Central banks are wrong to abandon key guardrails

Raghuram Rajan The writer is a former central banker and a professor of finance at the University of Chi- cago’s Booth School of Business · Dec 19, 2023

Macroeconomic policy in industrial countries has become much more discretionary of late, and not necessarily in a good way. When sensible, it is focused on the long term, and moves to stabilise the economic cycle rather than accentuate it. So the government should shrink deficits when the economy is doing well, even as monetary policy gets tighter, and the opposite should happen when the economy is doing poorly. One benefit of pulling back policy stimulus in boom times is that it preserves the capacity to intervene in downturns.

However, few politicians like to cut back when the economy is doing well, and central bankers might be unwilling to incur public ire by raising rates just as the party gets going. Countries with dysfunctional politics are particularly prone to overspending and contractionary policies set in only when there are no other alternatives.

Recognising the folly of such cycle-accentuating policies, many industrial countries previously adopted self-constraining guardrails such as inflationtargeting frameworks for the central bank, deficit rules and debt brakes for the government, and so on. Over time, as they saw economic volatility in industrial countries moderate, a number of emerging markets got religion and adopted these guardrails.

So far, so Economics 101. The global financial crisis of 2008 upended the political consensus. Central banks came under scrutiny, not so much for missing the pre-crisis risk-taking, but for not doing enough to revive growth — after all, inflation was consistently below target post-crisis. And so they pulled out all the stops, holding rates at zero for long periods, and engaging in quantitative easing. The Federal Reserve even changed its framework to target average inflation, committing to be more tolerant if it materialised.

Even before economies had normalised, though, the pandemic hit in 2020, followed by the Ukraine war. Government spending took off, with the rationale that these rare events were nobody’s fault, and everyone’s suffering should be alleviated. Fiscal concerns and constraining guardrails were overridden.

In the US, every constituency, from pensioners to airlines, was appeased through multiple rounds of stimulus. A bond market anaesthetised by Fed bond buying showed little concern. The spending contributed to inflation that the Fed, held back by its more tolerant framework, was initially slow to address. However, even as it has raised rates rapidly, the US continues with fiscal deficits of a size never seen outside recessions. With Congress divided, it is hard to see these shrinking significantly. Monetary policy is fighting fiscal policy, a textbook no-no.

There seems to be little urgency to rein in spending elsewhere either. Europe intends to return to its rules on deficits next year, but it is unlikely these will be enforced for some time. The over-indebted Japanese government’s latest supplementary budget is intended to help citizens with rising prices, even as inflation is taking off.

Interestingly, some emerging markets such as Brazil and Mexico have been much more cautious in expanding deficits. Borrowing was contained. They raised rates early, when they saw signs of inflation. Consequently, they have not experienced the usual emerging market jitters. Orthodox policy guardrails have stabilised their outcomes, despite domestic political volatility.

Notwithstanding such examples, there is a tendency among some industrial country policymakers to claim they do not need to restore their guardrails. They assume they will use discretion wisely. If only! Politics are likely to become yet more dysfunctional, not just in the US, but also in Europe, as countries grapple with ageing, immigration and climate action, even as debt service eats away more and more government revenues. In this regard, the German Constitutional Court’s decision to restore pre-pandemic constraints on deficits should be welcomed.

With the inflation genie unleashed, central banks need to refocus their frameworks on combating high inflation rather than being tolerant of it. The Fed seems to have rightly abandoned average inflation targeting, not least because recent high levels may require it to go well below 2 per cent if it is to reach a reasonable average. When inflation is tamed, the Fed will have to revisit its framework, perhaps restoring much of the pre-pandemic one.

Of course, reinstating macroeco- nomic guardrails may not do much to constrain Donald Trump, who even threatens democracy if he is restored to power. But as emerging markets have learnt, every little helps.