Will US monetary policy be normal, "abnormal" or modern?
Ten and a half years have gone by since November 2008, when the Fed announced the first phase of quantitative easing (QE), its unconventional policy of purchasing sovereign and para-sovereign debt and mortgage-backed securities. Which means ten and half years have also gone by since the Fed cut its base rate to 0.25%. We have since seen three successive waves of QE (QE1, QE2 in 2010 and QE3 in 2012) and a maturity extension programme (Operation Twist). The Fed’s balance sheet peaked at $4,500 billion at end 2014 before stabilising for three years, during which time the central bank began to hike interest rates, which now stand at 2.5%.
Towards a normal policy
Moves to exit this unconventional policy – i.e. to normalise monetary policy – were triggered by above-potential economic growth as far back as 2013, leading to a gradual reduction in the negative output gap that had built up during the crisis. The unemployment rate fell below its natural rate from mid-2017, and excess capacity had disappeared by 2018. And yet, not everything was running in accordance with the Fed’s timetable: while it had achieved its unemployment target, the same could not quite be said for its inflation target. Having met its 2% target as early as end 2015, inflation had once again fallen in 2017, remaining below target until the beginning of 2018. While annual inflation has now returned to 2.1%, this is still an astonishingly low level given such a low unemployment rate. Since end 2018, the Fed has been saying it will be patient as long as no solid argument in favour of a rate hike or rate cut prevails. Furthermore, the US central bank has clearly said it will use its balance sheet (size, composition and maturity) as a monetary policy tool to complement its primary tool, the intervention rate.
There are questions, then, over the Fed’s ability to bring inflation back to its target level… but that’s not all. Firstly, the Fed has observed that the relationship between activity and inflation has weakened, lessening the potential impact of monetary policy on inflation via aggregate demand.
However, there are broader questions over the Fed’s monetary policy strategy: since the crisis, the environment in which the central bank operates has changed significantly, posing major challenges to that strategy. The Fed’s base rate is determined on the basis of a reaction function that adjusts that rate above or below the equilibrium interest rate depending on the gap between actual and target inflation and between actual and natural (or long-term) unemployment. The equilibrium interest rate is simply the rate at which, in the absence of inflationary pressures and excess production capacity, supply and demand are in balance. This concept, while easy to define, cannot be observed. However, estimates – albeit with a considerable margin of error – put it at between 3% and 4% in the United States in the 1970s. While these estimates do not agree on the level of the equilibrium interest rate, they are more categorical and unanimous when it comes to changes in it. The rate has been declining since the 1980s. It is currently thought to be around 0.5% in the United States.
A number of factors explain this decline. First off, the ageing population is thought to account for around one third of the decline: a smaller working population, lower potential growth, less demand for capital, slowing productivity, and agents with a longer expected lifespan and more savings. With the ageing process still only in its early stages, this factor will put further downward pressure on the equilibrium interest rate over the coming decades. Other factors are thought to be in play, notably an increase in the share of profits and income inequalities in favour of agents with a higher propensity to save, leading to a growing imbalance between savings and investment. This is coupled with greater risk aversion, with yields on liquid and low-risk assets declining. These factors – which some consider more temporary and others more permanent – are not influenced by monetary policy, so other policy levers (structural or fiscal reform) must be actioned to influence their direction.
However, this decline in the equilibrium interest rate has a profound effect on monetary policy. At mid-cycle, setting the base rate at the same level as a low equilibrium interest rate would increase the probability of ending up with negative interest rates during a recession, or, if zero is considered the floor rate (zero effective lower bound), would lead to the central bank having to expand its balance sheet, failing which it would have limited monetary policy room for manoeuvre.
A major brainstorming exercise
Based on these considerations, the Fed has kicked off a process of revising its monetary policy strategy, tools and communications. This week, a major conference is bringing together academics, stakeholders from the economic world and various operators to lay the foundations of this revision. The conclusions will be made public in June 2020.
To respond to these challenges, four approaches have been tabled:
- more unconventional monetary policy (provided it is effective and compatible with financial stability objectives)
- a change in the inflation target, which would require a change in interpretation of the Federal Reserve Act and the scrutiny of Congress (difficult to implement in practice)
- a non-standard inflation targeting regime under which temporarily overshooting the target would be not only tolerated but clearly targeted; this indirect approach would influence inflation expectations which, being adaptive, require higher effective inflation, which means the Fed would need to leave interest rates lower than its current reaction function suggests for a given level of activity and inflation
- Japanese-style yield targeting, with the inflation target replaced by short and long target rates, influenced by the central bank via open market operations on sovereign debt
A “modern” political debate
Another monetary policy issue is stirring up debate in the United States. This more political debate, kicked off by the 2020 election campaign, brings into conflict not only the Democrat and Republican camps but also eminent economists and Nobel prizewinners. The debate is over “modern” monetary policy – the idea of taking advantage of the low interest rate environment to increase federal government borrowing, supported by a securities purchasing policy that maintains keeps interest rates low by increasing the money supply. Some see this as an attack on the Fed’s independence; others see it as sound economic sense at a time of low inflation and excess capacity. At this stage, it’s hard to predict who will win this debate. To casually dismiss any success of the proposal, won by the Democrats – who are in favour of such a policy – would be to ignore the potential risk of re-appropriation by a Trump administration keen to extend the current economic cycle, if necessary through artificial means.
What’s the benefit this side of the Atlantic?
These debates will be closely followed within our euro jurisdiction. The European Central Bank is faced with the same issues, albeit perhaps even more acute, with growth and inflation both weaker and normalisation not yet underway. Estimates of the eurozone’s current equilibrium interest rate put it at 0% or even in negative territory, compared with 2.5% in the 1970s. Some members of the Governing Council (notably Olli Rehn, Governor of the Bank of Finland and a credible candidate to succeed Mario Draghi) have already called for thought to be given to revising the ECB’s strategy and tools. Movements wanting the ECB to adopt a more interventionist stance have also won seats in the new European Parliament. While attacks on its independence, which is foundational to the very existence of the single currency, will have less chance of succeeding, they will be no less dangerous for that.
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