9 Min Read
By Tomasz Janowski and Paul Carrel
TOKYO/FRANKFURT, April 18 (Reuters) - It is your first day as the new U.S. Federal Reserve chief: the main interest rate is 4.50 percent, the economy is overheating and the task is to keep inflation and unemployment low.
Once in a while there is a curve ball -- an oil crisis or a dollar spike -- and if you move rates up or down appropriately you will be reappointed.
Central banking was never as straightforward as "Fed Chairman", an online game created by the San Francisco Fed over a decade ago for high school and college students.
But playing it could make Ben Bernanke and his global counterparts long for simpler times.
A 3-D shootout game would now be closer to reality as they reluctantly fill the policy void left by hamstrung governments, at risk of overreaching and experimenting with measures that may have unpredictable consequences.
"There was a time, not too long ago, when central banking was considered to be a rather boring and unexciting occupation," European Central Bank President Mario Draghi said this week.
"Some thought that monetary policy could effectively be placed on auto-pilot. I can confidently say that this time has passed."
There has been no respite since the 2008 global financial crisis. Top central banks have slashed rates to zero, pumped in vast amounts of cash, helped orchestrate bailouts and fired their "big bazookas": buying trillions of dollars of government bonds to calm markets and spur lending and growth.
Whatever they do never seems to be enough for governments saddled with high debt and markets still fighting the hangover from the debt-fuelled binge that preceded the crisis.
But here is the paradox: humbled, constantly pressured by politicians and having lost much of the respect accorded to former Fed Chairman Alan Greenspan and his colleagues in their heyday, central bankers are more important than ever.
They are expected to preserve financial stability and engineer economic recovery that political leaders by and large have been unable to produce. That is a radical departure from the 20th century model, where central banks focused on curbing inflation and protecting the value of their currencies.
"Monetary policymakers have become not only the lenders of last resort, but the policymakers of last resort," said Barry Eichengreen, a University of California professor and expert on the international monetary and financial system.
In Japan, Prime Minister Shinzo Abe is looking to the central bank to end deflation, British Finance Minister George Osborne hopes new Bank of England head Mark Carney can succeed where he has failed and revive the economy. Last month it was the ECB that threatened to cut off funding to Cyprus if it did not agree a bailout plan.
When short-sellers breathe down distressed governments' necks every time they hold a debt auction, unelected central bankers can act quickly enough: no lobbying, trade-offs or parliamentary votes required.
They also have something governments desperately lack: money. In fact, like modern-day alchemists, they can and are creating it in unprecedented amounts.
Following the crisis there is a broad agreement that low inflation is not enough for economic success. Financial stability is also essential but there is no consensus on what role central banks should play in achieving that.
Central bankers hark back to simpler times but critics say many of today's woes are due to complacency in the good times.
"There is this nostalgia among central bankers about the good old days of the 1990s and early 2000s when you just set interest rates and all was very straightforward, but that was a delusional paradise," says Adam Posen, a U.S. economist who served on the Bank of England's policy council in 2009-2012 and now heads the Peterson Institute, a Washington think-tank.
The crisis shattered the theory of "Great Moderation", that solid growth could go hand-in-hand with low inflation and bull markets if central banks focussed on price stability.
Today, economists and central bankers see two mistakes: giving policy too much credit for what was in part an effect of China's rise as a low-cost manufacturing powerhouse, and underestimating risks brought by sweeping deregulation.
After the crisis new risks for central bankers have emerged.
One is that out of a sense of duty -- or caving in to pressure from politicians, investors and the public -- central banks will end up promising more than they can deliver.
"A worry is that monetary policy would be pressured to do still more because not enough action has been taken in other areas," Jaime Caruana, chief of the Bank of International Settlements, said at the bank's annual conference last June.
"As the benefits of extraordinary monetary easing shrink and become less certain, the risks of expanding central bank balance sheets are likely to grow. Such hazards may materialise in ways that are not completely clear today."
Policymakers could also repeat the mistake of the Great Moderation and confuse broad and permanent structural changes in the world economy with problems that occur at different stages of the economic cycle.
Just as the "China effect" on inflation in the 1990s was underestimated, today the demographic and structural factors eroding rich nations' economic health are problems that central banks cannot fix.
"I think there is a little bit of desperation and thrashing around to find some way of getting a better economic picture," said Andrew Sentance, who served on the Bank of England's policy council in 2006-2011.
"Lots of the reasons for under-performance have nothing to do with monetary policy, and this is the new normal for Western economies in general."
Part of that "new normal" could be the average 2 percent economic growth the United States has seen since the crisis, he said. Yet the Fed keeps trying to shift the world's biggest economy into higher gear, having pumped over $3 trillion into it, equivalent to about a fifth of U.S. annual economic output, and continuing to buy government bonds and mortgage-backed securities.
Bank of England Governor Mervyn King said back in 2000 that it was the bank's ambition to be boring. He and his peers at the Fed, the ECB and the BOJ have been anything but.
Canada's central bank boss Carney, 48, who in July will succeed King to become the first foreigner to run the BoE in its 319-year history, aims to restore a measure of "boring". He told UK lawmakers: "I want my exit to be less newsworthy than my entrance."
However, some worry that with monetary stimulus affecting currencies and fund flows, central banks will in fact end up in an "arms race."
Earlier this month, Japan's new central bank chief Haruhiko Kuroda delivered spectacularly on his pledge to do "whatever it takes" to beat deflation with a $1.4 trillion stimulus plan that accelerated the yen's slide to four-year lows.
The BOJ pioneered the policy of "quantitative easing" a decade ago, when it switched to targeting the amount of funds pumped into the economy rather than short-term borrowing rates. But later it lost faith in its effectiveness and only under Kuroda has it fully embraced the Fed's thinking that the risk of doing too little is greater than of doing too much.
Spain's Prime Minister Mariano Rajoy wants Europe to look at changing the ECB's powers to give it instruments other authorities are using.
"The danger that we drown in money is small compared to the danger that we slide deeper into crisis and that it gets harder to get out," said Marcel Fratzscher, former head of research at the ECB and now head of Germany's DIW economic institute.
But nowhere is unease about expanding the role of central banks greater than in Germany, home to the fiercely independent Bundesbank.
Germans worry that relying on central banks minting cash creates a dangerous illusion that there are pain-free fixes to problems of largely political, social or demographic nature.
Another fear is that by venturing beyond their core responsibility of keeping prices in check, central banks risk compromising the credibility needed to fulfil that mandate.
While the spotlight is on central banks in the largest economies, most of the world's monetary institutions have not reached the limits of conventional interest rate policies. Some, like Poland's central bank boss, are sceptical of the new tools.
"Ultra-low rates or quantitative easing policy, ...it all leads to significant economic imbalances," Marek Belka said last week after holding rates at 3.25 percent. "That's why there's a willingness to run monetary policy in a conventional way."
With Abe and Kuroda experimenting to try and pull Japan out of its deflation trap, an elder statesman of policymaking has also warned against getting carried away again with expectations of what central banks can do.
"They think they can use deliberate fluctuations in the inflation rate to manage the economy," said Paul Volcker, 85, who led the Fed's charge to end high inflation in the 1970s.
"But the central bank is not an all-powerful tool."