CENTRAL BANKS RUN SHORT OF POLICY OPTIONS / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

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AUGUST 4, 2011.

Central Banks Run Short of Policy Options.

By RICHARD BARLEY

This is the stuff of financial nightmares: debt levels still far too high, growth stalled and fiscal policy now in retreat in many Western economies. All eyes are now on the one group of policy makers still able to act to prevent a disastrous drop in demand and slide into deflation. But what is a central banker to do to dispel the demons?


The challenge is to sustain nominal growth at levels that allow for orderly debt reduction. That means higher inflation, given that potential real GDP growth is likely lower than precrisis levels. But with interest rates close to zero in most developed countries, central banks will have to dig deep into their bag of unconventional policy tricks.


The Swiss National Bank is already grappling with the problem. Confronted with a surging Swiss franc that is hurting the economy and increasing the risk of deflation, the SNB on Wednesday slashed interest rates effectively to zero, cutting the target range for three-month Libor to 0%-0.25% from 0%-0.75%, and flooded the money market with cash. That bought only small respite for the franc.
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The Federal Reserve and the Bank of England have already tried large-scale purchases of government bonds. It isn't clear that further purchases of Treasurys or gilts will prove sufficient, particularly given that yields are already extremely low and can hardly be driven much lower. A survey of attendees at Fathom Consulting's Monetary Policy Forum this week showed that half think the Bank of England should buy something other than gilts if it undertakes more quantitative easing. Some suggest central banks could buy bank capital securities, mortgages or equities.


Meanwhile, Fed Chairman Ben Bernanke has already run through many of the options outlined in his 2002 speech on preventing deflation; among the remaining tools are direct loans to banks, caps on long-term bond yields or even purchases of foreign assets.


For the European Central Bank, the task is harder, given its pure inflation-busting mandate. True, it has room to cut rates, currently at 1.5%. It could also reintroduce six- or 12-month liquidity facilities for banks facing funding difficulties.


There has also been speculation that the ECB might dust off its bond-purchase program. But the bar for this is set high; the ECB is angry that euro-zone governments imposed losses on Greek bondholders, introducing explicit credit risk to sovereign debt. The ECB might balk at the scale of purchases required to shift Italian and Spanish yields. But it will be months before the beefed-up European Financial Stability Facility can buy bonds.


Of course, such policies alone won't ignite higher growth. And they risk triggering another bout of commodity inflation that squeezes consumers. But they are one way of trying to shore up confidence while debt is paid down. If the economy continues to slow, central banks are unlikely simply to stand by and watch.


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