Are central banks getting it all wrong?

By Sumeet Desai
Reuters
Friday, August 8, 2008

http://www.reuters.com/article/ousivMolt/idUSL721669220080808

LONDON -- The world may have changed on August 9 last year as the credit crunch first bit, and even some policymakers are beginning to question whether the way they work out what's happening in the economy is flawed.

The market upheavals which started a year ago have now spread to the wider economy. They are threatening to throw the industrialized world into recession but soaring fuel and food prices are pushing up inflation, preventing central banks from offering more succor.

Central bank forecasts this year have consistently been getting it wrong, underestimating how fast inflation would rise or how quickly economic growth would slow.

Many commentators and even some policymakers are now worried that central banks could be making the wrong decisions about interest rates because the tools they use for forecasting don't pay enough attention to the real world.

"I am very struck by the value placed on little models that are never actually confronted with data from the real world," said one G7 central banker. "This is not science in my view."

One argument is that models can be useless at economic turning points, the central banker told Reuters.

Instead of recognizing the economy is moving from growth into recession, the models can assume that everything is in balance. Many are linear and therefore may not account for a difference in the way in which economies act at different stages of the business cycle.

Models could also be misleading policymakers because some do not take account of the effect of changes in prices when a trigger point is reached. For example, the model could fail to highlight a step change in output growth that could occur if oil prices moved past a particular level.

... Unhappy birthday

It is commonly held that the global credit crunch started on August 9 last year. However, its cause can be taken back to exceptionally low interest rates after the September 11 2001 attacks on the United States, which prompted investors to look almost anywhere for greater profits.

Banks started making home loans to Americans who could not previously get credit, and packaged up this "sub-prime" debt into complex financial instruments which few people understood.

When U.S. property prices collapsed and defaults rose, financial institutions around the world found themselves holding billions of dollars' worth of toxic debt. They stopped lending to each other and the credit crunch began.

Since then it has claimed U.S. investment bank Bear Stearns, British mortgage lender Northern Rock and thousands of jobs in the financial industry.

Many economists are warning of possible recession which will help to tame inflationary pressures. But many policymakers seem to be more worried about their inflation-fighting credentials.

The European Central Bank raised interest rates last month. The U.S. Federal Reserve and the Bank of England have been thinking about doing so.

The guardians of price stability feel they have no choice. Fighting inflation is their primary focus, and in the case of the euro zone and British central banks their explicit mandate.

Their models assume people like price stability so they can make the right decisions with their money,

But people are not always so rational and can often talk themselves into recessionary behavior. Central banks put a lot of faith in inflation expectations but there is little consensus on a good way to measure these or how they are formed.

The ECB already appears to be back-pedaling a month after its rate rise, and President Jean-Claude Trichet said on Thursday that euro zone economic growth would be substantially weaker in the second half of the year.

The ECB had only partially anticipated the slowdown. Trichet, like many of his colleagues around the world, is worried that high inflation rates will cause so-called second-round effects -- when workers seek bigger wage increases and companies try to raise prices, leading to an inflationary spiral.

Dovish policymakers, however, argue that it is nonsense to expect big pay rises when unemployment is likely to climb.

While economic models might argue for higher interest rates now which could be followed by cuts later, the economic and political costs of such action could be severe.

Belgian economics professor Paul De Grauwe compares policymakers' defenses with those which German forces simply skirted around to invade France in World War II.

"There is a danger that the macroeconomic models now in use in central banks operate like a Maginot line. They have been constructed in the past as part of the war against inflation. The central banks are prepared to fight the last war," he wrote on his website.

"But are they prepared to fight the new one against financial upheavals and recession? The macroeconomic models they have today certainly do not provide them with the right tools to be successful."

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