The era of central bank convergence is over

It was in 1989 that the Reserve Bank of New Zealand became the first central bank to adopt a formal inflation target, along with the independence to hit it as it saw fit.

Since, the idea has spread around the world and about two-thirds of countries have adopted inflation targets, according to the Bank for International Settlements. Most advanced economies have goals of 2 per cent.

It’s a remarkable convergence. Yet there are signs that trend’s now fraying. Last week New Zealand’s government said it would force the central bank to consider the effect of its monetary policy on house prices, a move which would mean higher rates than a focus solely on consumer prices would entail.

This from the FT’s Jamie Smyth:

The contentious instruction, which some economists warned would undermine the Reserve Bank of New Zealand’s independence, was initially opposed by the central bank and sent government bond yields higher. But changes to the remit of the RBNZ’s monetary policy committee will require it to consider policies related to achieving more sustainable house prices, the government said on Thursday.

New Zealand is an outlier, not just in geographical terms, but in getting the virus under control. It is, therefore, no surprise that house prices here have shot up. According to Knight Frank, prices in Wellington rose by 8.7 per cent in the year to the third quarter of 2020, and by 5.8 per cent in Auckland. However, property prices have risen in most advanced economies since the pandemic (chart, again, via the BIS):

This does not mean a wave of central banks will drop their inflation targets. What we do expect, however, is for central banks to follow New Zealand’s lead by increasingly reflecting the national political mood.

Take the Federal Reserve. Its new framework has not only a greater tolerance of inflation above 2 per cent, but more of a focus on a broad and inclusive definition of employment. Lael Brainard, one of the most well regarded members of the FOMC, said last week the central bank would focus on a far broader set of metrics than the standard U3 rate that economists have tended to rely on:

At a time when the national headline unemployment rate was at a multidecade low, community and labor representatives and educators noted “it’s always a recession” in their communities. They challenged whether the overall economy could be characterized as at “full employment” while unemployment remained in the double digits in their communities.

Reflecting this input, and in light of persistently below-target inflation, low equilibrium interest rates, and low sensitivity of inflation to resource utilization, we made several important changes to the monetary policy framework. Two changes have particular relevance for the employment leg of the dual mandate. The new framework calls for monetary policy to seek to eliminate shortfalls of employment from its maximum level, in contrast to the previous approach that called for policy to minimize deviations when employment is too high as well as too low. The new framework also defines the maximum level of employment as a broad-based and inclusive goal assessed through a wide range of indicators.

That, of course, chimes with the views of prominent members of the Biden administration, including former Fed chair Janet Yellen. (Though the adoption of the new framework predates the appointment of both, it ties in with broader concerns about US inequality.)

Europe, meanwhile, has led the way in carving out policies to combat climate change. Is it any surprise, then, that both the Bank of England and the European Central Bank have been more proactive in speaking out about greening the financial system than the Fed? Or that the Fed only joined the Network for Greening the Financial System, a consortium of about 75 central banks that back the Paris goals to keep a lid on global warming, after Donald Trump had lost the US election?

As far as monetary policy goes, the big central banks are likely to continue to ape one another to a large degree for now. Indeed don’t discount others following the Bank of Japan’s lead and deploying yield curve targeting, should bond markets throw a fit.

But the era of ever greater convergence has ended.

The idea of central banks as independent institutions — an idea that arose alongside inflation targeting — was always a chimera in that it neglected independence was bestowed by governments.

In his recent documentary, Can’t Get You Out of My Head, there’s a segment where director Adam Curtis cuts to disgruntled voices in the UK’s north-east, their manufacturing communities hard hit by the summer rate hike in 1998 by a then-newly independent Bank of England. There’s deep flaws with the argument that central bank independence is to blame for the UK’s industrial decline. Germany has long had one of the most independent central banks in the world; its manufacturing sector has thrived. Yet Curtis speaks to the broader trend in the UK and elsewhere of the general public feeling ill at ease with the degree to which power has been handed to unelected experts.

In the case of some monetary authorities, such as the European Central Bank, independence is well enshrined — re-writing EU law is not easily done. In the case of most other central banks, not so much. Either monetary policymakers act like the Fed and wake up to the — occasionally more jingoistic and often more technocrat-phobic — mood of the times. Or risk a bigger backlash from lawmakers.