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Have we reached the limits of monetary policy? No. The central banks’ medicine cabinet is still full. Yet using the old treatments more aggressively or using altogether new treatments creates political, financial and economic risks. Worse, such action cannot solve some of the bigger difficulties the high-income economies confront. In an ideal world, therefore, monetary policy, should not remain “the only game in town”, as the title of a book by the economist and investment manager Mohamed El-Erian suggests it now is. Unfortunately, we do not live in an ideal world. In the real world, central banks must remain our doctors of choice.
Central banks have duly employed more radical treatments than ever before. All the leading central banks of advanced economies have set short-term intervention rates close to zero. The Bank of Japan has applied rates this low since 1995. The US Federal Reserve and the Bank of England have used ultra-low rates since early 2009. By 2013, the European Central Bank followed suit — albeit too slowly.
These central banks have also substantially expanded their balance sheets through quantitative easing or, in the case of the Bank of Japan, “quantitative and qualitative easing” (which includes lengthening of the maturity of the assets it buys). Like the Fed, the Bank of England has stopped purchasing assets. But its balance sheet is bigger, relative to UK gross domestic product, than throughout its long history. The BoJ and ECB are still expanding their balance sheets today (see charts).
More recently, as Mark Carney, governor of the Bank of England, noted in Shanghai in February: “Central bank innovation has . . . extended to negative rates, with around a quarter of global output produced in economies where policy rates are literally through the floor.”
Yet, even after years of such effort, the US is the only significant high-income economy to have achieved its target rate of core consumer price inflation. That is also why the Fed alone has started a tightening cycle, albeit in a gingerly fashion, with the federal funds rate still below 0.5 per cent.
One response to this apparent failure is the argument that hitting the inflation target does not matter. Some even argue that deflation has merits. This view is flawed, for three reasons.
First, if inflation is zero or, still worse, if it turns negative, it becomes harder to secure needed changes in relative prices and wages. The obstacle here is nominal wage rigidity. This difficulty is particularly important in a multi-country currency union, such as the eurozone.
Second, under deflation negative real interest rates are possible only with strongly negative nominal interest rates. Without negative real interest rates, countries might end up in a prolonged period of deficient demand, elevated unemployment and weak investment.
Third, under deflation the real burden implied by a given level of nominal debt spirals upwards. This risks creating “debt deflation”, a condition explained by the US economist, Irving Fisher, in the 1930s. While Japan managed to stabilise deflation at a slow rate, this may be due to its aggressive use of fiscal policy. With the latter ruled out in the eurozone, the risks of accelerating deflation might be even greater there.
It is important, then, for central banks to hit their inflation targets. This entails very low, or even negative, nominal rates. As Mario Draghi, president of the ECB, explained in a recent speech, many complain that these low interest rates are themselves the problem. “But,” he responds, “they are not the problem. They are the symptom of an underlying problem, which is insufficient investment demand, across the world, to absorb all the savings available in the economy.”
The question is how well monetary policy can remedy such a chronical deficiency in demand. One answer is that central banks possess many ways of delivering further monetary stimulus: low and even negative interest rates, asset purchases, forward guidance, higher inflation targets, outright monetary financing of government deficits, and direct dispatch of money to households.
In recent blogs, Ben Bernanke, former chairman of the Fed, demonstrates the potency of such tools. He could even be too cautious about how low negative rates can go, arguing that “beyond a certain point, people will just choose to hold currency, which pays zero interest”. But creating a payment system based on cash is a difficult and expensive task. More fundamentally, as Martin Sandbu has argued, it would be possible for the central bank or the banks to limit access to cash or impose charges on converting deposits into cash. Some economists even recommend abolishing cash.
Nevertheless, going further does run into significant difficulties.
First, the more unconventional the policy, the more difficult it is to calibrate its effects. It is necessary to create just enough additional demand, but not too much, along with manageable side effects. This is quite hard to do, not least because monetary policy works via many channels. Moreover, the effects can be unpredictable. Do negative rates, for example, increase confidence by showing that central banks are not out of ammunition, or damage it by proving how bad the illness is?
Second, some remedies might be worse than the disease. Perhaps the biggest concern is that extreme monetary policy risks distorting asset prices and generating new financial bubbles. Another critique is that reliance on monetary policy treatments relieves pressure on governments to conduct necessary structural reforms. Again, policies apparently designed to affect the exchange rate could be viewed as beggar-my-neighbour devices.
Third, extreme monetary policy runs into political objections. Creditors object to all policies aimed at lowering interest rates, for example. Again, people fear that direct financing of government deficits would merely encourage fiscal profligacy.
Apart from these objections, there are two other important difficulties with heavy reliance on monetary policy.
One of these is that, if the fundamental difficulty is an excess of savings over investment, fiscal policy would be a better targeted remedy. In Japan, for example, the great difficulty has been the excess savings of the non-financial corporate sector. The obvious remedy would be higher taxation of retained profits. Higher taxation of consumption is simply misdirected. An alternative would be for governments to increase spending on high-priority public investments.
Another objection is that weakness of demand is not the sole difficulty. At least as important is declining growth of productivity and, in a number of countries, the inflexibility of markets. For such reasons, a more complete package should include structural reforms. The latter are not a panacea, particularly in the short term, as the International Monetary Fund has noted. But they need to be a part of the mix.
Monetary policy is not exhausted, and active use of it is essential. But undue reliance on monetary policy is problematic.
One difficulty lies in the political limits to further action. Another limitation is the need to calibrate policy and mitigate side effects. Fiscal policy should play a far bigger part in demand management. More importantly, monetary policy can palliate, but not cure, structural problems of low growth and inflexible markets. We still need active monetary policy. But it is not all we need.
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