Global central banks, such as the US federal Reserve (the Fed), did most of the heavy lifting in the aftermath of the global financial crisis. But with markets signalling that an another downturn may be in the offing, the question being asked is if they have anything left in their tool-kit to avert another financial crisis. In order to answer this question, most of our focus will be on the Fed, though we also make reference to some of other major central banks as well.
1 An ageing economic cycle causes markets to agitate for rate cuts…
Given its status as the world’s largest economy, economic developments in the US can hardly be confined to the domestic domain. Indeed, the the economic cycle in the US tends to lead cycles in other countries as well as the global economy. That said, most economic data out recently suggest that an imminent recession is unlikely, However, some financial market indicators (in particular, the US yield curve) and the ageing nature of the current economic cycle – which at 121 months has become the longest on record (See Table 1) – would appear to suggest otherwise.
Against this backdrop, the past couple of months have seen a significant shift in interest rate expectations. Markets are now pricing in 75 basis points of rate cuts in the US by the end of 2019 compared with almost no move expected at the beginning of May. The change in expectations has been driven by concerns over global growth and trade tensions between the US and China. At the US Fed’s June rate setting meeting seven of the committee indicated that they saw a rate cut by the end of 2010. The median dot plot has a cut in rates in 2020, but the dots remain well above market expectations (see Chart 1). Meanwhile, bond yields have tumbled with 10-year US Treasury yields hovering around 2%, with much of the recent movement being driven by lower inflation expectations (see Chart 2).
These moves have not just been confined to the US, with yields falling sharply across developed sovereign bond markets. Recent comments from European Central Bank president, Mario Draghi, have added to this downward bias in bond yields. Indeed, following the dovish rhetoric from Draghi as well as other major central banks, the market value of bonds at the global level trading at negative yields topped US$13tn, beating the last peak in 2016.
2…But central banks policy options are at best limited…
With rates already at the “lower bound” across most major markets, this section will be devoted to the policy options that may potentially be open to their central banks.
- Cutting rates further
A long and shallow recovery from the 2007-09 financial crisis has meant that interest rates still stand at record lows for many developed markets (see Chart 3). From here, central banks have limited room to cut rates. The exception is the US, where the Fed has conducted a hiking cycle that has taken the policy rate from a low point of 0-0.25% to the current level of 2.25-2.5%. While this gives the Fed a better starting point from which to start cutting rates than its peers in other major developed markets, it’s much lower than that seen during previous hiking cycles. Indeed, the US policy rate stood at over 5% in the run-up to the last rate cutting cycle which commenced in 2007.The other point to note here is that to the detriment of bank profitability, some central banks, including the European Central Bank ECB and Bank of Japan (BoJ) have adopted negative interest rates, whereby they charge commercial banks to keep deposits at the central bank. For these economies in particular there is less scope to cut rates.
- Restarting QE
Another option open to central banks is to restart quantitative easing (QE). Large scale purchases of government bonds lowers bond yields as well as boosting the price of financial assets, generating positive wealth effects. QE can also impact interest rate expectations through the signaling effect of easier monetary policy. At their peak, the Fed and ECB balance sheets were 25% of GDP and 40% of GDP respectively. The experience of the BoJ and Swiss National Bank (SNB) show that central bank balance sheets can rise a lot further, exceeding 100% of GDP.However, some central banks are beginning run out of government bonds to buy. For example, the ECB has public debt ownership limit of 33% of the market, making Bund scarcity in particular an issue. Of course, this limit is self-imposed and can be changed. Even then, with bond yields already low, the impact of more QE may be limited.Central banks could also expand the scope of QE. The Fed limited QE to government bonds and mortgage backed securities. The ECB also bought corporate bonds and securities, while BoJ is also buying equities and real estate (see Chart 4).The Fed is currently barred by law from buying corporate assets. However, the idea of buying credit and equities has been raised by the central bank, as these assets have a more direct link to spending by the corporate sector. Meanwhile, it’s legal for the ECB to buy equities. However, as highlighted by the experience of BoJ, buying these assets raises governance concerns, especially around exercising shareholder voting rights.
- More forward guidance
After the introduction of QE, forward guidance – the signaling of future policy intentions – helped central banks to steer interest rate expectations without changing the level of interest rates. Such an approach can continue to be used by central banks, but also has its limitations. Future rates have a lower bound and central banks can tie their hands by committing to future policy. Meanwhile, guidance with no follow-through, particularly surrounding higher rates can reduce credibility. A case in point is the Bank of England whose Governor, Mark Carney, was characterised as an “unreliable boyfriend” thanks to his changing stance on rate rises. - Introducing yield curve control
Yield control was introduced by the BoJ in 2016 as modification to QE. By altering government bond purchases, the 10-year government bond yield is targeted at 0%, allowing central bank to shape the yield curve. This has allowed the BoJ to make fewer purchases of Japanese government bonds (JGBs) but keep yields low, making QE more sustainable. If implemented more widely, yield curve control would likely reduce interest rate and exchange rate volatility (see Charts 5 & 6).Members of the Fed have expressed an interest in yield targeting. The Fed actually adopted yield curve control in 1942 to help the Treasury finance World War II, implicitly capping the long-term government bond yield at 2.5%
3…So, what next?
Central bankers, most notably the ECB’s Mario Draghi, have been at pains to point out that there is only so much monetary policy can achieve in isolation. Fiscal policy, also needs to shoulder some the responsibility. Beyond this, there’s a growing recognition that, if all else fails, a policy of “helicopter money” – whereby a central bank prints money and distributes it directly – may also have to be considered.
- Fiscal policy
Ultimately, limited monetary ammunition means that the baton should be passed to fiscal policy in the next downturn. But which countries have the room spend? The IMF found that despite elevated debt levels most advanced countries have at least some “fiscal space” – room to use fiscal policy without endangering market access and debt sustainability. In the developed markets, Italy and to lesser extent Spain were found to have the least fiscal space due to concerns surrounding debt sustainability, despite reasonable access to financing. - Helicopter money
This is similar to the concept of “debt monetization”, where central banks finance the government directly. Requiring monetary and fiscal coordination, it’s currently illegal for most central banks. As well as raising inflationary concerns, helicopter money introduces a serious threat to fiscal discipline and, in turn, central bank independence. In the 1930s, Finance Minister Takahashi rescued Japan from the Great Depression using a money-financed fiscal programme but was later assassinated when he sought to rein in the deficit.
4. Taking stock/concluding thoughts
The aftermath of the financial crisis has shown that central banks have become more willing to “think outside the box”. As such, they’ve exhibited greater creatively about monetary policy, no longer confining themselves to interest rates. Various tools remain available but come with limitations. The Fed and Bank of England can cut interest rates and restart QE. The ECB has limited scope to cut rates, but can still do so. The ECB can also restart QE, which would likely require raising the holding limits of government bonds. Longer term, QE could then be expanded to include more assets. The BoJ is clearly the most limited in terms of options, but could still cut rates. This could be accompanied by some sort of macro-prudential policy, given the detrimental impact to the banking sector. Forward guidance can still be used across all central banks.
Ultimately, those who can coordinate a monetary and fiscal policy response should fare better in the next downturn. Given the political constraints and lower fiscal space, this could be particularly challenging for the Eurozone.
Source from: MERatings