Central banks have lost much of their clout
As leading central bankers meet this week in Jackson Hole, Wyoming, financial markets and media anxiously await indications of future policy direction. This year’s topic is Challenges for Monetary Policy and, amid slowing global growth, the talk is of interest rate cuts and clearer forward guidance.
In September, the European Central Bank may commit to keeping rates below zero beyond 2020. Some economists think the Bank of England’s Monetary Policy Committee should make explicit interest rate forecasts, mirroring the US Federal Reserve practice. Many hope that the Fed’s recent 0.25 per cent rate cut will be the first of many. Governor Haruhiko Kuroda of the Bank of Japan faces calls for action to counter stubbornly low inflation. More quantitative easing is possible.
Given the uncertainty, this year in particular the precise words spoken at Jackson Hole will be scrutinised with great care. But, in reality, what central banks can do alone is no longer very important.
It has been clear since the 2008 global financial crisis that when short and long-term interest rates are already very low, further cuts make little difference to real economic activity. If the BoE now cuts its rate from 0.75 per cent to 0.5 per cent the impact on consumption will be trivial. Because big German companies can already borrow 10-year money at less than 0.5 per cent, using quantitative easing to reduce that to, say, 0.4 per cent will make almost no difference to their investment plans. Pushing policy rates too far into negative territory could instead reduce growth by limiting bank profitability and lending.
Central banks’ attempts to manage expectations are also ineffective. When German bond yields show that investors expect negative ECB rates for a decade, promising they will not rise until 2021 cannot have more than trivial impact.
Despite all this, a mountain of economic commentary is still devoted to predicting minor shifts in central bank policy, and central bankers still obsess over the effectiveness of their communications. Two factors explain this disconnect between economic importance and the focus of economic debate.
The first is that while minor rate changes matter little to consumers and businesses, correctly anticipating them matters a lot to many asset managers, macro hedge funds, investment banks and their investor clients. Central bank-watching is, therefore, a preoccupation for many professional economists. Central bank announcements, with their ability to move markets and the drama of expectations confirmed or disappointed, also create a media buzz.
For financial investors “mixed messages” from central bank governors can turn potential speculative gains into embarrassing losses. When a member of the UK House of Commons Treasury select committee accused BoE governor Mark Carney of being like an “unreliable boyfriend”, it made for good headlines. But, in an era of structurally low interest rates, uncertainty about the timing of small future changes is just not that important.
Monetary easing can have a significant stimulative effect if interest rate changes drive currency depreciation. But that is a zero-sum game. US president Donald Trump wants a weak dollar, while China is allowing the renminbi to depreciate to offset the impact of his tariffs. No exchange rate policy can stimulate both economies.
The second factor is the fear of what follows if monetary policy has become powerless; for either we can then do nothing to offset potential recessions or fiscal policy must take the strain. But higher fiscal deficits mean rising public debt, unless they are financed with central bank money, and the latter seems to threaten central bank independence. So, for fear of finding something worse, central bankers cling to the hope that some sophisticated wrinkle of monetary policy will at last be effective.
However, large fiscal deficits and forms of monetary finance are already major drivers of global growth. In the spring of 2016, there were fears that central banks were “out of ammunition”. But, triggered by the Trump administration’s 2017 tax cuts, the US fiscal deficit has risen to today’s 4.5 per cent of gross domestic product. China’s fiscal deficit has grown from 2.8 per cent of GDP in 2015 to 6 per cent in 2019, with some of this financed by People’s Bank of China lending to state-owned banks to buy public bonds. Japan has run large deficits for a decade, fully matched by Bank of Japan purchases of government bonds, which will never be sold back to the private sector. And while Germany has stuck to the path of fiscal rectitude, its growth has relied on exports to these profligate rule breakers.
It is the eurozone that now faces the greatest danger. The Fed’s funds rate is now at 2-2.25 per cent, so the US can still cut by enough to make some difference — and if the economy continues to slow, the Trump administration will unleash increased spending or further tax cuts. Meanwhile, China and Japan will continue to run large fiscal deficits indirectly financed by their central banks. For the UK, as a smaller economy, exchange rate depreciation is a more powerful option than elsewhere.
But if global demand and eurozone exports remain subdued — and hardliners continue to block a European version of fiscal relaxation lubricated by central bank government bond purchases — there is no feasible action the ECB can take that will make more than a trivial difference to eurozone growth. The truth is that, acting alone, central bankers are no longer that important.
The writer is a former head of the UK Financial Services Authority