Given the prevailing atmosphere, it is worth considering a broader array of macro-economic scenarios for 2016 than a couple of months ago.
Under pessimistic scenarios, central banks may be called to the rescue, again. The issue is that they are perceived to be exhausted and that their track record since the Great Financial Crisis is being increasingly questioned. A great depression has admittedly been avoided, but the economic growth and price stability objectives have not been met despite a mammoth increase in central banks’ balance sheets across the industrialized world. In this context, business and market confidence is being challenged. What would save us this time around if things were to head South?
Here is a synthesis of some thoughts on monetary policies based on various readings, including a number of official reports, which may help explain the current issues and address this thorny question.
THE STARTING POINT: CENTRAL BANKS’ MASTER PLAN POST CRISIS
On the face of it, the central banks’ basic game plan to deal with the crisis looked simple and sound:
Reduce the bank funding rate to zero to lower short term interest rates
Implement quantitative easing (“QE”) to lower longer term interest rates (through the purchase of long-dated financial instruments, thereby lowering their yield)
Repeat ad nauseam a commitment to a c. 2% inflation rate, and confidence in achieving the objective to anchor inflation expectations at or close to that level
Use ultra-low interest rates, and even negative short term real interest rates when considering inflation expectations, to silently shift wealth from creditors to debtors to help the world deleverage
Have the same low interest rates environment drive aggregate demand and investments (and then GDP)—et voilà!
THE FALSE ISSUE: INFLATION RISK
Even in the US where QE was implemented aggressively and early on, the inflation risk is deemed to be perfectly manageable. Banks in possession of liquidity (received inter alia in exchange for long dated assets sold to the central bank through the quantitative easing programs) have had an incentive to park it safely at their central bank in the form of “excess reserves”, thereby earning an attractive interest rate, instead of lending it. This means that although the money base “printed” by the Fed has increased very substantially since QE1, the money actually available to the broader economy has not increased materially, allowing for some price stability. In economic terms, central banks managed to break the so-called money multiplier.3 Should the economy continue to recover, central banks would simply increase the interest on excess reserves so as to create an incentive for banks to leave their liquidity with the central bank instead of injecting it into the economy through loans (see for example the FOMC policy outlined here).
THE REAL ISSUE: THE LIQUIDITY TRAP
Whilst inflation has been prevented despite a large rise in the money base, the amount of liquidity parked at the central banks has grown beyond expectations. This strong preference for liquidity has been, and continues to be, driven by three factors in particular: (i) An uncertain macro-environment which has obviously had a negative impact on lending (and borrowing) appetite; (ii) A disinflationary environment (leading most recently to a straight deflation risk) which increases the value of cash tomorrow, and thus of liquidity today; and (iii) A low opportunity cost of owning liquidity in a low interest rate environment. As a result, the entire financial system has fallen into a “liquidity trap“.
THE WAY OUT: SHOCK AND AWE
So what could the central banks consider doing at this juncture should the global macro situation deteriorate further? Some argue that to extract the world from the liquidity trap, higher interest rates ought to be set to increase the cost of holding cash, thereby creating an incentive for holders to spend it. Given the macro-economic environment, this appears to be a risky proposition to me. A few more effective things can be contemplated by central bankers:
Express a preparedness to live with an inflation rate above 2% - say 4% - to give a new boost to inflation expectations, as convincingly argued by the IMF in 2014 already
Double-down on quantitate easing: Whilst the effectiveness of quantitative easing on its own is unproven from a purely mechanical perspective as outlined above, its signalling effect remains powerful whilst the ability to ultimately contain inflation is deemed to be robust
Apply a negative interest rate (currently +0.25%) on the surplus cash held by banks with the Fed (these excess reserves), as the Bank of Japan did last week and the ECB in June 2014, and get ready to go into more negative territory until holding cash at the central banks becomes deeply uneconomical
These central banks’ policies could even be more closely coordinated globally for a more powerful impact. One things appears to be certain: as for corporate strategies, there is no room for incrementalism should further action be required. If this thesis is correct, get ready to be shocked by central banks in the coming months. The situation now needs to be addressed once and for all.
APOCALYPSE (NOT) NOW
In a truly extreme case, central banks could decide to simply cancel part of the government debt they hold as assets. This would be equivalent to dropping money out of a helicopter. Whilst economically potent, it would be morally abhorrent: Picture that with Wagner’s epic “Ride of the Valkyries” in the background as in Apocalypse Now. We are not there yet. Still, the power of the world’s central banks should not be underestimated. Betting against them is perilous.
Federal Reserve Bank of St Louis, S Williamson, “Current Federal Reserve Policy Under the Lens of Economic History A Review Essay”, July 2015
Peterson Institute For International Economics, W. Cline, “Quantity Theory of Money Redux? Will inflation be the legacy of quantitative easing?”, May 2015
Federal Reserve Bank of St Louis, M Arias and Y Wen, “The Liquidity Trap: An alternative explanation for today’s low inflation”, April 2014
Federal Reserve Bank of San Francisco, John Williams, “Monetary Policy, Money and Inflation”, Economic Letter July 2012
European Central Bank, “The Supply of Money: Bank behaviour and the implications for monetary analysis”, October 2011