Lower, for longer, and nearly forever

With tapering in Europe and normalisation in the US, could 2018 herald the return to monetary policy fundamentals? Standish chief economist Vincent Reinhart thinks not.

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In the first part of this century, there was a flurry of research on the conduct of unconventional monetary policy. This explored the economic consequences of a zero or negative policy interest rate, yield guidance, asset purchases, and the outright imposition of a ceiling on the term structure.1 In the event, there were two attributes to this work. First, almost all of it was put into practice within a decade. Second, none of it will be ended by the policy makers who started it.

INV01039 003 Reinhart On Normalisation Graph 1

The Federal Reserve is furthest along, having raised the federal funds rate one percentage point from its zero floor and announced plans to trim its US$4.5 trillion balance sheet. The nominal federal funds rate is still about two percentage points below the median assessment of its long-run value by the Fed governors and bank presidents, as reported in the Summary of Economic Projections. In that assessment, none of them believe that they will get there by the end of 2018. As for the balance sheet, the Fed has announced a quarterly sequence of tightening caps on its reinvestment of maturing and prepaying securities. This will have the net effect, when they fully kick in by 2019, of reducing its holdings of Treasury, agency, and mortgage-backed securities by US$50 billion per month. Where they stop, no one, not even Fed officials, can be sure, as they have reassured that the decision will depend on the evolution of the economy and financial conditions and the functioning of markets.

INV01039 003 Reinhart On Normalisation Graph 2

As a result, the unconventional monetary policy actions initiated by Ben Bernanke and subject to unwinding by his successor, Janet Yellen, will still linger for her replacement given that her term expires early 2018. While the Fed chair is important, it is the entire institution, mindful of tradition, setting the tone for monetary policy over time. Expect Jerome Powell to follow the path laid down by Janet Yellen for both the policy rate and portfolio holdings, perhaps a bit faster than she might have but not dramatically so.

The European Central Bank (ECB) lags behind the Fed, only recently announcing the decision to slow net asset purchases. The ECB will cut net securities purchases from €60 billion to €30 billion a month, starting January 2018. The central bank promised to continue at that pace at least until September 2018 and stands ready to ramp up purchases if the outlook warrants. It will continue to roll over maturing securities “…for an extended period of time after the end of its net asset purchases” and expects its key interest rates “to remain at their present levels for an extended period of time, and well past the horizon of net asset purchases”.2 This open-ended waterfall of policy actions implies that some elements of the unconventional sort will remain in place after President Draghi’s term comes to an end in October 2019.

It is similarly unlikely Bank of Japan’s (BoJ) Governor Kuroda will unwind its unconventional policies even if he is reappointed for another five years when his current term ends 8 April 2018. The BoJ has put a ceiling on the 10-year JGB yield, a throwback to the Fed’s enforcement of US Treasury instructions from 1942 to 1951. In doing so, the BoJ has piled more assets onto its already enormous balance sheet to put it just beyond the Fed’s holdings in dollar terms. Given the relative size of the Japanese economy, the BoJ’s footprint on finance is over 90% of nominal GDP (compared to the Fed’s 23%). Two decades deep into the policy menu, the bank will not be able to get out of the business anytime soon.

The long wait

Why has this collectively taken so long? First, the blow to the economy from the financial crisis was enormous, with real GDP in advanced economies contracting 3.5% in 2009, pulling the level of output four percentage points below that of its potential. The scope for monetary policy to offset a shock that large and widespread is limited when the real interest rate can be pulled no more into negative territory than the prevailing low level of expected inflation.

Second, a financial crisis represents an enormous destruction of wealth. Officials have to admit the loss, allocate it across the citizenry, and use other policies to offset where possible. This is usually costly. Consider the worst 15 financial crises in the second half of the 20th century. The median level of real GDP per capita 10 years after a crisis was 15% below the trend predicted by the 10 years prior to the crisis.3 This time was worse, as the public and private leadership of Japan and Europe stumbled at the first post by being slow to admit the problem, thereby delaying the rationalisation and recapitalisation of financial intermediaries and keeping the headwinds to demand blowing.

Third, long-term trends have turned adverse. The ageing populations of advanced economies are growing slowly (or in the case of Japan, contracting), participating less in market activity, and adding less output per additional hour worked than had been the norm. That means the growth of potential output slowed. Potential output is an attractor to aggregate demand – and if households and firms expect incomes to grow more slowly in the future, then, respectively, they save more and invest less. The market outcome is a lower equilibrium real interest rate and less robust expansion of aggregate demand. Thus, monetary policy makers were less able to open a wedge between the actual real interest rate below its equilibrium. That is, they were not providing as much monetary accommodation as the headline nominal policy interest rate advertised.

In search of stability 

This is why central banks struggle – and have mostly failed – to achieve their core mandate of price stability. This has not always been the case. From 1998 to 2008, they managed to keep consumer price inflation around 2%, the enumeration of price stability for the Fed, near the ECB’s notion of inflation “close to, but below 2%,” and the implied desideratum of the BoJ. In fact, they were so successful it looks like they were enforcing a price level target along a steady expansion path of 2%.

Inflation has mostly fallen short of goal since, now cumulating to a 5% undershoot of the 2% solution they had previously satisfied. We think that is part of the reason unconventional policies are a feature, not a bug, of central bank policy design. As long as they fall short of goal, the changing cast of characters at the Fed, the ECB, and the BoJ will continue to act out a script of policy accommodation. The title of the play is “Lower, for Longer, and Nearly Forever” as that is what they are doing relative to previous generations of officials in the modern era of monetary policy making.

1. See Duke University: ‘Conducting Monetary Policy At Very Low Short-Term Interest Rates’, May 2004, for example.
2. ECB press release, 26 October 2017.
3. Federal Reserve Bank of Kansas City: ‘After the Fall’, August 2010.

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