Central banks: Running out of ammunition in the next downturn

Quick post here. Earlier today, I sent out a note about the Bank of England’s rate hike basically saying a large part of it was about the urge to normalize. When I wrote that I hadn’t seen Gavyn Davies’ most recent missive on central banks. And I wanted to point it out here because his message dovetails with mine.

Running out of ammo

The link to the full post is here. But let me quote the key bits I want you to take away:

For a recent Brookings Paper, Fed authors Michael Kiley and John Roberts conducted simulations on the main macroeconomic models used by the Fed to demonstrate the likely effects of a permanent decline in r* to only 1 per cent, roughly half its pre-2008 level. They conclude that the Fed’s policy rate “should” be below the effective lower bound (ELB) about 30-40 per cent of the time in order to keep average inflation at 2 per cent. Of course, this is impossible.

This means that interest rate policy alone could not deliver the optimal setting for monetary policy over long periods during the economic cycle, not only in the extreme conditions of a serious recession. The situations in Japan and the Eurozone are probably much worse.

When the central banks faced this situation during the Great Recession, they resorted to asset purchases and forward guidance to increase the degree of monetary accommodation after policy rates had reached the ELB. These unconventional instruments would be available to them again, but there are doubts about their effectiveness.

Solution: At the margin, normalize

Central banks don’t want to face another recession without having enough rate policy runway. So faced with an uncertain future nine years after the financial panic ended, they all lean toward tightening, even the Bank of Japan.

The Japanese want to tighten. But, earlier in the week, the Bank of Japan governor decided not to wind down monetary stimulus and instead announced a commitment to “continuous powerful monetary easing”. That’s failure.

And the Japanese failure is what all the other central banks are scared of. So when push comes to shove, they will tighten, even when they aren’t sure if doing so makes sense. For what it’s worth, the FT came out with an editorial saying the BoE’s rate hike was “a false step“. And while the BoE may not take another until after Brexit, if it takes any, the ECB is next in line to finally remove accommodation.

Do read Gavyn’s piece though. His conclusion is important:

The Fed might, with luck, be able to handle a normal recession with its established weapons. But an extreme American recession would be another matter entirely.

And the ECB and BoJ have already encountered a shortage of monetary options. Come the next recession, both could be in serious trouble.