Cen­tral banks can’t do much more

The Pak Banker - - OPINION - Clive Crook

ON Fri­day, the Bank of Ja­pan stunned fi­nan­cial ob­servers by an­nounc­ing a new neg­a­tive in­ter­est rate. Gov­er­nor Haruhiko Kuroda got the re­sult he in­tended: The stock mar­ket ral­lied and the yen de­pre­ci­ated, mak­ing ex­ports more com­pet­i­tive and giv­ing the econ­omy a boost.

The di­rect ef­fect of the change in pol­icy will be slight. The cen­tral bank set an in­ter­est rate of mi­nus 0.1 per­cent on ad­di­tional re­serves -- a small cut ap­plied to a nar­row cat­e­gory. But the move to less than zero has sym­bolic weight and no­body had ex­pected it, so the ef­fect on in­vestors was pow­er­ful. The Euro­pean Cen­tral Bank is in a sim­i­lar bind: strug­gling to per­suade mar­kets that it can push in­fla­tion back up to tar­get, with in­ter­est rates about as low as they can go and a huge bond­buy­ing pro­gram al­ready in place. Af­ter the bank's most re­cent pol­icy meet­ing, Pres­i­dent Mario Draghi an­nounced no change in pol­icy, but stressed he still had op­tions for pro­vid­ing fur­ther stim­u­lus and was ready and will­ing to use them. That worked too. In­vestors were sur­prised. The euro moved down.

A cur­rent para­dox of mon­e­tary pol­icy is that cen­tral bankers are try­ing to sta­bi­lize ex­pec­ta­tions of in­fla­tion by dis­pens­ing pe­ri­odic sur­prises: Sta­bil­ity through in­sta­bil­ity. When­ever in­vestors be­gin to ques­tion the au­thor­i­ties' will or means to push de­mand and Kuroda had said neg­a­tive ratesweren't in his plans. Weak fig­ures for house­hold spend­ing and in­dus­trial pro­duc­tion maybe jus­ti­fied a re­think. In any event, if you're look­ing to sur­prise peo­ple, con­tra­dict­ing your­self in the space of a week is a good ap­proach. The Bank of Ja­pan's vote in fa­vor of the change was close, as well, at 5 to 4. That added to the sense that some­thing dra­matic had hap­pened.

The prob­lem is that th­ese mostly rhetor­i­cal sur­prises are, so to speak, a de­pre­ci­at­ing cur­rency. It's the­ater that works well for a while, but then you need ac­tions to make it be­liev­able. That's get­ting harder. The next pol­icy an­nounce­ments from the Ja­panese and Euro­pean cen­tral banks are es­pe­cially keenly awaited. Mar­kets will be ask­ing, "So what have you got?" Mak­ing in­ter­est rates a bit more neg­a­tive is one pos­si­bil­ity. It turns out that the zero lower bound is a mis­nomer: As Den­mark, Swe­den, Switzer­land and the euro area had al­ready shown, the floor for nom­i­nal pol­icy rates is a bit less than zero. But cen­tral banks can't move very far into neg­a­tive ter­ri­tory with­out en­coun­ter­ing se­ri­ous fi­nan­cial and political ob­sta­cles.

To sus­tain sig­nif­i­cantly neg­a­tive rates, pa­per money would have to be­de­throned as the fun­da­men­tal mon­e­tary stan­dard. An­other ad­just­ment might seem even stranger. The idea that bor­row­ers pay savers is pretty well en­trenched; with sig­nif­i­cantly neg­a­tive rates, savers pay bor­row­ers. (Try ex­plain­ing that on the stump.) The eco­nom­ics is cor­rect. It could be done, and a lot of smart econ­o­mists think it should be done -- but it wouldn't be easy, least of all for a cen­tral bank act­ing on its own ini­tia­tive. The al­ter­na­tive is to fur­ther ex­pand the two banks' bond-buy­ing pro­grams. But they're al­ready huge, their ef­fec­tive­ness is be­gin­ning to be ques­tioned, and the con­se­quences for fi­nan­cial sta­bil­ity give grounds for con­cern. Again, at best, it's a case of di­min­ish­ing re­turns. How much big­ger would th­ese quan­ti­ta­tive-eas­ing pro­grams need to be to pro­vide the next sup­pos­edly sta­bi­liz­ing jolt?

If de­mand and in­fla­tion fail to get back on track in Ja­pan and Europe -- and if thedis­ap­point­ing fourth-quar­ter fig­ures for U.S. gross do­mes­tic prod­uct are a sign that Amer­ica's re­cov­ery is fail­ing too -- mon­e­tary pol­icy won't be enough. The shock that's re­quired is hy­brid macroe­co­nomic pol­icy, mean­ing an ap­proach that ex­plic­itly com­bines fis­cal ex­pan­sion with mon­e­tary ac­com­mo­da­tion. The idea is for gov­ern­ments to run big­ger bud­get deficits -- with tax cuts and/or higher pub­lic spend­ing -- then fi­nance them not with bor­row­ing but with newly cre­ated money. The most eye-catch­ing variant is di­rect cash pay­ments by cen­tral banks to house­holds, or so­called he­li­copter money.

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