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- Central banks have been aiming at growth and inflation targets for several years now without hitting them.
- The real issue that investors should be worried about is whether government policy can match the boldness of monetary policy.
- Without bold action on taxation, education, infrastructure, immigration and regulation, the policy actions of central banks will be the equivalent of firing blanks.
The arsenal of central banks is increasingly ineffective
Investors are nervous that central banks, like an arsenal low on ammo, have nearly exhausted their remaining options to stimulate economic growth and combat deflation. Central banks in Japan, Sweden, Switzerland and the eurozone have introduced negative interest rates, proving they do have policy options. My question is, why are we so concerned about this? I am struck by the futility of worrying whether guns have more ammo when the bullets they have been firing are blank. Central banks have been aiming at growth and inflation targets for several years now without hitting them. The scale of their actions and the originality of weapons used have been extraordinary, but the impact anemic. I believe the first rounds of quantitative easing (QE) were important in reducing risk and stabilizing the financial system, thereby creating the opportunity for economic growth. However, while subsequent rounds fired have shown diminishing returns, the benefits, however muted, might still be higher than the risks of doing nothing.
Monetary policy has been and remains critical in reducing risk in the financial system. The “we’ll do whatever it takes” message was critical in mitigating the perception of systemic risks. Once global central banks embraced QE and even more unconventional polices, they were emphasizing three key channels:
1. Asset price channel – low rates force investors into risk assets. The price of risk assets, especially equities, appears to have risen with monetary stimulus, but ultimately needs good economic and earnings growth to sustain.
2. Exchange rate channel – force a lower exchange rate to improve competiveness and inflation. While no one officially admits to a "beggar-thy-neighbor" policy, the decline in the value of the yen and euro and the potential impact on exports and inflationary expectations suggest tacit acceptance of these tangential benefits of QE.
3. Credit creation channel – lending should surge at artificially low rates. However, the need to improve capital and liquidity levels has led to higher lending standards – which have, at least in part, negated the impact of low rates. Perhaps negative rates will finally be enough to shift the balance for banks to want to lend, but consumers and corporations must also have confidence in the future to want to borrow. The charts below show no perceptible benefit of extraordinary monetary policy on corporate expenditures or consumer borrowing.
While accommodative monetary policy is a necessary condition to create economic growth, it is clearly not sufficient. While the chart below isn’t damning, it isn’t encouraging either considering the “bazooka” of easing that has been put in place. Further, U.S. government spending has until recently been a consistent drag on GDP growth. 2016 looks to have a mildly expansionary budget, which is a positive change.
Source: Bureau of Labor Statistics
Is growth faster after QE than before?
The effectiveness of easing is a tremendously difficult question, especially since the counterfactual of not easing at all (would another recession have begun if you didn’t ease?) can’t be tested. But since 2010, most of the developed economies have been on a path of slow GDP growth. Have economies accelerated in the period after additional easing measures were put in place? Not according to the chart below, which plots the change in economic growth 12 months after easing relative to economic growth 12 months before by major central banks (Federal Reserve, European Central Bank, Bank of England, Bank of Japan and Sweden’s Riksbank) since 2008. These economies, by this simple and relatively short account, have settled into a relatively slow growth paradigm that doesn’t seem to be responding less to monetary stimulus.
Government policy must match the boldness of monetary policy
Central banks are increasingly firing well-intentioned policy blanks. While not critical of central banks per se, I am simply observing that their policy actions are increasingly ineffective. The real issue that investors should be worried about is will government policy action begin to match the boldness of monetary policy. Without bold action on taxation, education, infrastructure, immigration and regulation, monetary policy, in isolation, will be the equivalent of firing blanks. Firing more will not impact the target.