At the Jackson Hole Economic Policy Symposium in 2014, Mario Draghi made a polite departure from the usual rhetoric around austerity, saying “it would be helpful” if fiscal policy could play a greater role, alongside monetary policy, in boosting demand.
Five years later, central bankers meet again in Jackson Hole as Mr Draghi prepares to leave the European Central Bank. They should not just heed Mr Draghi’s advice but take it much further. The next policy response to a downturn will probably require an unprecedented venture into “going direct”: finding ways to get money more directly in the hands of entities that can spend it, including consumers.
The issue at stake is that there is not enough monetary policy space to deal with the next downturn. Conventional and unconventional monetary policy mainly boosts growth by lowering short and long-term interest rates.
But this requires rates to go lower, and there is nowhere left for rates to go. The global economy is still expanding and yet in Europe about two-thirds of government bonds have negative yields. In the US, the 10-year Treasury yield is already approaching record lows and could head towards zero in a recession.
Going direct could include such steps as tax rebates with the explicit aim of bringing inflation back to or above target. But a clear framework will be needed to avoid undermining central bank independence or opening the door to reckless fiscal spending.
Going direct requires the following: first, defining the circumstances that would call for such unusual co-ordination. Second, an inflation objective that fiscal and monetary authorities are jointly held accountable for. Third, a mechanism that ensures nimble deployment of fiscal policy. And finally, a clear exit strategy.
For example, policymakers could create a standing emergency fiscal facility that would be activated only when monetary policy is tapped out and inflation is expected to systematically undershoot the target over the policy horizon.
The size of this facility would be determined by the central bank and calibrated to achieve an inflation goal, which would include making up for past inflation misses. The fiscal authority would deploy the funds. Once medium-term trend inflation was back to target and monetary policy regained some room for manoeuvre, the facility would be closed. Importantly, such a set-up would help preserve central bank independence and credibility.
Going direct relies on the ability for fiscal policy to boost aggregate demand and the longer term potential of the economy. Fiscal policy can boost activity without relying on lower rates, and there is a strong case for fiscal policy to do more of the heavy lifting. The “lower for even longer” rate environment provides more fiscal space. If rates stay lower than trend growth, it is possible to expand deficits and still see debt-to-GDP ratios fall.
The proponents of fiscal expansions point to powerful forces that should keep rates low: a persistent global savings glut and demand for the perceived safety of government bonds.
But fiscal policy will not be the whole answer. First, low rates cannot be taken for granted. A large fiscal expansion would materially reduce the global saving glut. With global debt at record levels and increasing, perceptions of debt sustainability could change, reducing the “safety bid” for sovereign bonds.
Second, fiscal policy has not been nimble enough, with tax and spending packages often being debated rather than implemented when needed.
Lastly, ensuring fiscal space goes towards a productive and efficient allocation of resources has proven difficult.
In recent years, central banks have been exploring changes to their policies, including strategies that would involve correcting undershoots of the inflation target with a commitment to generate above-target inflation. The idea is this change will lead to higher inflation expectations, reducing the real burden of borrowing.
But these ideas are too timid for the situation we face today. When interest rates cannot be meaningfully lowered, how will the central bank generate higher inflation?
Mr Draghi famously said he would do “whatever it takes” to preserve the euro. We need that same courage from central bankers as they prepare for another downturn. Greater clarity on how to successfully combat the next recession is more important for building confidence than any short-term easing of monetary policy.
Policymakers will need to embrace ideas that are not just unconventional, but rather unprecedented. Let us hope that at Jackson Hole this year, policymakers start embracing a bolder approach.
Jean Boivin, PhD, is global head of BlackRock Investment Institute
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