Monetary policy cannot protect us from each and every shock
Dario Perkins
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The idea that central banks can address any problem that emerges in markets is surely one of the most dangerous in finance. Since the outbreak of the coronavirus in China, it is reaching the point of parody.
Without doubt, the prospect of monetary stimulus has buoyed investor confidence over the past year, supporting a powerful rally in equities and a big easing in financial conditions.
But central bank officials are contributing to the fantasy that they can solve other ills, by continually talking about risks outside their mandates.
We can all agree, for example, that climate change will have severe macroeconomic consequences, but it is less clear how many trees policymakers can save with an extra €30bn a month in bond purchases, or how to translate the European Central Bank’s inflation target into degrees Celsius of global warming.
Even aside from such high concepts, while central banks still hold considerable sway over financial markets, their power to influence the real economy has steadily diminished over time.
Our analysis shows that every part of the transmission mechanism from monetary stimulus to the real economy has faded during the 2000s.
That is not to say monetary tightening would be ineffective; in a world of record leverage and a decade-long search for yield, there is no limit to the chaos large rate increases might bring. And yes, cutting interest rates can boost asset prices.
But the assumption of central bank support has become reflexive. Investors appear to believe that big central banks will respond to the economic shock of the coronavirus with further stimulus — a factor that has helped to buoy markets. It is hard, however, to see how interest rates can alleviate a health crisis.
More broadly, with a rising slice of wealth now in the form of equities rather than housing, the impact of monetary stimulus on spending is weaker than it has ever been. This is true for both consumers, where equity holdings are concentrated only among the wealthiest, and for businesses.
Economists like to assume that lower interest rates boost investment and encourage people to bring forward their spending plans from the future. Yet empirical studies have never really endorsed the link between capex and the cost of borrowing. Monetary stimulus may have played this role in the past, but it has diminished.
Spending on consumer durables such as cars, washing machines and even housing was always the most sensitive part of the economy to monetary policy, yet these sectors have declined as a share of overall gross domestic product, in the US and across the rich world.
It seems obvious, if stimulus works by bringing forward spending from the future, that a decade of low interest rates will eventually lose any potency. Maybe we have simply run out of “marginal” consumers who can be encouraged to spend — that is the impression you get from global car manufacturers, where demand has sagged as customers stopped borrowing. Put simply: consumers need a limited number of cars.
The traditional link between real interest rates and personal saving has also broken down. In some countries, it now even operates in the reverse direction. Recent research from Germany’s central bank suggests consumers in some euro-area countries will curb their spending in response to lower interest rates, as the losses they make on their bank deposits outweigh any tendency they might have to increase their spending. This shift is most notable in Germany where — contrary to the popular narrative in the foreign financial press — opposition to ECB policy is not just a matter of ideology.
The other issue is that when another serious economic shock strikes — whether the coronavirus, or something else — central banks will not be able to cut rates as much as they needed to in the past.
Past recessions required at least 5 percentage points, or 500 basis points, of rate cuts, not the 0-175 bp that is available today. Sensibly, the US Federal Reserve does not want to experiment with negative interest rates and even the European central banks, which have hit sub-zero deposit rates, are unlikely to push these policies further. They realise the costs of these experiments will soon outweigh the benefits.
The official solution to this problem is to react even more aggressively when facing a particular risk. By using the existing ammunition more forcefully, central banks hope they can create extra room for manoeuvre on policy. Two former Fed chairs, Ben Bernanke and Janet Yellen, recently explained this strategy in some detail. The idea clearly resonates with current monetary officials across the world, given how quickly they pivoted towards easing in 2019.
Investors have welcomed this new hypersensitive risk-management approach because they think it means they can rely on monetary stimulus whenever something goes wrong. They do not seem to realise this was an admission of weakness, not a display of strength.
The writer is managing director for global macro research at TS Lombard
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