

He also says that "it is often difficult to adjudge ex ante as to whether asset price misalignments are bubbles or not."

So "central banks need to take cognisance of emerging financial imbalances by lengthening their monetary policy horizons beyond the usual two-year framework. More importantly, in view of the possibility of the role of prices becoming muted as an equilibrating mechanism, central banks will have to contribute to financial stability more through prudential regulation and supervision."

In short, tell finance ministers to take a walk, and do now what they would have you do after the cloud has burst.