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The central bank trap

Just a few months ago, monetary policy was in the process of normalising on both sides of the Atlantic. In the US, the process – already well underway – was set to continue with an expected rate hike trajectory leading to neutral interest rates or even beyond, while the Fed’s balance sheet was set to be gradually downsized. The European Central Bank (ECB), at a less advanced stage of the process, had just terminated its asset purchase programme and stabilised the size of its balance sheet, and was hinting at an initial rate hike as early as the second half of 2019.

This forecast end to easy money reflected an economic cycle close to its peak – which, incidentally, highlighted just how far behind the curve central banks had fallen in normalising their policy since the end of the crisis.

 

The global economic slowdown, against a backdrop of escalating US/China trade tensions and last autumn’s financial turbulence, got the better of central banks’ determination, with the latter once again terrified at the prospect of withdrawing the life support that had been shoring up the debt- and growth-fuelled edifice. Indeed, the abortive normalisation cycle opened up the way for a fresh cycle of monetary easing. The Fed has cut rates twice since summer and says it is ready to take out additional insurance against the risk of a recession.

Meanwhile, the ECB has had to marshal every unconventional monetary tool at its disposal to further soften its policy, including lowering its deposit facility rate (already in negative territory) and introducing a tiered system, resuming its asset purchase (QE) programme, improving the terms of its TLTRO programme and bolstering its forward guidance.

 

Central banks are stepping on the gas even though they have zero ability to influence the political uncertainties that are poisoning the normal running of the cycle, thus casting doubt on the effectiveness of their actions. In fact, central banks have developed an extreme aversion to any kind of slowdown that might disrupt markets in a context of increasing and persistent financial weakness that they themselves are helping fuel.

Meanwhile, markets, on life support from ultra-accommodative monetary policy, continue to ask for more, with instability and the threat of a correction as another – even modest – tightening in monetary conditions approaches, in the end acting as an inhibitor.

 

Such market influence over monetary policy is toxic. The fact that the financial system has been on life support since the crisis has created a kind of addiction that is difficult to break. The sooner central banks gain the upper hand over markets, the less markets will have the upper hand over the economy. At each climb-down, newly becalmed markets inclined towards excess resume their search for returns, artificially inflating asset prices and excessively squeezing risk premiums pending an inevitable correction that cannot help but inflict collateral damage on the economy.

 

Accused of lax monetary policy, central banks are hiding being their nominal anchoring mandate – sometimes exclusive, notably as regards the ECB – at a time when fading inflationary pressure is a challenge for them. It’s hard for them to update their software when the transmission belt – from economic activity to wages and prices – is broken, with inflation very moderate, even with the cycle extended and unemployment at rock bottom. It’s hard for them to recognise that their high-dosage injections of liquidity have not succeeded in letting out the inflationary genie, thus defeating the monetary dogma according to which inflation is nothing more than a purely monetary phenomenon.

 

The problem is that, once inflation leaves the realm of the real economy, monetary principles of inflation targeting – based solely on expected movements in the prices of goods and services – result in monetary policy being excessively accommodative for too long, enabling debt to balloon and fuelling financial inflation, at the risk of reviving its opposite number, deflation. A world overloaded with debt is subject to deflationary pressures, with the risk that the purge of financial excesses might sooner or later trigger a vicious circle where declining asset prices, confidence, economic activity and prices feed all off each other. What makes the paradox even more striking is crisis-mode monetary hyper-activism, with unparallelled drastic actions aimed precisely at warding off the deflationary threat…

Finding ourselves, ten years down the line, in a situation where a serious global build-up of liabilities, secured on overvalued asset prices, makes the financial edifice extremely vulnerable to changing expectations, should stop us in our tracks and prompt us to see what lessons might be learned.

 

Monetary policy is not all-powerful. While it’s very tempting to demand ever more intervention, ever more liquidity at ever lower (or even negative) rates, the remedy prescribed by central banks is no longer working – not to mention its undesirable side-effects on banks and insurers.

Moreover, powerful disinflationary effects resulting from technical progress in a globalised world, where competition is taken to extremes, and new forms of more flexible and less stable employment are making the inflation target – central banks’ guiding light – unachievable. Debt, fuelled by low interest rates, cannot serve as a stopgap forever, with new lending – and the monetary creation that comes with it – struggling to find its way into the real economy, mostly mopped up by rising asset prices (notably in real estate) at the risk of fuelling further bubbles, raising the urgent question of a rebalancing act of the central banks’ first mandate between monetary stability and financial stability.

Lastly, the redistributive effects of these ultra-accommodative policies favour not only borrowers but also high-net-worth individuals invested in the stock market or real estate, while small investors, who place a premium on liquidity and security, suffer a slow death, thus widening inequalities in societies seeking greater social justice – an issue that barely makes it onto the agenda of central banks.

 

Isabelle Job-Bazille, Directrice des Etudes Economiques Groupe

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