Two weeks ago, the European Central Bank (ECB) chose unexpectedly – but not unwelcomely – to abstain from expanding its already dramatically loose monetary policies. Yet its motivation was not that the situation had improved. For example, the ECB declared that “underlying price pressures continue to lack a convincing upward trend, and remain an ongoing source of concern.” According to the ECB, there are also dominant downside risks to GDP growth.
| Monetary policy | ECB | Bank of Japan |
| Asset purchases (QE/CE) | ~ USD 90 billion/month | ~ USD 65 billion/month |
| Key interest rate | 0.00% | -0.10% |
| Extra lending to banks | TLTRO II x 4 | -- |
The ECB also emphatically repeated its message to political leaders: “in order to reap the full benefits from our monetary policy measures, other policy areas must contribute much more decisively”. This message is entirely consistent with the conclusions of recent Group of 20 meetings, for example.
| Key 2016 economic data | Eurozone | Japan |
| Public debt, % | 92 | 249 |
| Budget balance, % of GDP | -2 | -5 |
| Inflation, % | 0.1 | -0.3 |
| GDP growth, % | 1.6 | 0.5 |
The Bank of Japan (BoJ) seems to be following a similar “pattern”. The BoJ has also chosen not to expand its enormous monetary stimulus package despite continued deflation problems. Instead the Shinzo Abe government launched a 28 trillion yen (275 billion dollar) fiscal stimulus package, equivalent to 6 per cent of GDP. Although the BoJ says that it has not closed the door to new steps – including interest rate cuts – there are growing questions about the effectiveness of monetary policy.
Monetary policy at end of road – time for change
Growing risks associated with driving up asset prices and private debt further, with little or no effect on growth and inflation, is increasing pressure on governments and their fiscal and structural policies. Studies by the International Monetary Fund (IMF) and the Bank for International Settlements (BIS) – and official statements by the IMF and the G20 – are very carefully phrased, but their conclusions seem clear: monetary policy, including new rate cuts, negative interest rates and asset purchases has reached – or is close to – the end of the road. Obviously central banks are not likely ever to give up their struggle for better economic prospects and/or financial stability, nor should they. But most problems that the world is struggling with are beyond the potential influence of monetary policy. This again shifts the spotlight towards what government fiscal and structural policies can accomplish, now and in the future.
Today central banks are grappling with a number of major challenges. High indebtedness and credit risk in particular sectors are weakening the monetary policy transmission mechanism and putting added pressure on banking systems. Challenges to the profitability of the financial sector, due to both industry-specific trends and the unconventional monetary policies of recent years, are now restraining further interest rate cuts in the euro zone, Japan and elsewhere. The situation is especially troublesome for those banking systems that are dependent on deposits from the public and where lending mostly occurs at variable interest rates.
Central banks still have “medicine” left – mainly further asset purchases – but the main question must be answered: what is the “illness”? Merely increasing the “dose” is no solution to the problem, but instead risks creating new problems that will need to be dealt with in the future.
New reality, three phenomena, new policy tools
There is a discernible pattern in how the world’s finance ministers and central bank governors are now beginning to interpret the present situation. Current and future policymakers must deal with three phenomena. The concept of secular stagnation – a lengthy period of low growth and inflation, with a high risk of economic reversals – has crept ever deeper into decision making processes this past year.
Two driving forces behind lower interest rates
Furthermore, an increasing number of central banks are placing greater emphasis on the current decline in global real interest rates, caused by powerful “gravitational forces” of both a cyclical and structural nature (high propensity to save and low investment appetite). And sooner or later, economies will enter a new cyclical downturn. The question is how economic policy tools need to be adjusted in order to deal with new downturns when many of the traditional policy tools have already been used.
Three important tasks for fiscal policy
In this environment, there are three important tasks for fiscal and structural policymakers. First, they need to be better prepared to assume larger short-term responsibility for stabilising growth once monetary policy has reached the end of the road; in a number of countries, monetary policy has not only lost effectiveness but also its function as the “first line of defence” for fending off economic downturns and other problems. But if political systems pursue short-term fiscal policy, there are major risks and additional uncertainties. Here it is especially important to ensure that the economy has sufficiently strong and effective automatic stabilisers (such as social insurance systems) that kick in when the economy weakens and that are then withdrawn when the economy rebounds.
Second, fiscal and structural policymakers need to build in powerful buffers when interest rate and currency policy are not available. These are automatic discretionary fiscal stimulus packages that are activated without tedious political decision making processes, for example if unemployment exceeds – or GDP growth falls below – a predetermined level. The knowledge that this policy will be launched should, in itself, keep unemployment from rising or growth from falling.
Third, policymakers need to take vigorous action aimed at boosting economic growth potential. Some of today’s negative trends have natural explanations (such as an ageing population). But by lifting the long-term productive capacity of the economy and stimulating increased capital spending, the trend towards falling global real interest rates can be reversed.
The end of austerity policies in Europe?
The build-up of public debt in recent years and continued budget deficits are limiting the manoeuvring room of governments. Meanwhile a generally weak economic growth outlook is making debt restructuring difficult, even though interest rates are favourable. The European Union is facing a crucial choice: to build a stronger union, but probably to slow the pace of further economic integration (which the euro zone needs).
The EU’s “Brexit summit” in mid-September began laying the groundwork for re-thinking the EU. According to the agreed timetable, a roadmap will be ready in time for the EU summit in March 2017. A number of factors suggest that such re-thinking may include a more flexible interpretation of public finances in individual countries. In practice, this would imply a softening of the Stability and Growth Pact (SGP). Spain and Portugal are among the countries that have already been given greater slack, which can be regarded as confirming this. Aside from giving countries greater flexibility for budget deficits and public debt (adjustment periods), new proposals may allow them to exclude such investments as education and training from calculations of deficits and to speed up implementation of the EU’s 2014 “Juncker plan”, which aims to mobilise more than 300 billion euro in private and public investment to boost competitiveness and growth.
The main reasons why the EU will take such fiscal policy action are to improve growth prospects, boost EU production capacity and help prepare countries for low-growth scenarios that will make it more challenging to bring down high public debts. A further reason for fiscal and structural policymakers to play a larger role is Brexit; the British government’s strategy is to make the UK “super-competitive”, which will exert welcome pressure on various EU countries and on their long-term production capacity.
Less monetary policy responsibility
A monetary policy that succeeds in pushing up the prices of financial assets but not in boosting growth and inflation – combined with worries about secular stagnation and a new economic downturn – may explain the monetary policy decisions of both the ECB and the BoJ. Their decisions may thus be the first confirmations that we should not count on unconventional monetary policy to take further steps.
Yet our forecast is that the ECB will have problems pushing euro zone inflation reliably upward. This means that we still believe there is a high probability that the ECB has not yet exhausted its expansionary monetary policy (in the form of extended asset purchases). But if we are reading world developments correctly and euro zone countries are moving towards somewhat more expansionary fiscal policies, this will lower the probability that the ECB will continue with its asset purchases. In that case, the pressure on the Riksbank to do more would diminish radically; Swedish monetary policy is still strong dependent on ECB policy.
If this interpretation of 2016 developments and the policy tactics of the past few months is correct, financial markets are right to lift long-term yields to somewhat higher levels (reduced bond purchases and continued budget deficits). Central banks can probably accept a controlled up-turn in long-term yields. But continued downward pressure on short-term global real interest rates will still be a key force in shaping the future trend of long-term yields.