Can Governments Take Baton From Central Banks?

Central banks have long been calling for politicians to take action. The issue is becoming urgent.

By Richard Barley

2016 Rio Olympics. Relay races are all about the passing of the baton. The recovery from the global financial crisis is more a marathon than a sprint. Photo: Reuters

Monetary policy in Europe hasn’t quite gone from “whatever it takes” to “that’s all, folks.” But the days of central banks acting alone cannot last forever. Investors used to hanging on central bankers’ every word need to listen just as closely to governments to see whether calls for support are answered.

The expectation after the Brexit vote in June was for yet more central bank stimulus to be pumped into markets globally. In the end, only the Bank of England acted. And even it has now signaled a rethink, warning Thursday that policy could react to further developments by loosening or tightening policy from here. Fiscal policy is in focus.

And the debate in the eurozone is clearly on the move. At the hawkish end, Bundesbank chief Jens Weidmann warned Thursday about the dangers of keeping interest rates low for too long, including damage to the financial system, increased risk-taking and reducing the incentive for governments to fix their problems.

But European Central Bank President Mario Draghi and executive board members Peter Praet and Benoît Coeuré also gave speeches at the end of October that hit on the same challenges to monetary policy. Two issues, one economic and one rooted in the financial system and markets, are at play.

The first is that monetary policy can stabilize and smooth economic outcomes, not promote outright improvement. Potential growth for the eurozone is pegged at just 1%; core inflation is running around the same level. Persistently weak nominal growth may be shaping expectations about the future, meaning investment stays weak and unemployment stays higher than it otherwise might be. Monetary policy can do little about this.

The second is the risk of current monetary-policy settings becoming counterproductive for the financial system. Mr. Draghi highlights, for instance, that declining interest rates, which pose challenges to banks, have been accompanied by the benefit of higher asset prices. But once these capital gains have been taken—or indeed go into reverse—there is no offsetting force.

This is leading to a growing urgency in the calls for politicians to carry out labor-market and other reforms that might boost growth and find smart ways to use fiscal spending more effectively. Mr. Coeure says postponing reform “is not a valid option anymore.” Monetary policy can stay loose, but needs support from elsewhere.

Relay races are all about the passing of the baton. The recovery from the global financial crisis is more a marathon than a sprint, but markets should keep a close eye on whether politicians fumble the challenge.

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