Negative Rates Are About the Only Tool Central Banks Have Left

ECB President Mario Draghi recently grumbled that monetary policy had taken on a “disproportionate” burden in recent years. He and others warn that when the next downturn hits, governments will need to play a bigger part in aiding growth with fiscal stimulus. Christine Lagarde, the outgoing head of the International Monetary Fund—and Draghi’s expected successor at the ECB—has urged Germany, which tends to have budget surpluses, to cut taxes and raise spending.

The Organization for Economic Cooperation and Development proposes that euro-area nations coordinate fiscal stimulus in some countries, with structural reforms in others, in tandem with loose monetary policy. It estimates that such an effort would raise gross domestic product growth by around 0.75 percentage point this year and the next.

Some think central banks and governments might have to work even more closely. “Greater coordination between fiscal and monetary authorities is almost certainly the wave of the future,” said Stephanie Kelton, a professor at Stony Brook University in New York, in a Bloomberg News interview. She’s an advocate of Modern Monetary Theory, which says that lawmakers, not central bankers, should take the lead in managing economies via spending and taxes. Critics say this is a recipe for spiraling government debt and rampant inflation and would undermine the political independence of central banks. To proponents, the idea provides a solution to the risk of monetary policy impotence.

If governments continue to resist big fiscal stimulus, what else might central banks be able to do to get the economy and inflation to catch fire? For a start, they can buy more bonds, pushing further down on market borrowing costs in the hope consumers and companies will be willing to borrow to spend. That’s already in the cards for the ECB. Bloomberg Economics predicts it will start buying €45 billion ($50 billion) in assets a month from September. But such so-called quantitative easing has already been exhaustively deployed. Torsten Slok, chief economist at Deutsche Bank, recently read 16 academic studies and concluded they tend to suggest QE is “no longer a useful instrument.” If faced with an average slump, Oxford Economics reckons major central banks would need to buy assets worth more than 20% of GDP—and be even more radical in a deeper downturn.

If central banks want to be even more unconventional, the Bank of Japan could provide a road map: It’s expanded the range of assets it buys to include even stocks, via exchange-traded funds. For the ECB, traders are pondering if it will buy the bonds of banks, which it’s shied away from, in part because it also regulates banks. “It would not be ideal of course, but the ECB has already been forced to venture into pretty controversial territory,” says Gilles Moec, group chief economist at Axa Investment Managers. “Given what is left of the ECB’s arsenal, ideal options are not on the menu.”

Ultimately, central banks may have to aim higher. Since the early 1990s, most have set an inflation target only to undershoot it in recent years. Some are now debating whether they need to aim for an even faster rise in consumer prices—that way, they can make up for the times when they fall short. And it would signal to markets, consumers, and businesses that policymakers are serious about letting inflation run for a while. The ECB is reviewing its strategy, including asking whether its target of consumer price growth “below, but close to, 2%” is appropriate, officials told Bloomberg News this month. Draghi favors a “symmetrical” approach, meaning flexibility to be either above or below the 2% goal.

Adam Posen, a former Bank of England policymaker and now president of the Peterson Institute for International Economics in Washington, says central bankers should be even more gutsy and rally around a 4% inflation target, to allow even more stimulus. All these ideas might have sounded odd to policymakers a decade ago, but so would have an economy with negative rates and hardly a peep of inflation.

©2019 Bloomberg L.P.