What do central banks do? Or do they?

AS I PEN THIS, London interest rates on overnight s aps for TRY hit 1400, the highest in a decade. That may have limited the first impact on the level of the TRY/USD exchange rate. Because foreign banks demand TRY so they can sell and turn to dollars – and run – TRY scarcity has caused the swap rate to spike. What will happen to the exchange rate going forward is unknown at this stage.

A conservative central banker – this is a technical term inspired by the past deeds of the Bundesbank – is almost always preoccupied with inflation, even with the slightest possibility of a rise in the distant future. Typically, monetary policy through the commodities channel becomes effective in 6 to 9 months. So, central banks act in advance. Otherwise, they are either caught off guard or left “behind the curve”. Well, with the exception of a few countries, all major central banks target inflation – whether they are “conservative” or not, and this is their only legally binding goal. True, there have been many changes over the last decade or so, and central banks expanded their balance sheets through ‘bad asset’ or sovereign debt purchases in an attempt to stage a rather large private sector bail out scheme. Yet they still target inflation, or at least they are bound by the constraints their legally-mandated task imposes upon them. There is no way a central bank acts arbitrarily, changes course all too often, and traces an erratic policy path. There is no way a central bank doesn’t care about inflation either. As inflation is bound to go up further unless domestic demand is curbed, well, it will surely head north at some point if the bank initiates a rate cutting sequence. Actually, by keeping the policy rate “high” for a sustained period, it would be possible to render long-term market interest rates lower. A benign mechanism – the only mechanism there is – was slowly taking root when the correct policy circuit was cut short again.


The idea was about credibility, reputation and “tying one’s hands”. The design of monetary policy to minimize these costs is the primary focus. The central presumption behind the modelling is that the policy-maker has the possibility to influence output by engineering inflationary surprises. The government has an objective function V (I, i), increasing in employment (output) I to a certain target level I* and decreasing in inflation i from some target level i. The government controls i by setting either the money supply or the exchange-rate in a small open economy. The private sector consists of firms with a neo-classical labor demand function and a number of forward- looking wage setters. The nominal wage is set for one period at a time so as to maximize some objective over the real wage and/or employment. With a known government objective, equilibrium inflation and expected inflation must coincide and without any surprise, equilibrium employment must be at the privately desired level E. Before the wage has been declared, it is optimal to set inflation at i. If E* = E, this policy achieves a first-best outcome and there is no credibility problem. But if E* > E, due to a labor imperfection – arising from taxes or from union power – it can only achieve a second-best outcome and there is a credibility problem. Private employment, ex post – after the wage has been set – is a function of the real wage and differs from E only if there is surprise inflation. Then it is not credible to announce a policy i < i* because, for any nominal wage associated with expected inflation i(e) < i, there is an incentive to deviate from the announcement ex post – to increase employment by surprise inflation. Hence, the only credible policy is i = i. The smaller the weight the government puts on inflation, the higher is the credible inflation rate i relative to the desired rate i. This is clearly a one-shot game between the government and the private sector. Its basic insight is that, given the lack of pre-commitment, the economy is characterized by an inferior Nash equilibrium –having an inflationary bias – with unemployment remaining at its natural rate.


The above analysis can be extended to repeated games. The most fundamental characteristic of a repeated game is the presence of memory in the strategic behavior of players. Sustaining equilibrium between the government and the private sector is dictated by the reputational forces operating through threat strategies that punish a rival for bad behavior. Barro & Gordon elegantly analyzed this sort of repeated monetary policy game back in the 1980s. They envisage a trigger mechanism in which inflationary expectations of the private sector are revised in response to the actual – ex post – inflationary strategy pursued by the policymaker. The initial low inflation target announcement of policymakers is recorded as viable. If actual inflation has been kept low, private agents will hold down their inflationary expectations. A reputational trade-off between the benefits of current surprise inflation and the costs of future expected inflation where “the policymaker must weigh up the current gains from cheating with the subsequent loss of reputation reflected in higher expected inflation”. The degree of threat is obviously linked to the extent of reputation loss. The priority ascribed to inflation as a policy is also important.


Time inconsistency of optimal policies basically means that an optimal policy computed at the beginning of a planning horizon does not remain optimal at a later date. Prior to certain choices made by the private sector, an optimal policy induces a response from that sector. However, ex post responses may be very different from ex ante responses. This implies that the government’s ex post constraints are different from its ex ante constraints. Under the existence of a certain form of imperfection which makes the ex ante optimal policy a second-best rather than a best, there is an ex post incentive to deviate from the ex ante optimal policy. The incentive to deviate ex post vanishes if the government is able to make a binding pre-commitment to an ex ante optimal policy. It is difficult to envision the enforcement of such binding commitments since the government is by definition the dominant player and a sovereign decision maker. Hence, those policies that would be optimal if binding commitments could be enforced do face a credibility problem due to the ex post incentives of the government not to perform as pretended. Should the central bank deviate from pre-announced policies all too often, then monetary policy becomes time-inconsistent: no credibility, period.


So, which is it? Is there a decision or a will to force real interest rates to deeply negative territory again? Is there a decision to bail out some firms through securitized, or rather to-be-securitized, NPL purchases? Is there a decision to leave the exchange rate be, even if inflation runs away from garden-variety Turkish style to a higher plateau? Even today, nobody believes inflation is lower than 25%. Is inflation nobody’s concern? Is dollarization a concern? Or should that too be seen as normal? At some point, the current carry trade game won’t wash, and the policy rate will become entirely devoid of any content and interest. Technically, the policy rate will become entirely endogenous. It won’t have any power because the market rates will be set according to much different parameters.


Printing money to finance budget deficits isn’t a good idea. In the limit, it causes hyperinflation. In the short-run, it would increase the rate of inflation, unless of course inflation is on the fall for other reasons. In this case, it may take a while to reap what one sows, and inflationary effects of monetizing public debt will show themselves in the interim term. Also, an endogenous interest rate can’t be used as a policy instrument. Where the policy rate isn’t a completely independent instrument, i.e. it is bound by constraints, it isn’t exogenous vis-à-vis the financial system, it isn’t advisable to spread the idea that it is; because it isn’t, that simple. The normal outcome would be acceleration in dollarization. If the government wrongly believes that it can use the rate of interest in a discretionary way – because it is allegedly exogenous whereas it isn’t – the only outcome would be higher inflation, run-away dollarization, and higher market interest rates. It is a credibility cycle, and a vicious one at that.

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