Central banks face pressure from the political economy – 03/02/2024 – Ana Paula Vescovi

What would be the long-term effects of the measures (no longer so extraordinary) adopted by central banks (CBs), since the global financial crisis of 2008, to stabilize markets and increase growth?

The set of responses was used on an even greater scale during the pandemic and may have set a dangerous precedent: the more BCs do, the more they are expected to do and the more they end up doing.

Did the use of these new instruments truly help the Central Banks to achieve their objectives of inflation, unemployment and financial stability or did it just bring new demands to them?

This is the central question of the thought-provoking book “The Unintended Effects of Monetary Policy” (Raghuran Rajan, 2023), famous researcher at the University of Chicago and former president of India’s central bank (2013-2016).

Around the world, BCs have faced pressures typical of political economy. Treating monetary policy from this perspective is not new: there is extensive literature focused on the impacts of political pressures on monetary policy decisions. It is a fact, however, that the topic had been out of focus for a prolonged period.

After the period in which the Federal Reserve (Fed, the US Central Bank) was under the command of Paul Volcker, between 1979 and 1987, the fight against inflation was incredibly successful, so much so that the most relevant inflationary metrics had averages lower than those its goals in the developed world. However, it would be an exaggeration to attribute this achievement solely to monetary policy during the period, without recognizing that part of this success may have been explained by some concomitant supply and demand forces.

After the “Volcker era”, the world experienced a wave of liberalizing policies in the markets, as well as seeing China’s entry into the WTO (World Trade Organization), in the early 2000s, and the acceleration of globalization. To influence developing countries, there was also the Washington Consensus* and structural reforms pro-monetary stabilization. Such events contributed to increasing efficiency in the real economy, with a tendency for prices to fall, especially for industrialized goods.

The most recent scenario has changed this figure drastically and brought factors that complicate the mission of inflation control: protectionist disputes, higher standards of labor supply, changes in the perception of unlikely events (such as the Covid-19 pandemic) and political pressures to greater fiscal activism, with increased transfers to the private sector. It seems that we are witnessing the return of the times of the influence of political economy on monetary policy.

Some perception of reduced aversion to inflation has made it politically difficult to take preventive decisions to combat it, given a more relaxed fiscal policy. Tougher and more averse speeches against inflationary pressures to justify the increase in interest rates became fragile.

The anticipation of a more relaxed monetary policy with reduced interest rates for prolonged periods (also known as forward guidance) resulted in a more dependent market, with implicit beliefs that monetary authorities would be reactive to falls in asset prices.

It is nothing new that BCs in the developed world carry a significant portion of their respective countries’ sovereign debt and private assets in large volumes on their balance sheets. This fact also brings with it the difficulty that, when interest rates rise, there is a loss in value of public bonds, which implies losses for the government itself, through the results of the BCs. Furthermore, the shortening of the term of public debts, combined with their increasing size, intensifies political pressures on central banks in times of greater austerity.

Finally, the dependence of financial markets on the liquidity provided by BCs also limits their ability to reduce their balance sheets — this could be done through the sale of public and private securities, or simply by failing to repurchase them at maturity. Since 2008, it has not been possible to return to previous levels of assets carried on balance sheets.

From our vantage point, it is difficult to say that globally impactful events will be less recurrent or that we are just going through a transition to what would be a new global status quo.

The world seems to need more realistic narratives, which recognize the limits associated with monetary policy and financial stability, without giving up the fight against inflation. Faced with uncertainty, the best prescription would be to insist on more cautious action.

We dawned on the 21st with the sad news of the death of professor Affonso Celso Pastore.

His sharp mind was noteworthy, his kindness in sharing his extensive knowledge, his stern expression when he was concerned about Brazil’s direction, and even his recent curiosity about images and routes of space telescopes.

His legacy is a milestone in the Brazilian economy and he has already received many well-deserved honors during his lifetime. But, without a doubt, it leaves us with a huge gap.

*The Washington Consensus was a set of economic measures designed in the late 1980s by multilateral organizations and aimed at emerging countries in Latin America, which were then over-indebted and had inflation out of control. These measures aimed to stabilize these economies through fiscal discipline, the reorganization of public spending and greater economic openness.

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