ECB, RBI and the Monetary Policy Framework

As we keep chasing the central bank actions around the globe, sometimes the thought crosses my mind - how would the world have looked like without them? With exceptions like BOE which was incorporated in 1694 others like the Fed, ECB, RBI etc are of recent vintage only, so this is not an unimaginable construct. In the US, the idea of creating a central bank faced stiff resistance and it was only in the early twentieth century, following a bank run, that a proper Fed structure with defined charter was put in place. There is a book by the name 13 Bankers by James Kwak and Simon Johnson which traces the history of the creation of the Fed and surprisingly reads like a crime thriller. But history of their creation apart, one can’t deny the importance of these institutions and the order which they bring to the chaotic world in which we live today.

There are two developments of note which we follow today in the context of CBs. One is obviously the ECB meeting where the ECB chief is slated to announce the extension of bond buying both in terms of amount and tenor. A side show can be her comments on the euro strength. Last time ECB Chief Lagarde had said that they are keeping a close watch on the Euro levels without indicating what levels will spur them to act. The other news item of note appeared in the domestic markets yesterday and quoted some unnamed government officials saying that government might recommend easing of inflation targets to spur growth. The bond yields eased on the news with the 10 year benchmark bond witnessing a 3 bps drop.

In this context let’s take a brief detour to understand a bit more about the monetary policy framework under which these CBs work and how they have evolved over time. As we have written previously many times we can trace the beginning of the modern world that is the current structure which we identify with, to the start of the Bretton Woods system (around 1945).  CBs in the BW followed independent policy on the rate setting but the exchange rates were more or less fixed which ultimately was anchored to a specific gold/USD price. The cracks in the system started appearing in the 1960s and it was finally jettisoned in 1971 with the era of freely floating exchange rates coming in.

CBs in the new era then wanted a new anchor to base their policies on. The idea was to bring predictability in the conduct of current account which was the focus area. For a brief period, some CBs came with the idea of targeting the money supply in the economy. German Bundes Bank for example gave the annual money supply target based on a calculation of real GDP and inflation projections. Readers would identify the problem with this approach. CBs can obviously control primary money creation but the M2 and M3 quintessentially depend on the money creation which the credit ecosystem (read banks) in the economy are doing. As innovations in high finance happened the money targeting approach lost its heft as credit creation took lots of innovative forms.

Finally in the 1990s the search for the holy grail ended with the idea of inflation targeting, this is where we see majority of the central banks now. The idea was to give long term predictability to the market players on their interest rate expectations. The tool to achieve the same was to change the short term interest rates like Fed fund rates, repo rates etc. Any call to change the inflation targets need to be seen in this context. As paucity of time and space stops us today, we will come back to this topic in our later notes.