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Central banking – A deep design problem now in economic governance? Need a fix or new design?

Article’s Background

This article is based on views expressed by two globally leading business persons this week regarding operations of the US central bank, Federal Reserve (Fed), which can be applied in general to central banking. 

  • According to an article published in yahoo!finance website on 17 May 2024, Elon Musk, the third richest businessman in the US, has compared the Fed’s money printer to a game of monopoly (see article here) (It was reported that the President of Sri Lanka also met him today in Indonesia). This view is based on generally limitless amount of money that the Fed can supply and, therefore, the Fed never goes bankrupt. He also has raised concerns over the US fiscal deficit which is expansionary in money. 
  • According to an article published in Fortune website on 18 May 2024, Rick Rieder, Chief Investment Officer at Blackrock, has proposed (at a Bloomberg interview) that the Fed reverse the tight monetary policy course and cut interest rates now to tame inflationary pressures at the present stage (see article here). This is the opposite to the world view of central banks and conventional monetarists on inflation control.

The credibility of both gentlemen is not doubted for their comments. Therefore, this short article is designed to have an insight into the two views above on central banking to establish that central banks in the present model are significant misfits to the modern monetary economies and living standards.

Evolution of central banks and monetary policy

  • Invention

Central banks commenced evolving from commercial banking to unify multi-currency systems under the single legal tender or sovereign currency issued by central banks on behalf of the governments while performing as bankers’ bank and banker to the government. Accordingly, central banks became the monopoly printers of currency to drive the monetary system. Therefore, the public duty of early central banks was to maintain the stability of the monetary and banking system. 

  • Monetary policy

However, the creation of money through credit operations by banks on the use of currency as the reserve became the major source of the money stock circulating to fund real business activities. Therefore, central banks later started practicing the monetary policy or money printing to regulate the stock of money for various economic objectives such as the control of inflation and promotion of growth and employment. 

The monetary policy at the beginning was primarily about how central banks regulated the country’s stock of currency through their conscious actions such interest rates charged on loans given to member banks and restrictions imposed on such loans. Depending on the tightness of the availability of currency issued by central banks (monetary policy), credit conditions in the economy are affected as currency reserves kept by banks to support credit operations also are affected by the monetary policy.

  • Control of bank reserves

In present monetary systems with IT-based payment systems and fund management applications, banks maintain and operate their reserves at respective current accounts held with the central bank as the key conduit to manage their cash flows. Accordingly, these reserve balances are used for managing liquidity of banks including payment settlements taking place through inter-banks. This is especially required as the inter-bank payment system is operated and maintained by central banks where the settlement takes place through bank current accounts held with the central banks. 

  • Policy interest rates

Therefore, in controlling of bank reserves in modern market-based monetary policies, central banks target the aggregate amount of bank reserves available or flowing in bank accounts with them to be in line with relevant economic policy objects. The central bank interest rate or policy rate is the key policy instrument used to regulate bank reserves. The amount of reserves banks use in currency form depends on cash requirements of banks to meet the currency demand of their customers.

  • Present monetary policy model

In the present model of policy rates-based monetary policies, central banks have the common habit of changing policy rates by looking at deviations of annual change of the consumer price index from the inflation target, i.e., 2% in developed market economies. This is based on the questionable, old monetary concept of inflation as a monetary result arising from the direct impact of the money stock on the demand side of the economy, i.e., aggregate demand for goods and services. 

Accordingly, the common monetary policy prescription adopted world over is to raise policy interest rates to bring down inflation when it rises above the target inflation and vise versa. This instrument is envisaged to target the range of overnight inter-bank interest rate to deliver all macroeconomic wonders expected in the monetary theory.

Acceptability of Elan Musk’s view on monopoly money printing game

Therefore, monopoly money printing of present central banks imply the discretionary ability of central banks to expand or contract reserves or funds in bank accounts held with them. If one sees how central banks conduct monetary operations or so called open market operations, it is really a game of money printing as stated by Elan Musk because the way central banks behave in money printing and talk about underling monetary policies are confusing. Several instances are given below.

  • While standing facilities are available to provide reserve to banks, various other devices including trade of government securities also are adopted to provide reserves as well as to take out reserves from banks simultaneously.
  • These devices are operated on overnight basis and various term basis that nobody understands the specific purpose where central banks talk about short-term liquidity (or reserves) and long-term liquidity at times.
  • Special lending/liquidity facilities at favourable rates are provided covertly without any public communications.
  • For inter-bank settlements, interest-free, limitless lending facilities are provided for within the day repayment and interest is charged if not settled at the end of the day. Therefore, a huge amount of free reserves is provided for financing daily business operations as required by banks, irrespective of central bank targets of bank reserves.
  • Interest is paid on bank reserve balances overnight.
  • The trade of government securities and thereby the fiscal deficit are largely used conduits to to change the level of bank reserves and interest rates in the economy.
  • Policy interest rates and total reserve operations are inconsistent with the monetary policy story.
  • Ad-hoc change in interest rates on various grounds in cycles is a major part of the game as nobody can figure out their actual effects even after years of interest rate cycles. 
  • Central banks although they fund their asset operations through money printing report diverse figures of profits and losses.
  • Irrespective of losses and erosion of capital, no central bank goes bankrupt as they do not have to repay their currency liabilities. Even if the public reject currency as money or legal tender, for instance Zimbabwe and Venezuela, central banks neither go bankrupt nor get closed down.

The Fed’s money printing game can be understood by looking at irregular movements of Fed assets funded through money printing during last 15 years (see the chart below).

Rick Rieder’s view to cut interest rates to tame persistent inflationary pressures

Rick Rieder is a leading market player betting on interest rate and money printing game of the Fed and other central banks, given the wide investment profile of the Blackrock (also an investor in Sri Lankan Sovereign Bonds under default). Therefore, he has observed the presently unprecedented inflationary pressures reported after 1970s and highest levels of interest rates reported after 2001 to fight inflation in line with the old monetary book. A few highlights of the problem are as follows.

  • The US inflation which was mostly below 2% until the pandemic period since 2007/09 financial crisis rose precipitously to the peak of 9.1% in June 2023 as compared with 1.4% in January 2021 and fallen to 3.4% in April 2024.
  • The policy interest rate has been raised to 5.25%-5.5% at present from 0-0.25% in February 2022. The increase cycle has passed 11 consecutive hikes in total of 5.25%. The present level of 5.25%-5.5% has remained for the past 10 months.
  • The Fed keeps telling that interest rates are appropriate at current level and will stay longer until the full confidence is received towards inflation falling sustainably to 2% target. Therefore, inflation control still lays long way behind as inflation seems to be persistent and downward rigid.
  • In contrast to expectations in the monetary theory,  the growth and employment remain strong with an unemployment rate below 4% at 50 years low.
  • The position is similar in the UK and Euro Zone too (see two charts below). Inflation in all three countries is persistent above 2% target while policy rates have been in the range of high 4.75% – 5.50% for the past 8-10 months.

In this background, Rick Rieder proposes to cut policy rates now to tame persistent inflation. His view is supported by several facts.

  • First, non-response of inflation to so tight monetary policy to bring inflation back to the target of 2% even after two years of monetary tightening shows the strong existence of non-monetary and supply side factors behind high and persistent inflationary pressures.
  • Second, high interest rates have led to rising interest income on investments of the middle and high income classes and they have tended to use this income to raise spending on services products. Therefore, services inflation continues to stay high and transmit further inflationary pressures to other demand sectors.
  • Third, in modern monetary economies, interest rate is a fundamental component in the cost of production and product pricing where production activities are not significantly sensitive to interest rate changes. This position is proved by the continued strong growth and tight labor market conditions. Therefore, high interest rates is a part of the problem of high prices and persistent inflationary pressures through cost-push factors. This is the position strongly taken by the present Turkish President who sacked three central bank governors in the row on the allegation of raising interest rates to control inflationary pressures. He has been continuously advocating for lower interest rates to reduce cost and increase production which jointly reduce inflation. That is the reason why the US government now implements the Inflation Reduction Act to fix supply bottlenecks behind structural inflation although inflation control is the Fed responsibility.

Accordingly, Rick Rieder’s view is that cutting policy rates now will revise inflation dynamics such as sectoral inflation differences and cost of production/productivity in the US economy which will help ease present inflationary pressures. This is a very practical position that is not provided for in the monetary theory of inflation. Therefore, this view is against the present model of interest rates-based monetary policy.

Remarks – The need to redesign central banking service

  • World over, public agitations are rising against unbearably high interest rates and inflationary pressures although central banks promise to tame inflation over medium-term.
  • In the UK, central bank’s interest rate setting monetary independence has already been challenged by Conservative MPs.
  • In the US, Presidential candidate Donald Trump has promised to abolish the present interest rate setting system of the Fed and to take it under the President. There are allegations that the Fed purposely delays cutting interest rates now despite significant disinflation path as it could drive political benefits to the incumbent President at the election due in November this years.
  • Overall, monetary and economic perspectives of modern economies are vastly different from those at the inception of central banks and development of monetary/inflation theory and market-based monetary policies in 1980s. The policy model was spread to developing countries by the IMF/World Bank subsequently through conditions imposed on their lending programs.
  • The pandemic has challenged the validity of the policy model as central banks did not have experience in dealing with economies confronted with global health pandemics. They have policy experiences only in dealing with business cycles and financial crises and connected price pressures. That is why central banks in advanced market economies have miserably failed to arrest post-pandemic inflationary pressures being confronted from the middle of 2021.
  • Central bank inflation control/price stability work is only a statistical exercise in estimation of inflation as well as analysis of dynamics and forecast of inflation. What is important for the price stability is to control the cost of living of general public. However, central banks do not have instruments to bring back prices to previous levels after changes. Therefore, inflation control or price stability object of the monetary policy is meaningless for stable cost of living.
  • Financial stability also is a broken mandate of central banks in view of the history of financial crises. They talk about strong and resilient financial systems until crises touch down unexpectedly.
  • Markets have invented a lot of electronic moneys operated by private markets cross border  leading to falling needs of cash reserves and, therefore, theoretical monetary policy stories have become redundant in evolving markets. 
  • Therefore, central banking of the present model has become a deep design problem of the state confronting economies and societies driven by the modern technological advances with the latest being Artificial Intelligence that central bank bureaucracies will not be ready to adopt soon.

Therefore, unless central banks are redesigned to be effective in modern market mechanism and monetary and financial needs of the public, they will remain to be another deep state bureaucracy not serving the general public in improvement for their living standards. As such, the wide spread notion of the central bank independence will be a threat to the national security too as independent central bank managers do not fall from the divine world.

It is unthinkable why Sri Lankan lawmakers gave a brand new independence to the central bank which has miserably failed in its stability mandate on all fronts pushing the country into bankruptcy in 2022.

This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures. All are personal views of the author based on his research in the subject of Economics which have no intension to personally or maliciously discredit characters of any individuals.)

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 12 Economics and Banking Books and a large number of articles published.  

Source: Economy Forward

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