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Why central banks are approaching the policy wall

U.S. chairman of the Federal Reserve Ben Bernanke speaks during a news conference in Washington on Dec. 12, 2012.


Central banks, which bravely entered uncharted territory to arrest the financial crisis, could be approaching the limits of how far they are willing to go without better maps.

The Federal Reserve's decision on Wednesday to replace Operation Twist – its policy of selling short-term Treasuries to buy longer-term Treasuries – with quantitative easing – creating money to purchase the longer-term Treasuries – was the latest reminder that central banks in developed countries aren't troubling themselves with inflation. The Fed also said that it would leave its benchmark rate near zero until the unemployment rate drops to 6.5 per cent from its current rate of 7.7 per cent, so long as the outlook for inflation stays below 2.5 per cent.

"Heaven help us if more central banks start pushing concern about inflation out the window," remarked Finn Poschmann, vice president, research at the C.D. Howe Institute in Toronto, who devotes a good amount of his to the study of monetary policy.

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But in the last couple of weeks, the Bank of Canada and the Fed both have acknowledged wariness about the experimental policies they've implemented to keep their economies from sliding into recession. Their policy decisions are being constrained, to some degree, by fear of the unknown.

Canada's central bank acknowledged last week in its twice-annual Financial System Review that "concerns" that ultra-low interest rates threaten financial stability had "increased slightly" since mid-year. (Low rates are a problem for big institutional investors such as insurance companies and defined-benefit pension plans that hold long-duration liabilities, and they tend to induce yield-hungry investors to seek out risky assets that they would otherwise avoid.)

"Without question, a low-for-long-interest-rate environment creates financial stability risks," Mr. Carney said Tuesday at a press conference in Toronto.

And Wednesday, Fed chairman Ben Bernanke acknowledged that the U.S. central bank could theoretically do more to stimulate the economy, but is holding back out of fear more bond buying would only cause more harm than good.

"Given that we are now in the world of unconventional policy that has both uncertain costs and uncertain efficacy or uncertain benefits, you now, that creates a more – somewhat more complicated policy decision than the old style of just changing the federal funds rate," Mr. Bernanke said at a press conference Wednesday. "What we're trying to do here is balance the potential benefits in terms of lower unemployment and inflation at target against the reality that as the balance sheet gets bigger, that there's greater costs that might be associated with that and those have to be taken into account."

For those who think like Mr. Poschmann, the new signs of self-constraint by central bankers are coming too late. Mr. Poschmann said he thinks Mr. Bernanke and other central bankers are repeating the mistake former Fed chairman Alan Greenspan, who kept borrowing costs low even as the economy strengthened, sowing the seeds for the financial crisis.

The Fed's new guidance is exactly the one proposed by Chicago Fed president Charles Evans at an event hosted by the C.D. Howe Institute in Toronto last month. Mr. Poschmann didn't like Mr. Evans's idea then, and he definitely doesn't like it now that it's official policy. He argues the pledge to keep rates low for so long reinforces the bad feeling people have about the sluggish recovery. "Gloom as far as the eye can see, and maybe with a little inflation to boot," Mr. Poschmann said Thursday.

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Maybe. The other way to think about the Fed's unprecedented guidance is that it will bring about more timely adjustments. Mr. Bernanke likened the 6.5 per cent/2.5 per cent pledge an "automatic stabilizer." Rather than wait for guidance from the Fed, market participants will be able to anticipate policy by watching economic indicators. Provided the public believes the Fed is serious about keeping a lid on prices, the Fed's pledge could induce a natural break against inflation.

Regardless, there's reason to think that Mr. Bernanke has pushed the bounds of policy as far as he's willing to, at least for now. The radicals are getting ready to take a breather.

"We've innovated quite a bit in the last few years and it's always possible we can find new ways to provide support for the economy," Mr. Bernanke said Wednesday. "There is no doubt that with interest rates near zero, and with the balance sheet already large, that the ability to provide additional accommodation is not unlimited, and that's just a reality."

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