The halo that shone over Greenspan as Fed chief symbolises the prestige that the world’s central bankers enjoyed for about 30 years after the Fed under Paul Volcker crushed inflation in the early 1980s and ushered in economic good times and bumper investment returns. This elevated status was extended to the Reserve Bank of Australia as our economy expanded in a low-inflationary way through the 1990s and 2000s.

But central bankers these days have far less chance of earning such plaudits. While central banking has never been easy and central bankers will still have their victories, the job has become tougher for three reasons that won’t fade any time soon.

The first challenge is that many central banks, powerless when it comes to stimulating their economies with interest rates already near zero, are using unconventional monetary-policy tools that are controversial, unproven and could even backfire. These weapons include asset-buying programs, lengthening the maturity structure of government bonds held on central-bank balance sheets (which the Fed said it will do on September 21), announcing the cash rate may stay low for a long time (which the Fed did on 8 August) and allowing higher inflation.

The most controversial and risky of these strategies already in use is the asset-buying programs known as quantitative easing. These are primarily used to lower long-term bond yields to encourage consumers and business to borrow to spend and invest. But global bond yields are so low that making them any lower is virtually pointless in terms of stimulating economies.

The other aim of asset-buying programs is to steer investors towards risky assets. The Fed’s second asset-buying program (dubbed QE2) certainly boosted stocks – the S&P 500 Index rose 28% in the six months after Bernanke hinted at the program in August last year (a US$600 billion program was formally announced in November) – though this effect peters out if economies stay stagnant.

For central bankers, the big risks with massive expansions of the money supply (for that is what asset-buying programs do) is that they encourage speculation, add to trade tensions by undermining currencies and could ignite consumer inflation and financial bubbles. There is even opposition to them within central banks. On August 10, three of the Fed’s 12-strong policy-setting board members “dissented” when the Fed board said it may expand monetary stimulus and intends to keep interest rates low until 2013.(1)

The same three dissented again on September 21 with the decisions to sell short-date securities to buy long-dated ones.(2)

While the European Central Bank doesn’t undertake quantitative easing (though the Bank of England does), the ECB is buying government bonds and providing unlimited liquidity to banks to counteract the eurozone debt crisis. The ECB has recently bought Spanish and Italian government debt to drive down yields from levels that signify these countries may have trouble meeting debt schedules; in the week ended August 15, for instance, the ECB bought 22 billion euros (A$30 billion) of these securities.(3)

The risk for the ECB is that these bond purchases will prove futile in insulating countries from the eurozone debt crisis and European tax payers will eventually foot its bond losses.

So far, no major central bank has boosted its inflation targets as a way to reduce consumer and government debt burdens and spur its economy (by prompting consumers to spend now before prices rise). Even advocates of the strategy concede it is radical because it almost negates the raison d’etre of central banking – preserving the value of money. Opponents of the strategy say it could lead to the galloping inflation of the 1970s. There will be a firestorm of criticism if any major central bank does boost inflation targets.

Thick skins needed
This brings us to the second unpleasant fact of modern-day life for central bankers: they are subject to unprecedented criticism and political pressure for trying to resuscitate their economies. Previously the political heat came when they raised interest rates and boosted unemployment or, if you were Greenspan, just about never. The denigration, and even threats, today are occurring as many governments are tightening fiscal policies, which places more strain on central banks to revive economies.

Accusations of treason in the US used to be aimed at those with links to communism. On August 15, the Republican presidential candidate Rick Perry told a political rally it would be “treasonous” if Bernanke were to “print money” and, if he did, he would be treated “pretty ugly down in Texas” where he is governor. (Never mind the fact that central banks expand the money supply all the time to ensure enough notes are in circulation to meet greater demand for money as GDP rises.) Another high-profile Republican presidential candidate is no fan of Bernanke either. Mitt Romney said during a debate on September 7 that he will replace Bernanke because he has “overinflated the amount of currency he has created”.(4)

Republicans in Congress are strident too. On February 9, Paul Ryan, when quizzing Bernanke as chairman of the House Budget Committee about the Fed’s latest asset-buying program, told the Fed head that “there is nothing more insidious that a country can do to its citizens than debase its currency”.(5)

During the Fed’s policy-setting meeting on September 20 and 21, the four top Republicans in Congress sent a letter to Bernanke urging the central bank not to undertake more stimulus. “We have serious concerns that further intervention by the Federal Reserve could exacerbate current problems,” the letter said.(6)

In Europe, the pressure is just as rigorous. On August 25, German President Christian Wulff accused the ECB of “legally questionable” action for buying bonds to support troubled eurozone countries.(7)

On September 8, Sigmar Gabriel, Germany’s opposition Social Democrat leader, accused the ECB of succumbing to political pressure from German Chancellor Angela Merkel, while Germany’s media lampoons the ECB as the “European bad bank” for buying Spanish and Italian government bonds.(8) On September 9, ECB President Jean-Claude Trichet lost his cool for six minutes at a media conference after a reporter asked if Germany should abandon the euro and return to the mark.(9)

He would have been grumpier only days later when Germany’s member of the ECB’s policy-setting board quit in protest at the central bank’s handling of the debt crisis.

The pressure is not just local. The reaction from Asian countries, especially China, when the Fed embarked on its second asset-buying program last November was strong in diplomatic terms. Many countries criticised the Fed for adding to inflationary measures in emerging markets. China, with much of its US$3.2 trillion foreign exchange reserves in US-dollar-denominated assets, accused the Fed of undermining the US dollar, thereby “intensifying a currency war”.(10)

Bernanke retaliated against his US critics during a speech in August at an annual gathering of central bankers in Jackson Hole, Wyoming, when he blamed politicians for the financial upheaval in recent months, saying the US “would be well served by a better process for making fiscal decisions”.(11)

Even if that’s hard-hitting for central-bank talk, overall the attacks on central bankers limit their ability to respond to today’s emergencies. While being nominally independent, central banks are no doubt weighing more the political consequences of their actions or inaction, least of all so they are not the centre of more political controversy. Nobel prize-winning economist Paul Krugman, an advocate of more action from the Fed including raising the Fed’s unofficial 2% inflation target, says that due to political pressure the “Fed is suffering from externally induced paralysis”.(12)

No help from China
The other problem for central bankers – and perhaps the most troublesome in the medium term – is that China is now an inflationary force whereas for the past 15 years or so it was a source of deflation.

A key reason why central bankers were able to promote low-inflationary growth in the second half of the Greenspan era was that the shift in production to China and other low-cost producers reduced cost pressures in developed countries. A Fed study in 2004 (13) says the country reduced inflation by 0.25% a year, though it could easily be more. Whatever the number, it allowed central banks to set interest rates lower than they would have been otherwise.

Now the higher demand from China and other fast-growing emerging markets are boosting the price of many key materials. Higher prices for commodities such as oil, iron ore and copper are adding to inflation in developed countries, even when their economies are spluttering. Today’s central bankers are thus snookered.

Nowhere is this dilemma better illustrated than in Europe. In April this year, the eurozone debt crisis had spread beyond Greece to Ireland and Portugal with no solution in sight, doubts remained about the capitalisation of Europe’s banks and economic growth in the eurozone was faltering. Yet the ECB raised the cash rate from 1% to 1.25% on April 7 and matched that increase on July 7, to haul inflation back within its 2% band. When the first rate rise was implemented the eurozone CPI was running at an annual rate of 2.6% (the year to March) and a 2.7% annual pace for the second (thought it’s slowed to 2.5% now).

The Bank of England is similarly torn. It confronts annual inflation of 4.5%, well above its 2% inflation target, while its economy only grew 0.1% in the second quarter, and the government’s austerity measures are yet to fully hit. So far the Bank of England has kept its cash rate at 0.5% since March 2009 while embarking on asset-buying programs. (The bank’s 75-billion-pound asset-buying program announced on October 6 is equivalent to 5% of GDP).

The Fed faces the same dilemma. In the US, where bond yields appear to be pricing in recession, consumer inflation is running at 3.8%, getting close to double the Fed’s unofficial target. In Australia, inflation at 2.9%, just inside the central bank’s 2% to 3% limit, makes it hard for the Reserve Bank to cut the cash rate from 4.75%.

Good luck to central bankers as they confront rising inflation, while being slammed for taking radical steps to deal with the greatest economic shock in 80 years. Perhaps the best they can hope for is the opposite fate to Greenspan – that history will appreciate them more than their contemporaries.

SOURCES
(1) Bloomberg News. “Bernanke signals Fed dissenters won’t impede more stimulus”. 10 August 2011
(2) The New York Times . “Fed will shift debt holdings to lift growth”. 21 September 2011. http://www.nytimes.com/2011/09/22/business/fed-to-shift-400-billion-in-holdings-to-spur-growth.html?hp
(3) Bloomberg News. “ECB settled record 22 billion euros in weekly bond purchases.” 15 August 2011
(4) Reuters. Mitt Romney says he wouldn’t keep Bernanke. 7 September 2011.
(5) The Economist. “Paul Ryan’s Republicanomics.” 9 February 2011. http://www.economist.com/blogs/democracyinamerica/2011/02/reaganomics_debased
(6) The New York Times. GOP urges no further Fed stimulus. 21 September 2011. The letter was signed by Mitch McConnell of Kentucky, the Senate Republican leader; Jon Kyl of Arizona, the Senate Republican whip; House Speaker John Boehner of Ohio and House Majority Leader Eric Cantor of Virginia. http://www.nytimes.com/2011/09/21/business/economy/gop-urges-no-further-fed-stimulus.html?_r=1&emc=eta1
(7) Financial Times. ECB bond buying raises ire in Berlin”. Page 3. 25 August 2011.
(8) Financial Times. Trichet attacks German criticism over handling of eurozone debt crisis. 9 September 2011.
(9) Bloomberg News. “Trichet loses his cool at prospect of Deutsche mark’s revival”. 9 September 2011.
(10) Bloomberg News. “China ministry says dollar weakness may worsen ‘currency war’”. 1 November 2010.
(11) The New York Times. Bernanke blames politics for financial upheaval”. 26 August 2011.
(12) Paul Krugman, Op-ed columnist in The New York Times. “Bernanke’s Perry problem”. 25 August 2011.
http://www.nytimes.com/2011/08/26/opinion/bernankes-perry-problem.html?_r=1&hp
(13) Board of Governors of the Federal Reserve System. International Finance Discussion Papers. Number 791, January 2004. “Is China ‘exporting deflation’” by Steven B. Kamin, Mario Marazzi, and John W. Schindler. http://www.federalreserve.gov/pubs/ifdp/2004/791/ifdp791.htm

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