This article was first published in the Financial Times on 17 September 2019
Market pessimism is here to stay. Whether over global economic health or the power of central banks to improve it, the gloom is understandable.
About a third of government bonds globally and just over half of those in Europe are yielding negative rates. Looking at the shape of government bond yield curves, you would think we were in a recession – and a deep and prolonged one at that.
Some central bankers in the US and eurozone question the consensus view that they need to do more, urging caution instead. Regional presidents in the US Federal Reserve system have voiced their reluctance to cut rates further. Likewise, some influential members of the European Central Bank have expressed reservations on the urgency of resuming the quantitative easing programme.
Things are not as bad as markets suggest, one argument goes, and it is worth keeping some ammunition dry. After all, labour markets are generally tight and household confidence resilient. And there are no big imbalances with the potential to trigger a significant correction.
However, there is more to market pricing than just pessimism about the short-term economic outlook. There is outright doubt among market participants that central banks and the broader policy framework have what it takes to respond to shocks.
Two key problems lie at the core of investors’ concern.
First, a scarcity of policy instruments. When the next recession comes – a matter of time after 10 years of economic recovery, if history is any guide – central banks in a low-interest rate world might not have the tools to fix to it.
Central banks’ failure to meet their inflation targets supports this point. The lack of inflation might be due to unusually long lags, cyclical factors or more structural issues. Much of it can be attributed to price expectations – which tend to reflect experience – trending lower, an unusual occurrence at this advanced stage of the economic cycle.
Whatever the reason, inflation remains stubbornly low. That is despite unprecedented monetary policy stimulus, including sizeable QE programmes and exceptionally low or even negative interest rates. It is the case even in economies that are operating close to full potential, such as the US.
Persistently low inflation leaves central banks with scope for additional easing, and we believe they will use it, despite some policymakers’ reluctance.
But if that easing has not worked so far, why should it work now? In a typical recession, the Fed cuts rates by about five percentage points. In the last cycle, it resorted to unconventional monetary policy, but it does not seem to have had the hoped-for result.
In many economies, growth is being hobbled by structural factors or uncertainty, not by credit supply constraints. Policymakers might find their emergency response channels stymied, as neither low interest rates nor expectations are easily moved when a large portion of the G10 nations’ government bond market attracts a negative yield.
Combine some policymakers’ doubts about the need for action with doubts about the potential impact of such action and it’s questionable whether central bankers have what it takes to jolt the economy out of its lethargy.
Second, and more fundamentally, there is a scarcity of ideas. Conventional macroeconomic models have not kept up with reality. Central bankers’ caution about further monetary easing is built on economic models that failed to predict and understand the global financial crisis and are failing to explain why inflation remains subdued after a decade of uninterrupted growth.
The challenges to mainstream economics posed by the Depression of the 1930s and the inflationary shocks of the 1970s sparked intellectual revolutions. The former gave birth to Keynesian interventionism. The latter bolstered the monetarist theories that came to form the basis of the current framework of central bank independence and inflation targeting.
Today’s challenge is on a similar scale. What is needed is humility and ambition. Humility in acknowledging the shortcomings of the current intellectual framework and ambition in putting aside the caution about action and using all available means to mount an aggressive policy response.
While we wait for the new academic underpinnings to emerge, the answer to the global economy’s quandary lies in bold, co-ordinated monetary policy in concert with fiscal measures, adding up to something close to debt monetisation. That is where governments issue debt to finance spending and the central bank purchases the debt on secondary markets, thereby increasing the money supply.
This may not work, either, but the worst-case outcome would be too much inflation, and inflation is an enemy we know and, crucially, know how to fight with the trusty, traditional arsenal.
The sort of policy response that might lead to a normalisation of the rate environment requires political will and time. Meanwhile, we expect markets to remain sceptical and yields downcast.
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