The Chal­lenges Loom­ing For Cen­tral Banks In 2018

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The US Fed­eral Re­serve raised in­ter­est rates for the third time and laid the ground for fur­ther tight­en­ing. The Euro­pean Cen­tral Bank left its stim­u­lus poli­cies in place but con­firmed plans to scale back as­set pur­chases. The Bank of Eng­land paused af­ter its Novem­ber rate rise, but sig­nalled that in­ter­est rates were likely to rise again in 2018.

The lack of re­ac­tion to seem­ingly im­mi­nent tight­en­ing is worth cel­e­brat­ing. In­vestors no longer hang on cen­tral bankers’ every word be­cause, af­ter the great­est fire fight­ing oper­a­tion in gen­er­a­tions, most ma­jor economies are in de­cent health and mon­e­tary pol­icy has of late be­come more pre­dictable.

In the US, the out­go­ing Fed chair Janet Yellen has over­seen the econ­omy’s re­turn to full em­ploy­ment — ac­com­pa­nied, at last, by ris­ing wages. She has also proved defter than her pre­de­ces­sor at putting the Fed’s vast pro­gramme of quan­ti­ta­tive eas­ing into reverse with­out un­set­tling mar­kets.

In the EU, Mario Draghi de­serves enor­mous credit for over­com­ing re­sis­tance to rad­i­cal poli­cies that are start­ing to bear fruit: un­em­ploy­ment is fall­ing across the euro zone and the lat­est data sug­gest the bloc is grow­ing at its fastest pace in seven years. Pe­riph­ery economies such as Spain, Por­tu­gal and even Greece are on the mend. Neigh­bour­ing Ice­land — an early ca­su­alty of the 2008 crash — has lifted cap­i­tal con­trols and is re­gain­ing its stand­ing in in­ter­na­tional mar­kets.

The out­look for the UK is less be­nign, thanks to the un­cer­tain­ties at­tend­ing Brexit. But the global up­swing is at least cush­ion­ing the blow and Mark Carney, the BOE gov­er­nor, can ar­gue that the cen­tral bank is now a sup­port­ing ac­tor in the drama, not the pro­tag­o­nist.

How­ever, cen­tral bankers can­not rest on their lau­rels. The de­ci­sions they must take in 2018, over the pace and ex­tent of tight­en­ing will be fiercely con­tested and they will be com­pli­cated by the un­even nature of the re­cov­ery, in the euro zone in par­tic­u­lar.

Mean­while, the di­rec­tion of pol­icy is likely to be­come less pre­dictable for in­vestors, with a wave of new ap­point­ments at the Fed and spec­u­la­tion al­ready be­gin­ning over who might suc­ceed Mr Draghi at the ECB in 2019.

On one side of the de­bate, the worry is that with­draw­ing stim­u­lus too early, in the name of “nor­mal­i­sa­tion”, will choke off growth, or trig­ger big falls in as­set prices and re­newed debt prob­lems. On the other side, the con­cern is that an ex­tended pe­riod of ul­tra loose pol­icy is al­low­ing risks to build up in the fi­nan­cial sys­tem that could gen­er­ate the next cri­sis — and that cen­tral banks might have no am­mu­ni­tion left to fight it when it struck.

For mon­e­tary pol­i­cy­mak­ers, tight­en­ing too fast looks like the big­ger risk, given the stub­born ab­sence of in­fla­tion­ary pres­sures. The Fed has cho­sen to em­bark on a tight­en­ing cycle trust­ing that higher in­fla­tion will fol­low the im­prove­ment in jobs and growth. There is not much sign of it yet. The ECB’s lat­est fore­casts show in­fla­tion still be­low tar­get in 2020, even if in­ter­est rates re­main at his­toric lows.

All the more rea­son, though, for cen­tral banks to use the macro pru­den­tial tools at their dis­posal to con­tain fi­nan­cial risks and stop as­set prices over­heat­ing. Jay Pow­ell, the new Fed chair, and Ran­dal Quar­les, its new su­per­vi­sory chief, should not be too quick to dereg­u­late. The ECB has a fight on its hands to force banks to tackle the cri­sis legacy of bad loans: it must press on.

Cen­tral banks, much ma­ligned in re­cent years, can now claim suc­cess for their un­ortho­dox poli­cies. But their job is not about to be­come any eas­ier.

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