Has monetary policy reached its limit?

By David Katsnelson, Director, Macroeconomics, RISI

Since the global financial crisis in 2007, central banks around the world have taken some extraordinary measures to first rescue banking systems and economies from collapse, and later to support growth. Over that time period, global central banks have cut policy rates 667 times and instituted many unconventional policies, including quantitative easing (QE) and negative interest rates.

The recent meetings of the key central banks of the world—The US Federal Reserve, the European Central Bank (ECB), the Bank of Japan (BoJ) and the Bank of England (BoE)—yielded two cases of “hurry up and wait,” and two additional attempts at unconventional monetary policy. The Federal Reserve decided to once again hold off on a 25 basis point rate increase, although both the central bank and the markets are indicating that the hike will happen in December. The ECB also held off, not on raising rates but on additional easing, and hinted that there may be additional policy moves if inflation does not start moving higher. Meanwhile, the BoJ and the BoE moved further into monetary accommodation: the BoJ by changing its program to directly target 10-year bond yields, and the BoE by lowering interest rates in August and continuing quantitative easing.

However, it seems that we are now reaching the point where further unconventional measures are not having the desired effects and may in fact be detrimental. Quantitative easing—the purchase of bonds by central banks—has been successful in lowering longer-term bond yields around the world. In fact, at this point, close to $10 trillion of debt now carries a negative yield, meaning investors have to pay for the privilege of lending money to those borrowers. QE, however, has not been able to do the other things it was supposed to—increase inflation and promote better growth. Not being able to affect the desired outcomes through QE, central bankers have moved on to the next experiment—negative interest rates.

Sweden's central bank was the first to implement negative interest rates in 2009, the Danish central bank followed in 2012, the ECB in 2014, the Swiss in 2015 and the BoJ in early 2016. The goal of negative rates was to disincentivize saving by individuals and increased lending by banks that would lead to higher rates of consumption and an increase in the inflation rate. The results have been very mixed so far, with inflation remaining much below target and growth still agonizingly slow. This is not a great surprise. Negative interest rates are effectively a tax on banks reserves. As with any tax, the question is one of tax incidence, that is who actually pays the tax.

Banks really have three choices as to how to deal with this tax. They could not pass along the tax to their customers, in which case their profits will be lower, depressing their share price and weakening their balance sheet and potentially reducing their lending. They could pass the tax on to depositors by paying less interest or charging depositors to hold their money, thereby reducing the income they could spend on other goods and services. Or finally banks could pass it on to borrowers in the form of higher interest rates. None of these outcomes seems stimulative, as is almost always the case with taxes. Additionally, recent research has shown that the household savings rate in Europe increased, as retirement incomes becomes more uncertain, meaning that negative rates are having the opposite effect of what they were meant to achieve.

So has monetary policy reached the limits of its effectiveness? It seems the answer to that is “yes.” Each new experiment has produced diminishing results and outside of “helicopter money,” where central banks would directly inject cash into the accounts of individuals to promote spending and stimulate growth, it does not seem like they have much ammunition left. Given that it is likely that we will face another economic downturn in the next few years, the ineffectiveness of additional monetary policy actions would be highly problematic.

But until the inevitable downturn, it seems that one of the policies that is necessary to push growth higher would be an effective fiscal stimulus program. Both candidates for US President have promised increased spending, but it will be politically difficult to increase spending as much as either of them proposes, especially if the election once again produces a divided government. Additionally, a poorly designed fiscal stimulus program could do more harm than good, increasing debt without having a major effect on growth. A stimulus needs to be timely, targeted and temporary to have a desired effect, and given the current political environment, it is unlikely to happen in the USA.

David Katsnelson, Director, Macroeconomics, author of the Monthly Economic Commentary, works out of RISI's Bedford, Massachusetts, office and can be reached by email at dkatsnelson@risi.com.

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