To Raise or not to Raise – Central Bank’s Monetary Dilemma

Just wanted to highlight this article here by Reuters on the difficulties of being a central bank. As you all know, interest rates by historical standards are at an all time low all over the world now. This has raised concerns on over-inflated stock markets, excessive credit growth and asset bubbles. 

The ultimate question is what should central banks target in their policies? Conventionally, central banks are concerned with economic growth, low inflation, and full employment, where it has utilised interest rates as their main policy tool to influence consumption, investment, and export-import markets. If the economy is having a recession with low economic growth and high unemployment, a central bank would reduce interest rates to influence savers to consume more and make investments much cheaper to take up, provided that inflation remains below the central bank’s target.

But what we are seeing more often in the world right now is that interest rates have remained low for a long time, with only recent calls to tighten emerging. Even under this growing need to tighten, inflation has remained low and this has prompted most central banks to hold off on tightening its monetary policy. Tightening monetary policy is much more complex to consider as most central bankers know how devastating a rate hike is to asset bubbles. Remember the 1930s depression, the decision to raise interest rates devastated the US stock market and subsequently much of the world. 

Central bankers know this, and no central bankers would want to be the person to cause big losses in country wealth by tightening monetary policy needlessly. That is why being a central banker is so tough in this world. On one hand, they know asset bubbles should be controlled to some extent so that there is no need to burst them. On the other, when it does burst, the central banks would inevitably have to loosen monetary policy to stimulate economic activity and the cycle repeats again. 

In the end, central bankers are fighting a losing battle on trying to control the boom and bust cycle. A decisions to burst an asset bubble inevitably calls for a loosening of monetary policy after that, and that in turn fuels the next asset bubble. As long as central banks have the mandate of being the lender of last resort, they will always be fueling the next asset bubble.

But then, is this really a bad thing? Yes, if the nations’ inequality is high (like the US) as the rich stands to benefit the most no matter the consequences. We have seen the rich increasingly engage in financial gains rather than economic gains. Most of the money are not used for productive investment purposes but rather to speculate on short term asset classes. And when they get burned, the central banks would have to step in as the wealth losses are biggest in the middle and low income class. So this is a heads: I win, Tails: You lose kind of bet being undertaken. 

And this is the issue that central banks would have to acknowledge sooner or later, that its monetary policy needs to take into account inequality issues. Bank Negara did a brief paper on the inequality issue here and explain that monetary policy impacts the various income classes differently. A loosening of monetary policy is basically a subsidy for the high income class as they have more access to the fruits of monetary policy. Banks tend to lend more to high net worth individuals as they are more solvent, liquid and have more assets as collateral for loans. The poor however have limited access to these services and already are highly leveraged with limited assets. It is time central banks acknowledge that a recovery on paper (GDP growth and unemployment numbers) is not sufficient and should instead look at income growth between the classes as an indicator of equitable recovery. 

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