Back in 1966, he showed that, when faced with uncertainty, central bankers should change monetary policy by less than they would in a certain world. Alan Blinder, a former vice-chairman of the Federal Reserve, summarised the rule as: “Estimate how much you need to tighten or loosen monetary policy to ‘get it right’. Then do less.” He’s called this the hotel thermostat principle. If your hotel room is too cold and you whack up the thermostat a lot, you’ll end up too hot. Instead, you should gradually tweak the thermostat up, because only this way will you learn how the room temperature responds to the heating system.
There are other reasons for central banks to act conservatively. One is that if they were to announce a massive easing, the outside world might respond by thinking “Yikes! If they are that desperate, the economy must be in worse shape than we thought.” This could cause businesses and consumers to cut spending, thus actually deepening the recession the central bank was trying to avoid. Alternatively, if interest rates were to move up and down regularly, they would lose their ability to influence spending; why invest after an interest rate cut if you think the cut will be reversed?
One big fact tells us that central bankers have for years followed the idea of Brainard conservatism. If they had set policy based only upon rational economic forecasts, interest rates and quantitative easing would have followed a random walk. This is because a good forecast embodies all available information and so should change only in response to unforeseeable events. As these events follow a random walk, so too should changes in monetary policy. But this does not describe policy in any major economy. Instead, easings have tended to follow easings, and tightenings have tended to follow tightenings. This strongly suggests that central bankers did follow Brainard’s principle. As Professor Blinder said, the idea “was never far from my mind when I occupied the Vice Chairman’s office at the Federal Reserve.”
It’s in this context that we should understand the ECB’s behaviour. It’s generally agreed that last week’s 25 basis point cut in the refinancing rate was too little, too late. That’s consistent with Brainard conservatism. So too is ECB President Mario Draghi’s statement that the risks to the economy are “on the downside” and that he “will stand ready to act if needed.” He’s acknowledging that he’s done less than might well be needed.
Those people who criticize the ECB for dragging its feet are, then, missing an important point – that “dragging its feet” is a long-established principle of central bank behaviour, with a good economic logic behind it.
So, what’s wrong with the idea? One thing. Brainard assumed that the cost to central bankers of missing a target was symmetric – that an overshoot of unemployment or inflation was as bad as an undershoot. This is questionable, especially now. A rise in euro area inflation from 1.2 per cent to, say, three per cent would at worst be mildly unpleasant. But mass unemployment inflicts terrible misery and even death.
Is Brainard, therefore, to blame for the ECB’s slowness to act? No, for two reasons. First, his assumption of symmetric costs was explicit – and assumptions are made to be relaxed. Secondly, he pointed out another effect of uncertainty. Just as investors facing uncertainty should hold different assets, so policy-makers should use different tools. He wrote: “With one target and two instruments it will generally be optimal to use some combination of both instruments.” In renouncing counter-cyclical fiscal policy, European policy-makers are, therefore, acting in an anti-Brainard way.
This is yet more evidence that our rulers draw upon economists’ expertise in a rather selective way.
