1. The search
for growth
Central banks in
uncharted territory
A report from the Economist Intelligence Unit
Sponsored by

2. The Search for Growth Central banks in uncharted territory
Contents
1 Introduction 2
2 The critics 4
3 The defenders 6
The euro zone 6
4 The future 8
A larger role for emerging-market central banks? 8
5 Conclusion 10
1 © The Economist Intelligence Unit Limited 2012

3. The Search for Growth Central banks in uncharted territory
1 Introduction
The European Central Bank (ECB) created a small bankers remain so prevalent, investors interviewed
sensation in August when it said that it was pointed to the long-standing respect for central
considering buying unlimited amounts of bankers in the financial world and their assumed
government bonds in order to cap the yields on the detachment from politics. Others suggested that
debts of Spain, Italy and other beleaguered euro central banks have indirectly benefited from the
zone states. A month later, the US Federal Reserve dim view that many institutional investors and
announced a third round of quantitative easing corporate leaders have taken of governments’
that it said would end only when economic performance following the financial crisis. Only
conditions improved. The two announcements were 36% of survey respondents said they were
widely anticipated; two years ago, they would have confident of governments’ ability to make the right
been unthinkable. decisions.
In their ongoing response to the aftershocks of But the vast and fundamental changes in the
❛❛ the global financial crisis, central banks are role of central banks have unlocked a host of
Central banks are
abandoning the narrow role they traditionally questions about the wisdom and impact of these
abandoning the played in economic affairs. In developed economies changes. Some give credit to central bankers for
narrow role they in particular, they have greatly expanded their averting financial catastrophe and preventing a
traditionally direct participation in financial markets, working to much deeper economic slump—a point that the
played in sway investor sentiment and restore confidence. Federal Reserve chairman, Ben Bernanke, himself
economic affairs. Much of this shift has been reluctant, and arguably made at the Fed’s annual symposium in Jackson
❜❜ it is spurred by lack of government action to Hole, Wyoming, in early September. But questions
stimulate the global economy or correct structural remain about the wider role central banks have
imbalances. But many observers expect the changes assumed since then. Others blame central banks for
to be permanent. creating the conditions that led to the 2007-08
Through it all, institutional investors and meltdown, and doubt they have fundamentally
corporate executives have maintained relatively rethought the policies that preceded it. Some
high confidence in central banks. In a survey by the criticise central bankers for being too
Economist Intelligence Unit of over 800 investors accommodating of large financial institutions.
and corporate leaders conducted in January 2012 Others accuse them of enabling improvident
and sponsored by BNY Mellon, 54% expressed governments to continue to run up large deficits
confidence in central banks’ handling of monetary that have destroyed confidence in long-term
policy, up from 51% in 2011. economic recovery and of causing market
Asked why overall positive views of central distortions as a result of their accommodative
2 © The Economist Intelligence Unit Limited 2012

4. The Search for Growth Central banks in uncharted territory
interest rate policies. There are also unanswered in-depth interviews with nine prominent
questions about how long central banks will retain economists, analysts and portfolio managers.
the wider role they have carved out for themselves, These experts expressed a wide range of views.
and if they even have a choice in the matter. Some were especially critical of central bank action
To examine these questions and to better over the last four years. All had pointed opinions
understand the challenges facing central banks in about the role central banks should assume in the
the post-recessionary period, the EIU conducted future.
3 © The Economist Intelligence Unit Limited 2012

5. The Search for Growth Central banks in uncharted territory
2 The critics
Most observers agree that central banks cannot of 2000. This engendered global investors’ “search
restore a healthy global economy by themselves. for yield” that helped to create the housing bubble
But they disagree on where to place the blame for and overinvestment by European banks in
the current crisis, and on their critiques of current peripheral economies like Greece. Mr Schiff
central bank policies. There is deep disagreement expressed these views as early as 2006, and was
about what specific actions governments need to interviewed extensively post-financial crisis as
take, and whether central bank policies might be being the “man who got it right”. But low interest
hindering governments from taking those steps. rates were not the root of the problem, points out
There is also concern that central banks may be Ethan Harris, co-head of global economics research
subjected to greater political wrangling. At the at Bank of America Merrill Lynch. Mr Harris, who
❛❛
With so many Jackson Hole meeting, some expressed fears that worked at the Federal Reserve Bank of New York for
the Fed could be pressured to extend its nine years, believes that the main failure of the
regulators—both
accommodative interest rate policy or even to Fed, and other regulators, was weak regulation of
federal and state- compromise its independence by subjecting its the subprime mortgage market. “With so many
level—overseeing monetary policy to regular audits. regulators—both federal and state-level—
different parts of Central banks’ strongest critics argue that easy overseeing different parts of the market, it was
the market, it was credit policies, while perhaps justified in the unclear who was really in charge,” he says.
unclear who was immediate aftermath of the 2008 crisis, now The most dangerous consequence of
really in charge. threaten long-term economic recovery and maintaining a low interest rate environment,
stability. The critics also accuse central bankers of according to critics like Mr Schiff, is that it distorts
❜❜
Ethan Harris, co-head of
having failed to notice the formation of the the pricing of supposedly risk-free government
global economics research, housing bubble that led to the crisis and then debt—and, by extension, the pricing of the many
Bank of America Merrill Lynch failing to appreciate the extent of the collapse other assets that are directly or indirectly based on
until it was too late. Furthermore, the central a risk-free rate of return. This facilitates the
banks did not learn the appropriate lessons from formation of asset bubble in many areas, most
the period leading up to the crisis—although there notably in government debt. Once investors grasp
is disagreement about the substance of those this, Mr Schiff suggests, they could retreat en
lessons. masse from bonds to equities and “other assets
Peter Schiff, CEO of Euro Pacific Capital, argues that are in scarce supply”. Jason Hsu, co-founding
that the Fed, the Bank of England and others principal and CIO at Research Affiliates in Newport
maintained a low interest rate policy for too long Beach, California, believes that new asset bubbles
after the recession following the dot.com collapse are forming today. He warns that investors in
4 © The Economist Intelligence Unit Limited 2012

6. The Search for Growth Central banks in uncharted territory
Nothing’s risk free: Central bank base rates European Central Bank
(%) Bank of England
Federal Reserve
7
6
5
4
3
2
1
0
February-00
June-00
October-00
February-01
June-01
October-01
February-02
June-02
October-02
February-03
June-03
October-03
February-04
June-04
October-04
February-05
June-05
October-05
February-06
June-06
October-06
February-07
June-07
October-07
February-08
June-08
September-08
January-09
May-09
September-09
January-10
May-10
September-10
January-11
May-11
September-11
January-12
May-12
September-12
Source: Bank of England, European Central Bank, Federal Reserve.
search of higher returns are shifting some of their guard against another bubble forming, their failure
holdings into precious metals and high-end real to prevent the last credit bubble in 2003-07 has
estate in emerging markets, bidding up these dented their claims to prescience.
investments and threatening to “export” inflation Mr Schiff warns that central bank efforts to lower
to these markets. interest rates are also enabling governments to
If these imbalances result in inflation in the delay needed cuts in spending. Low rates augment
emerging markets, some believe that they could the temptation for investors to shift from the most
have a global feedback effect. Warwick McKibbin, troubled markets, such as Greece, Spain and Italy,
professor of economics at Australian National into high-rated sovereign debt such as US
University and a former board member of the Treasuries, British gilts, German bunds and
Reserve Bank of Australia, who has made this Japanese government bonds. This enables the
argument, believes that inflation is going up favoured governments to sell their debt at ultra-
everywhere except in the US and that “it will go up low rates, which in turn encourages them to
in the US over the next six to 12 months”. While continue to fund deficit spending without suffering
central bankers insist they now have the tools to any consequences.
5 © The Economist Intelligence Unit Limited 2012

7. The Search for Growth Central banks in uncharted territory
3 The defenders
The central banks have few defenders on some trading loss for JP Morgan Chase, appeared to
counts, particularly their failure to respond to a confirm these fears. The defenders are far less
metastasising financial bubble prior to 2008. There inclined to believe the central banks’ policies are
is considerable scepticism that central banks and fuelling another disaster; many, however, believe
their regulatory counterparts are doing enough to that the banks may retard recovery through
police large institutions. The ‘London Whale’ excessive accommodation of big banks.
episode in May 2012, which resulted in a US$5.8bn In the central banks’ defence, these experts
The euro zone
The euro zone is at the epicentre of most experts’ concerns survival of the euro zone. He terminated the Securities Markets
about a mismatch between fiscal and monetary policy. Dan Programme (SMP) and replaced it with a pledge to buy
Steinbock of the India, China & America Institute described unlimited quantities of one- to three-year bonds from
the response to the crisis in Europe as being like fixing a plane European governments, in conjunction with the rescue fund,
in mid-air. In the second quarter, the euro zone economy the European Stability Mechanism (ESM). This moves the euro
contracted at an annualised rate of 0.7%—a figure that might zone considerably further down the road towards more
have been worse save for a weak but positive performance by centralised control of individual countries’ economic policy. To
Germany. receive the assistance, however, governments must agree to a
Despite the constraints of its mandate, the ECB has done “macroeconomic adjustment programme” with the ESM. It
more than is sometimes recognised. Given the unwillingness of remains to be seen whether the Spanish and Italian
creditor euro members, led by Germany, to commit sufficient governments will be willing to do this, although the markets
resources to bailout funds, the ECB is the only institution with may force their hands.
the firepower to ease the funding pressures on peripheral The euro zone is edging, slowly, towards a comprehensive
sovereigns and banks. But according to its mandate, the ECB is plan that could stabilise the single-currency zone. But the
charged with only maintaining price stability (unlike the Fed, process remains painfully slow, and the risk in coming months
whose mandate also encompasses employment) and direct of a market-induced shock—which could drive one or more
financing of governments by the ECB is expressly forbidden by countries (starting with Greece) out of the euro zone—remains
EU treaties. high. This, then, is a race between euro zone authorities and
In early September, the ECB’s president, Mario Draghi, the markets, and it is by no means clear that the governments
made good on a promise to do whatever it takes to ensure the will win.
6 © The Economist Intelligence Unit Limited 2012

8. The Search for Growth Central banks in uncharted territory
note that once the disastrous chain of events early years of the Great Depression into the 1950s.
began in September 2008, the Fed stepped in Japanese rates have been low since the real estate
strongly to assure liquidity and prevent a market bubble burst in 1990.
collapse. They also take issue with the argument Mr Galbraith believes that interest rates are
that central banks may be facilitating the likely to follow the same pattern this time.
formation of new asset bubbles. According to Consequently, he dismisses fears that they will
James Galbraith, Lloyd M. Bentsen Jr. chair in shoot up in the near future, ratcheting up public-
❛❛ government and business relations at the sector borrowing and debt-service costs to
The Fed should
University of Texas’s Lyndon B. Johnson School of economically crippling levels. “The entire
squeeze the Public Affairs, such arguments do not take full exaggerated concern over projected budget deficits
margins on the account of the depth of the recession that began in in the US is premised on the idea that short-term
banks to get them 2008. Mr Galbraith notes that even after multiple interest rates will go back to 3-6% in the next five
to take more risks rounds of quantitative easing by the Fed, the ECB, years,” says Mr Galbraith, “Come back in 30 years
in the real the Bank of England and the Bank of Japan, the and see if we’re out of this yet.” In his scenario,
economy. risk of asset-fuelled inflation remains far lower government debt costs remain low, keeping deficits
than that of a Japanese-style cycle of debt under control and creating new opportunities for
❜❜
deflation in the developed economies. governments to invest in infrastructure, education,
James Galbraith, Lloyd M.
Bentsen Jr. chair in Mr Galbraith and others disagree that today’s and other long-term economic building blocks.
government and business low-interest environment is destined to end soon, However, Mr Galbraith is one of several experts
relations, University of
Texas’s Lyndon B. Johnson or is even unusual for a period of sluggish growth— who argue that central banks should do more to
School of Public Affairs. or that it is necessarily all the central banks’ push banks to restart lending. Accommodative
handiwork. Christopher Reicher, a researcher at policies by the Fed and the ECB allow banks to
the Kiel Institute for the World Economy focused on hoard capital rather than use it to give consumers
the effects of monetary policy, notes that recession and businesses more access to credit. In the US,
and depression have typically resulted in low- “the Fed should squeeze the margins on the banks
interest regimes that can last for many years. to get them to take more risks in the real
Interest rates remained low in the US from the economy,” argues Mr Galbraith.
7 © The Economist Intelligence Unit Limited 2012

9. The Search for Growth Central banks in uncharted territory
4 The future
Most experts agree that the more fundamental term fiscal adjustments,” says Dan Steinbock,
problems facing the global economy are political, research director of international business at the
not monetary, and that governments are best India, China & America Institute in New York. “The
positioned to address them. They disagree US needs a debt-and-deficit deal, but the elections
significantly, however, on which problems are have contributed to an even more polarised
more urgent and what measures governments environment, while in Europe they don’t have the
should take. institutional design to support that kind of action.”
The US and the euro zone need “credible, long- Mr Galbraith, who calls concerns over the size of
A larger role for emerging-market central banks?
For some time, fast-growing emerging economies—particularly the ECB, is still years away, according to Mr Jadresic, echoing
in Asia—have been demanding a larger voice within the the views of other experts. The PBOC still plays a bifurcated
multilateral bodies overseeing the global financial system, role, believes Mr McKibbin, managing the national economy
such as the IMF and the World Bank. While the developed and managing complex exchange-rate relationships with the
economies are reluctantly accepting this new order, over time US and other trading partners. Until the renminbi is unpegged
it will become harder to resolve global issues without the from the US dollar and becomes a more widely held currency,
participation of central banks from the emerging economies. the PBOC will not exercise a larger role in managing the global
These institutions are now better able to assume the role monetary system.
because their ability to manage monetary policy has matured The PBOC is only moving very slowly in this direction.
and thus inspires greater confidence, observes Mr Reicher. He Foreign-exchange trading centres for the renminbi are still
believes the decline in Brazil’s long-term interest rates indicates few—London established one only in January. Some experts
that its economy may be moving beyond a long boom-and-bust believe it would be a mistake for China to seek a larger global
cycle, although rates in Brazil remain high in comparison with role too quickly for its central bank. Mr Hsu notes that China’s
most industrialised countries. Central banks in China, Brazil, banking sector is still dominated by state-owned entities that
South Africa and elsewhere have also received high marks for have a different relationship with the central bank than in
their response to the 2008 financial crisis. Most experts approve other countries. The PBOC itself is less transparent in its
of the efforts of the People’s Bank of China (PBOC) to control a operations than its counterparts in the developed world and it
potential bubble in the country’s housing market. has considerably less institutional memory as a global currency
A larger role for the PBOC, comparable to that of the Fed or manager.
8 © The Economist Intelligence Unit Limited 2012

10. The Search for Growth Central banks in uncharted territory
US budget deficits “hysteria”, argues that governments in many developed countries are
continued focus on central bank policy has become paralysed by political gridlock, preventing decisive
“a big efficiency loss”, distracting from measures action in either direction. So long as government
that could revive economic growth, such as raising policy remains stymied, Mr Harris argues, central
the minimum wage, making room for younger banks can, and probably should, continue to search
workers by making early retirement easier for their for means within their power to spur growth, “even
older counterparts and exploiting new, cleaner if it isn’t particularly effective”, as a way to
energy sources. maintain a degree of confidence.
Both arguments underscore the fact that
9 © The Economist Intelligence Unit Limited 2012

11. The Search for Growth Central banks in uncharted territory
5 Conclusion
Most experts give central banks high marks for global financial markets. “The Fed, which was
tempering what could have been a far worse global created as a lender of last resort, is now also a
financial crisis in 2008 and providing breathing provider of liquidity and a dealer of last resort,”
room for governments to reach agreement on comments Jeffrey Cleveland, senior economist at
measures that would build a stronger and more Payden & Rygel in Los Angeles.
durable long-term economic recovery. Absent such The Fed and the ECB “won’t return back to their
measures, however, central banks have found pre-crisis stance,” he says, “where the Fed, for
themselves stuck with the job of propping up the example, was minimally invasive in markets, mostly
recovery, often through measures that, some tinkering with the federal funds rate as the
critics believe, could be setting the scene for situation called for.” In particular, he anticipates
inflation and further asset bubbles. that the Fed will retain an active role in the
Will central bankers be able to raise interest commercial paper and repo markets—major
rates and withdraw other supports from the segments of the shadow banking system. The ECB,
financial sector before another crisis of this sort too, he expects will be a very different institution,
takes hold? “Central banks have made mistakes, assuming a role much closer to the Fed’s than its
but from a medium-term perspective I expect them original, narrower focus on currency management.
to do the right things,” says Esteban Jadresic, chief The West’s problems—high unemployment,
economist and global investment strategist at creaking infrastructure, unsustainable healthcare
Moneda Asset Management and a former adviser to and pension costs, and the need to move to greater
the board of the Central Bank of Chile. “I’m more federalism in the euro zone—are structural. While
concerned about what other policymakers— monetary easing will provide some relief, it is no
governments, parliaments, euro zone leaders—will panacea, and it is unable to galvanise the global
do,” he adds. economy alone. Solutions require political
Central banks nevertheless are unlikely to pull compromises that are not within central banks’
back from the more prominent role they have powers to devise but that are proving elusive amid
carved out for themselves post-2008. This has less polarisation in Washington and the stand-off
to do with the recent crises and lack of government between the creditor core and debtor periphery in
action than with the growing complexity of the the euro zone.
10 © The Economist Intelligence Unit Limited 2012

12. The Search for Growth Central banks in uncharted territory
Whilst every effort has been taken to verify the accuracy of this
information, neither The Economist Intelligence Unit Ltd. nor the
sponsor of this report can accept any responsibility or liability
for reliance by any person on this white paper or any of the
information, opinions or conclusions set out in the white paper.
The following regulatory disclosure language only applies to
BNY Mellon and the distribution of this report by BNY Mellon.
BNY Mellon is the corporate brand of The Bank of New York
Mellon Corporation. The statements and opinions expressed in
this report do not necessarily represent the views of BNY Mellon
or any of its respective affiliates. The information in this report
is not intended and should not be construed to be investment
advice in any manner or form; its redistribution by BNY Mellon
may be deemed a financial promotion in non-U.S. jurisdictions.
Accordingly, where this report is used or distributed in any
non-U.S. jurisdiction, the information provided is for use by
professional investors only and not for onward distribution to,
or to be relied upon by, retail investors. • This report is not
intended, and should not be construed, as an offer or solicitation
of services or products or an endorsement thereof by BNY Mellon
in any jurisdiction or in any circumstance that is otherwise
unlawful or unauthorized. BNY Mellon Asset Management
International Limited and its affiliates are not responsible
for any subsequent investment advice given based on the
information supplied. • Past performance is not a guide to future
performance. The value of investments and the income from them
Cover: Shutterstock
is not guaranteed and can fall as well as rise due to stock market
and currency movements. When you sell your investment you may
get back less than you originally invested.
11 © The Economist Intelligence Unit Limited 2012

13. London New York Hong Kong Geneva
26 Red Lion Square 750 Third Avenue 6001, Central Plaza Boulevard des
London 5th Floor 18 Harbour Road Tranchées 16
WC1R 4HQ New York, NY 10017 Wanchai 1206 Geneva
United Kingdom United States Hong Kong Switzerland
Tel: (44.20) 7576 8000 Tel: (1.212) 554 0600 Tel: (852) 2585 3888 Tel: (41) 22 566 2470
Fax: (44.20) 7576 8476 Fax: (1.212) 586 0248 Fax: (852) 2802 7638 Fax: (41) 22 346 93 47
E-mail: london@eiu.com E-mail: newyork@eiu.com E-mail: hongkong@eiu.com E-mail: geneva@eiu.com