This article serves to justify two points. First, central banks have largely exhausted their capacity to further stimulate the global economy using the current set of tools. And second, while they’re probably reluctant to use them, there are other levers available to be pulled should a new major crisis present itself.
The central banks of the world currently use interest rates and asset purchases as their primary policy tools. Interest rates are at extremely low levels in virtually all cases and, given the economic climate, are likely to remain low for the foreseeable future. There is an implicit lower bound to where this can go before banks are unable to transmit further reductions as depositors are unlikely to accept lower than 0% interest rates from their banks – the point at which hoarding physical cash becomes attractive. The bank does seem to survive a little below zero but cannot extend much further as one only needs to look at the share prices of European and Japanese banks to see that the pain is already fairly extreme for bank profits. In short, it’s difficult to envision a significant downward move in this regard.
Looking at the central banks’ asset purchases, one would not expect the world to be battling against deflation! With the benefit of hindsight we can say there has indeed been inflation, but it has largely been concentrated on prices that do not form part of the typical inflation basket, namely asset prices. In my opinion this is because money is not entering through channels exhibiting high marginal propensities to spend; rather it enters through channels that save the money, inflating all asset prices as investors move further along the risk scale in search of acceptable returns. So while central banks’ asset purchase policies have undoubtedly calmed financial markets, their impact on increasing inflation has been more muted. Given the large-scale execution of these programmes, the limited effect they’ve had on inflation and the current price of the eligible assets, it seems unlikely that this policy has much room to expand.
As such, I believe central banks have their backs against the wall and are unable to meaningfully loosen monetary policy with the current set of tools at their disposal. Also, as discussed in a previous blog piece, puts them in an awkward position in terms of tightening policy should the global economy start to exhibit stronger signs of health, as starting to normalise interest rates too early could derail the global economic recovery and leave them with little space to backtrack. From this point of view it’s logical that central banks will tread on the side of caution and wait for definitive confirmation that monetary tightening is necessary. In the fight against deflation, I believe policy will not move decisively tighter without enduring signs that inflation is back.
Lastly, it’s important for investors to bear in mind that there are other tools available to policy-makers should they wish to use them. While I consider these highly unlikely possibilities, examples would be lower reserve requirements or even printing money for governments or the public to spend. Central bankers are generally reactionary, and despite the apparent exhaustion of their current options, I believe that if circumstances deteriorate dramatically, they will make it up as they go along and find solutions to the problems of the day.