To say that the world’s top central banks have been under strain this year would be a big understatement given the amount of political pressure, public blame and economic condemnation thrown their way. (Indeed, because of the Federal Reserve’s consequential domestic and global impact, I have been critical of its prolonged mischaracterization of inflation and its initially underwhelming policy response to an economic threat that has already undermined economic and social well-being and that has hit the poor particularly hard.) In the last few weeks, however, global central banking has received a welcome respite in large part because of the Bank of England’s smart handling of a tough domestic situation and some easing of inflationary pressures in the US. These recent developments carry important lessons for the period ahead.
The conventional wisdom is that central banks are inherently prone to criticism because their job is, to quote William McChesney Martin, who was the longest-serving Fed chair (1951-1970), “to take away the punch bowl just as the party gets going” — that is, consider tightening financial conditions during an economic boom that could end up in tears because of runaway inflation. This was not the case, however, between 2008 and a year ago. For the vast majority of this period, central banks maintained ultra-low interest rates, repeatedly injected huge liquidity into the financial system and conditioned financial markets to expect support in the face of virtually any asset price volatility.