As investors substitute real capital assets for currency and government bonds, central banks find that manipulating interest rates becomes a less effective tool for managing the economic cycle. When a central bank changes the value of its currency, it changes the price of assets denominated in that currency but does not change the value of those assets.
The increasing impotency of monetary policy does not end our need for central banks. Because market liquidity sometimes fails (i.e., bank runs), we still need a lender of last resort. With securities representing claims on capital assets now performing more of the functions of money, ensuring the orderly settlement of financial transactions has become an increasingly important function of central banks and prudential regulators. Bill Dudley, president of the New York Fed, recently called our attention to “gaps in the lender-of-last-resort function” because the “Federal Reserve has a very limited ability to provide funding to a securities firm” (Dudley, 2016).
Central banks haven’t yet learned to limit their attention on this core function of ensuring financial liquidity. Continued attempts to boost employment and real economic output by pursuing evermore quixotic monetary policy experiments increases the long-term risk of inflation. To date, quantitative easing and negative interest rate policies have not created inflation because these programs have been largely limited to the purchase of securities from banks rather than directly creating money (Brightman, 2015). However, if and when central banks actually do begin to create money directly—the modern equivalent of dropping money from a helicopter, as in Milton Friedman’s famous analogy repeated by Ben Bernanke—inflation may soon follow. Worryingly, the political constraints to such direct money printing are diminishing (Flanders, 2016).
During the normal and healthy conduct of monetary policy, the measured rate of inflation often deviates from official targets within a range of a percentage point or two because of the challenges of defining, measuring, and hitting a precise inflation target over a short-term period. History teaches, however, that a sustained regime of financial repression—an intentional policy of sustained negative real interest rates imposed for the purpose of inflating away the real value of debt—eventually produces high and volatile inflation (Reinhart and Rugoff, 2009). During periods of financial repression, government bonds are hardly risk free.