Unmaking Orthodoxies

After a decade of low or negative interest rates, central banks are back in the business of fighting inflation. One of the clearest signs of the change in monetary policy stance is the largely synchronized tightening across high-income countries—last year, interest rates were increased by the central banks of Australia, Canada, the Euro Area, New Zealand, Norway, Sweden, Switzerland, the United Kingdom, and the United States, which together account for around half of global gross domestic product (GDP). As interest rates go up, however, so do the risks of economic contraction. 

The trade-off between stabilizing inflation and stabilizing output (at least in the short-run) is ultimately what monetary policy is about: central banks must decide how much output losses and unemployment they are willing to tolerate in order to attain more stable inflation. So far, central banks have claimed that stabilizing inflation takes priority to avoid harsher monetary tightening and thus more economic pain down the road. Given the uncertainty in the inflation outlook, the most common advice from monetary academics and practitioners is for central banks to stay tight but ready to reverse course should the circumstances require, aka if a very severe recession takes hold.¹

The assumption behind these claims and suggestions is that central banks can rather unproblematically switch from their role as inflation fighter to the one of recession fighter. In other words, the underlying idea is that, at different points in time, central banks are equally capable of fighting inflation as protecting employment and economic activity. Yet the experience of the past decade casts serious doubt on this assumption.² Yes, central banks unmade monetary orthodoxy to stimulate economic activity and sustain employment in the aftermath of the 2008 global financial crisis. As the financial crisis unleashed severe deflationary and recessionary forces, central banks experimented with then largely unknown and unconventional policies, whose intended effects were to stimulate the economy once conventional interest rate policy had reached the zero-lower bound.³ Despite this turnaround, central banks deviated from orthodoxy reluctantly and only under specific conditions: when they could protect their reputation as conservative and politically neutral inflation-fighter. That is to say, central banks’ support to economic activity was conditional on the preservation of the institutional image that monetary authorities have carefully crafted since the 1980s. 

Central banks are incentivized to uphold their reputation in order to preserve their independence and political survival over time. Keeping up with reputation, however, can undermine the well-being of domestic economies. This is what happened as deflation supplanted inflation as the main economic problem: central banks often subordinated monetary accommodation to the preservation of their preexisting reputation, thereby making them reluctant to sustain economic activity. In a nutshell, central banks “cannot have it both ways”: they cannot equally fight both inflationary and recessionary forces if they are to preserve institutional expectations. Here is what the recent historical record tells us about central banks’ ability to deviate from their inflation-fighting mandate and what lessons this record suggests for current economic and political circumstances. 

Monetary orthodoxy and reputation: 1980-2008

For over four decades, economic policymakers in high-income countries have been preoccupied with inflation. The inflation wave that started in the 1960s and deepened in the 1970s came alongside stagnating economic growth and soaring unemployment. The process of taming inflation was not straightforward and often marked by renewed inflationary virulence.

Fighting this inflationary wave was so formative for economic theory and policy that it is widely recognized as “the defining macroeconomic event of the second half of the twentieth century.”⁴ In particular, the success in controlling inflation that started in the 1980s, heralded by the US Fed under the leadership of Chairman Paul Volcker, marked the rise of a distinct monetary—and broadly macroeconomic—regime. Under the new regime, low inflation was elevated as the primary macroeconomic goal for domestic societies to pursue, and central banks were empowered to achieve that goal via the use of interest rate technology. 

In order for central banks to be credible—to convince economic and financial actors of their resolve to keep inflation low and stable—two conditions were identified: legal independence, which led to the wave of legislated delegation of monetary policy to central banks around the world, and, importantly, a reputation based on conservativeness and political neutrality. Indeed, the Volcker Fed fight against inflation came to epitomize a distinct view of central banks’ mission, namely, the view according to which “central banks can and should use monetary policy to maintain low inflation over time.”⁵  The notion of monetary neutrality was based on the observation that, in the long run, interest rate policy affects only nominal variables (i.e., price and inflation) and not real economic variables (i.e., employment and output). As a result, central banks could claim that their decisions do not have real distributional economic effects. One way in which central banks have signaled the distributional neutrality of their decisions has been the break-up of any form of explicit coordination with fiscal authorities. “The idea of financing fiscal deficits via money creation thus came to be seen as a mortal threat to central bank independence.”⁶ Monetary policy should simply not be enmeshed with governments’ policy and the attendant distributional consequences.

Reputation has proved a key political asset for contemporary central banks. Indeed, even if they are legally independent, central banks are still public institutions and, as such, they are dependent on government and public support to operate and survive over time. Their reputation has been instrumental in this endeavor. That is to say, sustaining and maintaining a reputation for being inflation-averse and politically neutral institutions had been the trademark of successful central banks since the 1980s and a crucial channel through which to build political and societal support for central bank policy.

Before the recent crisis period, central banks’ reputation was perfectly attuned to the economic and political conditions of the times. From the late 1980s until the early 2000s, low inflation and sustained economic activity justified what central banks had been doing, namely, placing relatively more weight on achieving the inflation objective as a way to tame, or even put an end to, the business cycle. 

Then, the world changed. The crises of 2008 and 2020  took their toll on economic production and employment. Fighting recessionary and deflationary forces as to avoid the kind of 1930s Depression scenario thus became the first order of business. 

In these changed circumstances, central banks moved away from the pursuit of low inflation—and interestingly so given the implications of recession and deflation fighting for central banks’ reputation. Indeed, fighting depressionary forces requires central banks to commit to actions that generate (not counter) inflationary pressures. With interest rates at the zero lower bound, fighting depressionary forces also entailed that central banks utilize openly distributive decisions, such as direct credit allocation to specific sectors and groups in order to sustain economic activity and employment. In practice, deflation fighting required central banks to act irresponsibly, that is, to act against the conservative and neutrality principles that had been the hallmark of their reputation.⁷

Yet, central banks did it—at least at first glance. Between 2008 and 2020, not only did major central banks bring interest rates to zero to boost moribund domestic economies. They also provided and sustained monetary accommodation by venturing into unconventional policies that up to that point had been considered a “theoretical curiosity” at best.⁸ With policies such as lending to banks (and even to nonbanks) in huge volume and large-scale asset purchases (so-called “quantitative easing”) central banks have strayed away from the orthodox terrain of interest rate policy and price stabilization to give pride of place to economic growth and employment considerations. Indeed, although the precise objective of unconventional policies varied among countries and over time, the key common thread of policies such as large-volume liquidity provision to financial institutions and the purchase of long-term government bonds and private securities has been that of lowering interest rates in order to support the supply of credit to the economy and maintain an accommodative monetary stance to sustain economic activity and employment.

Central banks’ unconventional policies have also tested the politically neutral pillar of central bank reputation. Indeed, by stepping into decisions regarding which firms to support and which assets to buy (including public debt), central banks have reduced the traditional arms-length distance of monetary policy from fiscal policy and blurred the principle of monetary dominance. In what sounds like an anathema to any casual central banking observer, postcrises central banks have even stretched the view that monetary policy can influence only the level of inflation by claiming overt responsibility for employment objectives and even issues such as inclusive growth and climate change. For instance, between 2020 and 2021, the US Fed and the European Central Bank (ECB) revised their monetary strategies in a way that signaled increased attention to employment considerations, as well as to social goals, including the pursuit of inclusive growth (in the United States) and climate change (in Europe).

According to a central banking veteran, “This [transformation] was something historically unprecedented and would simply have been unthinkable until then.”⁹ This is not meant to gloss over the cross-country differences that do exist in terms of the specific design of unconventional policies. However, these differences simply “do not invalidate [the] general picture,”¹⁰ namely, the picture of a profound transformation in the monetary regime firmly centered on the objective of price stability administered by conservative and politically neutral central banks.

Deviating from orthodoxy

Central banks were thus able to deviate from monetary orthodoxy and prioritize the support to economic activity. But appearances are deceptive. Analyzed closely,  the transformations in central banking in the US and Europe¹¹ reveal that the shift from inflation fighting to  the promotion of economic activity was, at best, reluctant. Rather than putting their reputation as inflation-averse and politically neutral institutions on the line, both the US Fed and the ECB moved into unconventional terrain when the conditions to preempt or deflect reputational risks were in place. This reputation-protection behavior is evident in at least three ways.  

First, unconventional policies were often expressly designed to circumscribe the scope of the policies adopted and so signal compatibility with central banks’ past reputation. In other words, central banks deviated from orthodoxy but with “caveats.” This is, for instance, clearly visible in the way in which the ECB designed its early liquidity operations to support markets and economic activity. Indeed, the ECB designed those policies by committing to the so-called “separation principle,” that is, divorcing policies oriented towards repairing the liquidity of financial markets from the policies aimed at influencing economic activity and inflation. By separating liquidity from formal monetary policy, “the message implicit in the ‘separation’ doctrine was that rates could always be raised to tame inflation,” as a group of ECB officials later acknowledged.¹² Similar design constraints can be found in the design of the ECB’s early asset purchase programs; both the Securities Market Programme (SMP) and Outright Monetary Transactions (OMT) were designed to absorb the liquidity injected by the central bank’s purchases (the so-called sterilization) to control potential inflation and allow the ECB to continue projecting an image as a conservative institution. 

The Fed’s unconventional policies were also executed in line with  past reputation. For instance, the bank’s early asset purchase programs relied mostly on the purchases of extremely safe Treasury securities, shaping general financial conditions without extending credit to particular sectors of the economy. The Fed’s repeated calls for policy “normalization” and “exit strategies” along with the implementation of its unconventional policies are further examples of the “caveats” that the central bank used to signal a return to monetary policy as usual and so protect its reputation.

In addition to policy caveats, central bank policies were strategically timed with government interventions. Some of the most unorthodox policies were adopted exactly when governments offered central banks political cover for monetary decisions that openly challenged the conservative and apolitical reputation that they had built since the 1980s. This political cover came in different forms on the two sides of the Atlantic. In the US, the Treasury offered open political and credit support for the Fed’s monetary decisions, including the Fed’s controversial liquidity support for financial firms (for instance, the Fed’s bridge loan to investment bank Bear Stearns) and the Fed’s interventions in asset-backed securities markets since 2008. In Europe, political support took the form of a sequenced division of responsibilities among the Eurozone governments and the ECB. Indeed, some of the ECB’s most unorthodox decisions, including the early asset purchase programs with their reputation-damaging distributive implications across national lines, were subordinated to the interventions of the Euro area governments. Specifically, Eurozone governments developed new policy instruments to lower pressures in sovereign debt markets (such as the European Stability Mechanism) and committed to fiscal austerity, which, in turn, created the conditions for the ECB to adopt policies that could more decidedly counteract recessionary and deflationary forces in the aftermath of the 2010 crisis. 

Finally, central banks deviated from conventional tools in order to deflect criticisms of their reputation and win back political support. In particular, the increased salience and contestation of monetary policy among citizens in the US and Euro area prompted the banks to signal their willingness to meet the demands and expectations articulated by the public. Before the return of inflationary pressures in early 2022, both the Fed and the ECB tried to manage their public image by de-emphasizing their inflation-fighting credentials and committing to policy actions geared at attaining a “high-pressure economy,” i.e., one with stronger-than-average economic growth and low unemployment. Furthermore, the Fed and the ECB revised their monetary strategies in order to signal increased attention to employment considerations, as well as to attain social goals, including the pursuit of inclusive growth (in the United States) and climate change (in Europe).

From deflation to inflation to recession

The process through which the Fed and the ECB responded to the depressionary challenges unleashed by the 2008 and 2020 crises highlights a key lesson: central banks cannot unproblematically move back and forth between their roles as inflation- and deflation-fighters. In recent decades, they did mildly, with great difficulty, and under particular circumstances—government intervention key among them.

The reason lies not so much in the limits of an interest rate policy that hits the zero lower bound. The crucial hindrance to the symmetry of the price stability mandate has historical roots. Indeed, it was central banks’ past that led them to choose policies that could be made compatible with their preexisting reputation or to venture into controversial policies only when the conditions for protecting reputation were in place. In short, central banks’ capacity to combat recessions and stimulate economic growth is severely hindered by the reputational capital that central banks have carefully built in the past. This means that the trap central banks confront lies in their own identity: central banks have difficulties stimulating economic activity because they are primarily hardwired to fight inflation.

Recognizing the importance of reputation to central banks and the attendant difficulties that central banks confront in providing monetary accommodation and dispel depressionary forces cast serious doubt about central banks’ ability to stabilize domestic economies in a highly volatile scenario, like the present one. Despite the inflationary surge, the forces that contributed to the post-2008 deflationary pressures (among them globalized trade, automation, and demographics) persist. Added to these are new challenges, the most glaring of which is the transition toward a green economy.¹³

In recent decades, we have grown used to thinking about central banks as the “masters of the economic universe,” that is, political actors who are able to steer domestic societies out of the woods of an economic and financial crisis. This flattering image largely stemmed from the success that central banks had reaped in fighting inflation since the 1980s. Fighting post-crises deflation and recession, however, has fully exposed the limitations that central banks are confronted with as political institutions. Independent central banks are poorly equipped to fight deflationary forces because the policies needed to counteract deflation call into question their institutional identity, which is staked on their reputation as conservative and technocratic bodies. Central banks are also poorly equipped to sustain reflationary policies over time because doing so invites social and political backlash with regard to their independence. As a result, we cannot wait for central banks to stimulate economic activity—doing so meaningfully would stretch their reputational limits.