Friday, April 17, 2009

Central Banks and current global economic crisis (I)

While the discussion about the current global economy crisis goes on, there are tough evaluations about the implications of Central Bank decisions concerning interest rate, in the previous years (2001-2005). In particular, the effect of a longer than necessary easy monetary policy, applied in the USA economy after 2001, and how it ignited the housing bubble. On this regards some annalist have suggested that Central Bank approach to economy policy, is driven in such way , that regardless of macro economic conditions, this institution seek to support the next bubble, rather than its traditional stand on inflation growth and employment.-
On the other side , the tools available for Central Banks might also be under scrutiny to prevent future crisis. The connection between price stability and financial stability, has not been addressed to the full extent of its significance for economic policy decisions. The normative macroeconomic and rules for policy making (Taylor Rule), is just one side of the problem, as long as it also matters the missing variables from that equation ,specially in the case of financial variables such as the ratio of private debt to GDP. To consider this parameter it would mean that as long as inflation ,and gdp above long run trend justify higher interest rate , so it would when the private debt / GDP ratio, increase above long run trend . An adjustment in interest rate, is necessary to prevent falling into the area of higher systemic risk . In this case ,given all other variables , this deviation from long run trends, might justify an increase in interest rate early that real fundamentals might suggest, preventing the bubble to go out of control.
The question about the responsibility of Central Bank (The Federal Reserve) in the housing bubble will not be easily settle down either. However, it is important to keep in mind that price stability is not disconnected from real variables performances, such as productivity level. Let assume that there is no housing bubbles, because people has the proper information to anticipate rationally the final outcome of such a bubble. Thus, if productivity increase , it means that any demand pressure on prices, is counterbalanced by supply factors, allowing for better price performance within the Central bank target than otherwise. In fact, the productivity level in the USA economy between 2000 and 2008 averaged 2,5 %, such that it was possible to have low interest rate longer than expected .Inflation started to be an higher risk beyond the mid of the year 2000 , not just for demand factor but because of supply shock .(food prices and oil prices increase).-
On this regard , it might be plausible that when Central Bank (USA), started to raise interest rate at a stronger pace(2005- 2006), it was not that much late to do so, as long as inflationary level is concern , because productivity was increasing. Given the way the Taylor rule is defined ,which excludes financial variables, then the key problem might be about the proper specification of the rule.In other word ,it was a misspecification of the tool which mislead Central bank not to raise interest rate stronlgy before when private debt was probably moving above its long run trend. -