Monetary policy is at the end of the line

The last few days have made clear that monetary policy is having less and less impact as time goes along.In particular, the latest salvos from the Bank of Japan smack of desperation, as if BOJ Governor Kuroda has decided to throw everything but the kitchen sink into his grab bag of unorthodox monetary policy. Because the Bank of Japan is so far along the curve toward both secular stagnation and unorthodox policy to counteract that slowing, we should pay attention to how their experiments go. I do not expect good results.

How central banks operate

Let me start off with a baseline on how I think about monetary policy. I apologize if this is a bit wonkish. But I think it’s important in understanding why central banks’ unorthodox policy tool kits are limited.

The first and main tool in the arsenal of any central bank is interest rate policy. And this is because the central bank is a monopolist. In Japan, for example, the Japanese government is the monopoly issuer of Japanese currency, and has given the Bank of Japan monopoly power as its agent to control the reserve monetary base. The Bank of Japan exercises its monopoly power by targeting the overnight rate for money, currently at zero percent with an added tax on excess reserves to boot.

This is how all modern central banks operate. They have explicit targets or target ranges for the overnight interest rate and act within the reserve market that they control to ensure they hit their targets. The point of course is that modern central banks use a price or interest rate target, not a quantity target like targeting reserves or monetary aggregates. And since a monopolist can only control either price or quantity, not both simultaneously, central banks have to pick one or the other. The Volcker experiment at the Fed in the late 1970s and early 1980s made clear that quantity targets don’t work. So central banks target interest rates i.e. price.

Now central banks can’t do that unless they supply their banks with all the reserves that those banks desire to make loans at the target interest rate — meaning central banks must be committed to supplying as many reserves as banks want or need in accordance with the lending that they do. Failure to supply the reserves means failure to hit the interest rate target, since banks would bid up the price of reserves above the target.

The transmission mechanism

So how does this help or hurt the economy? First, when an economy is in distress — in recession or headed there — lower interest rates decrease interest payments and help reduce financial distress for the most precarious borrowers. Moreover, other borrowers benefit from lower rates too and are more likely to increase spending because of the increased disposable income. We see that with mortgage refinancing activity in the United States or lower mortgage payments on variable rate loans in the UK, for example.

Moreover, when an economy is in distress, lower base rates help banks by increasing net interest margins through steepening the yield curve. A lower overnight rate means that short-term interest rates are lower relative to long-term interest rates. And that’s good for bank net interest margins. That affords banks the chance to build capital buffers. And since banks experience larger loan losses when an economy is in distress and must reserve against those losses, building those buffers is important to banks’ willingness to lend as loan loss reserves affect the banks’ capital position, which they use as the buffer between assets and liabilities to not only remain solvent but also to make loans. (As an aside, I should also point out that banks are never reserve constrained because the central bank supplies all the reserves banks need in order to hit the overnight interest rate target. They are capital constrained because they can’t make loans unless they have enough capital to do so and remain a safe and sound financial institution.)

That’s all fine and good. But then economists take it a step further and say that when the central bank lowers or raises interest rates, it raises or lowers demand for borrowing for investment by firms. But this simply isn’t true. There is no empirical evidence that lower rates spur capital investment. Even studies by the Federal Reserve note this fact. In fact, as former UBS chief economist George Magnus recently pointed out regarding the Bank of Japan, what really happens with investment as central banks lower rates is that it creates a skew toward high risk investment due to investor’s search for higher yield. It’s not more investment that we see, but skewed investment toward projects with longer lead times and higher risk. As George puts it, “zombie companies are kept alive perpetuating a misallocation of capital, and retarding new investment opportunities” (underlining for emphasis added).

What happens when rates are at zero

When the central bank has cut as much as it can i.e. to zero, you’ve got a big problem. First of all, the central bank can’t lower interest rates further to help debtors in distress. It’s already as low as it can go. Second, it can’t lower them any more to help banks pad their net interest margins because – again – they’re at zero. Basically the central bank is stuck. And that’s where we  landed everywhere during the most recent financial crisis: in Europe, in Japan, and in the US. The central banks, thus in order to prove their potency, fabricated a bunch of unconventional policy tools they told us were just as good as interest rate policy. And they’re using them.

We’re talking about:

  1. Forward guidance: where the central bank tells you they will keep rates at zero for longer as a way of keeping long-term rates down too
  2. Quantitative easing (QE): where the central bank buys up financial assets with printed reserve money in order to boost asset prices and maintain lower interest rates. The Bank of Japan is even getting exchange-traded equity funds created to invest in.
  3. Negative interest rate policy (NIRP): where the central bank taxes the excess reserves it has created through quantitative easing in an attempt to make it onerous to have excess reserves in the first place, thinking banks might make more loans than otherwise.
The US has used the first two tools and Japan and Europe have employed all three. Yet growth remains slow, especially in Japan, which has been wracked by deflation for years. So the BOJ has upped the ante this week with two new policies
  1. A higher inflation target: where it has said it would permit inflation to go above its long-term inflation target, in order to get markets to expect higher inflation and, therefore, faster nominal GDP growth
  2. An explicit long-term rate target: where it says explicitly it will not allow the long-term 10-year interest rate to rise above zero, hoping the lower rates in the economy will increase borrowing for investment

It won’t work

All of this is destined to fail. And it’s clear from the framework I set out to begin with why.

  • Forward guidance and explicit long-term interest rate targets flatten the yield curve and reduce bank net interest margins. That’s anti-stimulus. Moreover, lower interest rates reduce savings interest. And since the private sector in every advanced economy is a net receiver of interest, in a normal, growing, non-distressed economic situation, this factor swamps the benefits from relieving financial distress. When the economy is not distressed, net-net lower rates are not stimulative since the private sector is a net receiver of interest. They make it harder to save and could induce more savings and less spending.
  • Quantitative easing is based on quantity target thinking. And we already know that quantity targets don’t work.
  • Negative interest rate policy is based on the flawed assumption that banks are reserve constrained when they’re not. Nowhere where they have been implemented have negative interest rates resulted in increased lending. They are a tax. And as time goes on, this tax is likely to be passed on to bank customers, reducing aggregate demand.
  • Finally, there’s the higher inflation target the Bank of Japan has just set. This won’t work either. Just because the Bank of Japan says it is willing to accept higher inflation doesn’t mean they will get higher inflation. And higher inflation doesn’t mean higher real GDP growth, it could just mean an erosion of purchasing power, which would cause people to retrench.

All of these unconventional policies are poor substitutes for interest rate policy. And the only reason they are being tried is because policy rates around the world are at or near zero. If central banks could cut interest rates and steepen the yield curve, they would. But they can’t and they have fallen back on this increasingly desperate set of alternative policy tools.

My view is that in the absence of increases in median wages in advanced economies, we are unlikely to see a meaningful and durable increase in growth in those economies. And the result is going to be not just low short-term interest rates, but low long-term interest rates. When recession hits, yield curves will flatten instead of steepen, since we are at the zero lower bound. And the full measure of loan loss distress will come to bear on bank balance sheets, restricting credit and deepening the downturn. At that point, we will just have to see when and whether we get a fiscal response and how effective that response is. Monetary policy is out of bullets.

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