How should treasurers interpret central banks’ latest moves?

14 November 2019
Illustration of a submarine and a per cent symbol in the ocean

What does central banks’ handling of interest rates say about the broader global economy? Kallum Pickering explains

In recent months, central banks have been spurred back into action by the ongoing global economic slowdown, wobbly financial markets and heightened uncertainty from the noisy US-China trade war and political risks in Europe.

The US Federal Reserve has cut rates twice already and may cut once more before the year is out. The European Central Bank (ECB) has cut rates and restarted massive bonds purchases.

Other, smaller central banks are pursuing similar policies.

Some pundits argue that these latest efforts will hardly have any impact on the real economy and that central banks are running out of ammunition. That misses two key points.

First, lower growth must be matched by looser monetary policy else central banks themselves will be adding a further dampener on economic momentum. Second, central banks could supply ample liquidity at extremely generous conditions.

In this way, they might contain the risk of economic softness triggering serious financial tensions of the kind that could reverberate back into the real economy.


Excess of savings

Slow economic growth and low interest rates in the developed world is the new normal. This has changed the orthodoxy for central banks. Ultra-low policy rates and huge balance sheets are a symptom of the slow growth.

Growth is slow because trend productivity is weak. This is not a legacy of the financial crisis or bad economic policies. The record of history is clear.

Every once in a while we enjoy a major flush of innovation that dramatically lifts living standards and economic growth for decades at a time.

We eagerly await the next one.

Market interest rates are low because there are more savings than there are genuine opportunities for investment. The global economy is indeed awash with savings and liquidity.

But the private sector of the advanced world largely occupies the edge of the known technological frontier. This excess of savings drives down interest rates, especially on low-risk assets.

It is no longer true, therefore, that low interest rates equate to easy monetary policy. Yet it is all too common to hear pundits and analysts make this point.

What matters is where policy rates are relative to potential economic growth. The open market operations that enable a central bank to achieve a 0% policy rate are more stimulative when the real GDP growth trend is 3% than if it is 1.5%.

In a low-growth environment, stimulating economic growth with monetary policy is tricky. First, the zero lower bound limits how low central banks can drop their main policy rates.

Although some central banks have experimented with negative interest rate policies, including the ECB, the Bank of Japan and the Swiss National Bank, they have not yet dared to lower interest rates much below zer

‘Helicopter money’

Second, central banks are constrained by what is considered by policymakers as acceptable means to stimulate demand.

In the post-Lehman period, central banks’ toolkits have expanded through necessity. Nowadays, central balance sheets directly influence market liquidity through the purchases of public and private assets on the open market, ie quantitative easing (QE). But in theory, there is no real constraint on how central banks can use their balance sheet.

Some economists argue that central banks should directly deposit money in people’s accounts for them to spend – so-called helicopter money.

Others argue that central banks should simply finance government spending. For now, the consensus is that both ideas would damage the central banks’ credibility and trigger a surge in inflation. Then again, this was once said of QE as well.


About the author

Kallum Pickering is senior economist at Berenberg Bank

This article was taken from the October/November 2019 issue of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership

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