NNIP: What more can central banks do?
- Now more than ever, central banks must act pre-emptively to retain control over expectations
- With further challenges looming, the Fed looks capable of sustaining the economic expansion with bold action
- The BoJ and ECB are at risk of falling into a liquidity trap where monetary policy becomes ineffective
The European Central Bank signaled last week that it is ready to ease policy in response to worsening growth and below-target inflation in the Eurozone. The US Federal Reserve, meanwhile, looks poised to cut borrowing costs for the first time in more than a decade tomorrow as insurance against a potential economic downturn. Economist Willem Verhagen assesses how much control central banks can maintain over inflation expectations and whether they can revive a stagnating global economy.
The task of sustaining the economic expansion has rested firmly on the shoulders of central banks for the past 30 years, but this job has clearly become much harder than it was prior to 2008. Equilibrium safe government bond yields are now much lower, while there is also a risk that inflation expectations will drift downwards.
Since the great financial crisis, central banks have had to act pre-emptively to combat downside risks so as to retain control over expectations for future policy and inflation. So far the Fed has played this game well, while political developments have somewhat constrained the ECB. But with low interest rates making monetary policy measures less effective, the Fed and its counterparts will find it more and more challenging to mitigate the damage to financial conditions caused by trade disputes, political uncertainties and declining business confidence.
Forward guidance – the Fed’s panacea
The key issue is that monetary policy-makers are in the business of managing expectations. These pertain mainly to the direction monetary policy will take and the future path of inflation. Until 2008, central banks seemed to do this job very well. By clearly communicating their strategy, they maintained considerable control over the nominal yield curve. What’s more, from the mid-1990s onwards they also successfully anchored inflation expectations to their targets. However, after 2008 life became more complicated as the policy rate fell to zero.
The big question then became whether or not central banks could still successfully manage expectations. If actual inflation remains persistently below target, at some point expectations will start to slip too. Also, when the policy rate can no longer be used to influence future monetary policy expectations, the central bank will need to find other ways to manage the safe Treasury yield curve.
In order to maintain some degree of control, central banks started to provide forward guidance on the policy rate, with a larger degree of commitment than before 2008. They also used quantitative easing (QE) to lower and flatten the yield curve by directly suppressing the term premium and enhancing the message implicit in forward guidance. This guidance often incorporated a promise not to start raising the policy rate until sometime after the end of QE.
Credibility is easy to lose, hard to regain
The Fed’s experience shows that this approach can succeed, but the ECB and BoJ have been unable to follow in the Fed’s footsteps, partly because of differing trajectories for private-sector expectations. So far the Fed has managed these expectations effectively by being very pre-emptive. The US central bank has consistently attempted to aggressively push nominal yields below their equilibrium level in the face of rising downside risks; as a result, it has retained a reasonable degree of inflation credibility.
At the other end of the spectrum, the BoJ lost the battle for expectations in the early 2000s by signaling that it believed monetary policy was powerless to cure deflation. Since then, the Kuroda BoJ has been trying to regain its credibility. The big lesson to take from the Japanese experience is that once you lose control over expectations as a central bank, it is extremely difficult to get it back.
Meanwhile, the ECB is somewhere in between: it clearly has less control over expectations than the Fed, but the economy has not yet slid into deflation. This is because the ECB is willing to act pre-emptively but is unable to do so due to political constraints. The ECB can only take action and attempt to get ahead of the risk curve when the pain is deemed to have become unbearable.
The possibility of central banks losing control over expectations suggests that monetary policy may become ineffective in certain regions. If this occurs, the economy will fall into a liquidity trap that weakens the effectiveness of monetary policy in two ways. First, if there is limited room for the safe Treasury yield curve to move lower or flatten out, the central bank loses its ability to further ease financial conditions. Second, even if there is still room to manipulate the yield curve, the private sector already has doubts that such a step can materially affect nominal growth.
Animal spirits could give rise to a vicious cycle
So nominal growth in general and private investment in particular may have become less susceptible to easing financial conditions. In the 1930s, Keynes argued that investment is primarily driven by animal spirits, which can be extremely fickle and are easily influenced by fads and fashions. This is because agents operate in an environment of fundamental uncertainty in which it is extremely difficult to formulate predictions for the future. If businesses are pessimistic, they will not invest and thus push the economy towards a worse equilibrium, even if their pessimism is unfounded.
This notion of animal spirits could well be relevant right now. Back in 2017, an easing of financial conditions coincided with a surge in business confidence, producing a strong capex acceleration. This year we see an easing of financial conditions but a continued decline in business confidence on the back of ongoing trade worries, which have together produced a slump in investment spending.
Fortune favours the bold
Effectively managing expectations is thus crucial, and in this respect fortune certainly favours the bold. The Fed’s control over expectations is still sufficiently strong to believe that the bank can keep the economy on a reasonably robust nominal growth path. Still, the extent of this control is less than it once was, and the risks lean towards the Fed gradually losing more control if DM secular stagnation forces pick up momentum.
In contrast, the BoJ and probably also the ECB seem closer to a liquidity trap where private expectations have slid/are sliding towards a low nominal growth equilibrium. With these central banks having lost some of their control over expectations, there is no guarantee that they can single-handedly regain it. A helping hand in the form of fiscal policy assistance to push up equilibrium yields in these economies would, therefore, be very welcome.