While the financial crisis and its aftermath have been a humbling experience for the banking industry, there is a need for humility among central bankers, too.

The global credit boom that preceded the financial crisis was supported by a view that central banks could guarantee a world of continuing steady growth and price stability in most Western economies. This belief – encouraged by the statements of then chairman of the US Federal Reserve Alan Greenspan and other central bank governors – increased the risk appetite of the financial markets which fuelled irresponsible lending.

There are other reasons for central bankers to reflect humbly on their recent achievements. Loose global monetary policy supported the excesses, which led to the financial crisis – particularly the large and sustained relaxation in US monetary policy in the early 2000s. And while low inflation could be readily achieved in a world where Asia and the emerging market economies were driving down the prices of traded goods, it has proved much harder to achieve when the same economies have been exerting upward pressure on global energy and commodity prices. Yet the central banks, which were all too ready to claim the credit for low inflation in a global disinflationary environment, are now blaming current inflation on 'one-off' price shocks.

Halos slipping

The financial crisis exposed the limitations of the view that monetary policy could keep economies on a steady-growth, low-inflation track indefinitely. It should have resulted in a more cautious assessment of the role of monetary policy. But the opposite has happened.

While commercial bankers are now pilloried as society’s villains, central bankers are riding high. They are the 'go to' players on the economic pitch, to help provide support to the economy when it is needed. And once the power of interest rate cuts is exhausted, they have now started to come to the rescue with 'unconventional' monetary policies, expanding their balance sheets and pumping money out into the wider economy.

These policies were probably necessary and justified in the depths of the financial crisis in 2008 to 2009, when demand was collapsing across the world economy. As a member of the Bank of England monetary policy committee (MPC), I supported all the bank rate cuts and quantitative easing (QE) injections made in the UK from the autumn of 2008 until the end of 2009.

No longer effective

But it is far from clear that they are justified now, three years on from those traumatic events. Monetary policy should be able to affect economic growth in the short term, over a period of one to two years. But in the longer term, its impact on growth will fade. As the time horizon expands – to three years, five years and beyond – it is supply-side and structural features of economies that determine growth. And yet we seem to be clinging to a view that all that the economy needs is another injection of stimulus to keep it going, just as the impact of the last injection appears to be fading.

In the UK and the US, there still seems a strong belief that more monetary injections will do the trick, even though both economies are experiencing inflation around double the normal level

Andrew Sentance

What is needed in the current climate – particularly in the UK and the US – is a bit more humility from central bankers and a recognition of the limits of monetary policy. The warning signs are already apparent. Across the world economy, 2010 and 2011 have seen much more inflation than conventional monetary policy would regard as acceptable, despite the impact of a massive global recession. In the Asia-Pacific region, policies have been tightened to rein this in. And a number of Western central banks also tightened policy – including Canada, Sweden and the European Central Bank.

But in the UK and the US, there still seems a strong belief that more monetary injections will do the trick, even though both economies are experiencing inflation around double the normal level. This reflects a refusal to acknowledge a key lesson from the financial crisis – that there are limits to the effectiveness of monetary policy to support economic growth over the longer term.

Limits laid bare

Unconventional monetary policy measures – such as QE in the UK – can be effective in unusual and exceptionally difficult circumstances. But we are in danger of pulling the monetary trigger repeatedly when it is not clear it will be effective or is warranted. The latest MPC decision is an example of this. And while the MPC argues that this decision is justified in terms of its inflation target framework, that claim lacks credibility when its forecasts have persistently underpredicted inflation for a number of years.

Independent central banks were established for a reason – to take tough decisions when needed, in order to maintain price stability and monetary discipline. They are not the 'saviours of the universe' just as the commercial bankers were not the 'masters of the universe'. It is time to recognise the limits of repeated bouts of stimulus and return monetary policy to a more conventional focus on price stability.

Andrew Sentance was a member of the Bank of England monetary policy committee from October 2006 to May 2011.

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