One of the principle conclusions of economic thinking regarding monetary policy during the last quarter of the 20th century involves the binding role of expectations on Central Banks. As the old argument went, central banks could always spur extra growth by printing more money. This works while people are deceived into believing they have more wealth, and spend it, but runs afoul as soon as they catch on. Worse, from the point of a central banker, if people are aware of this process, if it is part of how the form their expectations for the future course of the economy they live in, printing money will have no effect but to raise prices.
Several research articles thus brought us the notion that the best a central bank can do is control inflation, and can only do so effectively if it is credibly committed to following such a rule (i.e. 'I won't try to cheat you in the future by printing money). This notion of credibility is closely intertwined with the call to "manage expectations," "expectations" here being those of consumers and firms and "manage", well, that's the tricky part.
The theory, in essence, suggests Central Banks should commit to one rule of behavior and stick to it. Managing expectations is no more involved than that. But if you work for a central bank, that's not too sexy. You are essentially an automaton, not a "big player", a mover and shaker of the economy. So in the last years of the twentieth century central bankers began to think they could manage expectations in the broadest sense, that is expectations over the entire economic reality we live in. The culmination of this process within central banks is the belief that their single opinions can shape the direction of entire economies.
Over the last month the Bank of Canada has shown that is suffers from this delusion of grandeur. In December the Bank told us the recession would be deep and prolonged. This week the announcement is of a short recession. So short, in fact, all will be back to normal by 2010. While this goes smack against the forecasts of more venerable institutions (let alone its own statements of a few weeks ago), it confirms a growing sense that the bank is not only poor at forecasting, it is vulnerable to political interference, increasingly singing the government's tune (Central Bank independence is a sine qua non condition for credibility).
The risk for all of us is the eventual loss of all credibility of future statements by the Bank of Canada, unraveling the entire process by which the bank has any hope of achieve in intended mission of controlling inflation.
11 years ago
