Monetary policy in a low-rate world

Posted on September 13, 2016

James Ferguson©James Ferguson

Central banks are, as Mohamed El-Erian has written, “the only game in town”. They are certainly the main players of the game of macroeconomic stabilisation. So do they know what they are doing?

One line of attack, popular among libertarians, is that it is arrogant for central banks to attempt macroeconomic stabilisation. They should be either abolished or forced to follow a mechanical rule: the gold standard, for example. The lesson of history seems absolutely clear: a democracy will not accept that money is outside purposeful control. For now and the foreseeable future, we will remain in a world of monetary policy. But, ever since the financial crisis, central banks have done unusual and unpopular things. In unusual circumstances, that was inevitable.

    Unfortunately, the unusual circumstances now appear to be usual. The reasons for — and implications of — this come clearly out of a critique by Lawrence Summers of the speech by Janet Yellen, chair of the Federal Reserve, at this year’s Jackson Hole symposium. As he wrote, “countering the next recession is the major monetary policy challenge facing the Fed”. But, he fears, the Fed is in a disturbingly poor position to do so.

    Much the most important symptoms of the state of the world economy are today’s low real and nominal long-term interest rates. Yet these represent a continuation of trends over 20 years. Both a sustained decline in real interest rates and a fall in inflation expectations lie behind these trends. The latter is, in large part, the result of monetary policy. But monetary policy cannot set the real interest rates over the long run. Indeed, monetary policy actions may not have much impact on these even in the short run. Powerful real factors are at work.

    John Williams of the San Francisco Fed, has recently reported estimates of the natural rate of interest. He describes this as the short-term, inflation-adjusted interest rate that “balances monetary policy so that it is neither accommodative nor contractionary”. By 2015 these estimates had dropped to 1.5 per cent in the UK, near zero for the US and below zero for the eurozone. Note: these are the levels one would expect not in recessions but in normal times.

    The determinants of the secular decline in the real natural (or neutral) rate of interest are forces affecting the supply and demand for funds. These include ageing, slowing productivity growth, falling prices of investment goods, reductions in public investment, rising inequality, the “global savings glut” and shifting preferences for less risky assets. A study by the Bank of England
    has found that such factors could explain most of the 4.5 percentage-point fall in the neutral real rate of interest since the early 1980s.

    G0045_16X 10 yr gov bond yields chart png

    Both the steep decline in estimated natural real interest rates and the analysis of what lies behind it have big implications. The most important is that it is hard to see what would reverse the trends in the near term. We are likely to be living with ultra-low interest rates for an extended period. This means that handling the next recession in the normal way would be quite difficult.

    G0045_16X rates of interest png

    Suppose short-term nominal interest rates were a little above the natural rate on the eve of the next recession. In the US, they might then be 3 per cent. In the eurozone, they might be even lower. But, as Ms Yellen’s speech shows, in all US recessions since the late 1960s, short-term interest rates have fallen by at least 5 percentage points. That would seem to mean a move to highly negative rates. The Fed is sure that the range of instruments it has to hand would work in such circumstances. But, as Mr Summers notes, there is good reason to question whether that would be the case: the efficacy of large-scale asset purchases is debatable (and the side effects on asset markets arguably damaging), while the political and institutional feasibility of strongly negative interest rates is also questionable.

    G0045_16X neutral real interest rate png

    Presumably for such reasons, Mr Williams argues that “countercyclical fiscal policy should be our equivalent of a first responder to recessions”. Indeed, making that possible would seem to be a first order of priority for policymakers. Also relevant are forms of monetary policy that are complementary to fiscal policy or even an alternative to it. “Helicopter money” — direct support of spending — comes at once to mind. It is also possible to raise targets for inflation or target price levels, instead. Above all, one must not assume all is bound to be well. It is necessary to prepare the future tool kit now. It might be needed quite soon.

    Two further points arise. The first concerns what to do now. Above, I assumed that rates will have risen substantially, before the next recession. Yet this is far more likely if the economy is allowed to build up a substantial head of steam. Premature rises in interest rates might trigger a sharper slowdown than people expect and put central banks in the worst possible situation: tackling recession when rates remain extremely low. For this reason, as Fed governor Lael Brainard argues, “the costs to the economy of greater-than-expected strength in demand are likely to be lower than the costs of significant unexpected weakness”. The riskier policy is tightening policy too soon, not too late.

    The second point is that a dominant aim of policy should now be to tackle the causes of the ultra-low natural rates. Matching bigger fiscal deficits with greater public investment would be doubly blessed. This would not only make the job of the monetary authorities easier, but, if done well, would also raise potential economic growth. A widespread view is that public investment must always be wasteful. But this is far too pessimistic. Historically, public investment has often been a catalyst for private investment. Today’s remarkably low real interest rates mean that a big push on public investment has never been more opportune. Central banks must not remain the only game in town.

    martin.wolf@ft.com

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