(Bloomberg Opinion) -- Central bankers deserve credit for saving the economy from the financial crisis. They won the battle, but not the war. So now they are asking for new powers to fix the side effects of a decade of ultra-low low and even negative interest rates. The price may be a Faustian bargain with governments.
The Federal Reserve had room in 2007 to cut its target rate by 500 basis points, or 5 percentage points, just as it did in the early 2000s when the U.S. economy fell into recession. But with the federal funds rate now in a range of 1.50% to 1.75%, the Fed has limited ammunition. This is why the Fed announced in November 2018 a review of its policy strategies. The ECB has its own review coming up in the first half of 2020.
Which tools will central banks seek to combat new challenges? So far, they have been doing more of the same. The ECB cut its deposit rate from -0.4% to -0.5% in September, and resumed asset purchases “for as long as necessary” at a pace of 20 billion euros ($22.3 billion) a month. The Fed also began expanding its balance sheet again by buying short term debt, causing its assets to rise by $335 billion since late August to $4.095 trillion.
This is a painkiller, not a cure. Inflation expectations remain muted, particularly in the euro zone, where the so-called 5-year, 5-year inflation forward rate trades at 1.3%, well below the ECB’s 2% target for inflation. One reason why inflation expectations remain low is that negative interest rates have depressed bank profitability and constrained lending - the mechanism at the core of monetary policy transmission from banks to the real economy. In fact, central bankers themselves are growing skeptical of negative rates, with ECB governing council members voicing concerns and Sweden's Riksbank, which on Thursday raised its key rate to zero.
If central bankers' existing tools are increasingly constrained, their ability to come up with something new will be key going forward. Christine Lagarde, the ECB’s new President, is already working in this direction, planning to improve coordination between monetary and fiscal policy. This is easier said than done, as Germany’s CDU-SPD coalition remains engulfed in internal debates challenging its “black zero” deficit rule.
But the global narrative is changing, and governments are increasingly tempted to take advantage of low borrowing costs and spend their way out of trouble. Japan recently launched a 26 trillion yen ($239 billion) fiscal stimulus plan. China’s policy makers recently lowered their expected growth rate for 2020, but pledged to do more to counter a slowdown. The UK’s new Conservative government will likely boost spending to offset the impact of Brexit next year.
As central bankers call for increased coordination with fiscal policy, politicians are calling for radical changes in monetary policy. President Donald Trump has criticized the Fed for keeping rates too high, which he says is making the dollar too strong. Some Democrats including Senator Bernie Sanders and Representative Alexandra Ocasio-Cortez support modern monetary theory, stating that governments should essentially print money to finance spending until full employment is reached. Similarly, the UK’s Labour Party has sponsored quantitative easing for the people, a more literal version of former Fed Chairman Ben S. Bernanke’s “helicopter money.”
The price for central banks’ new powers could be steep. Sure, they will gain new tools, but they will likely lose their independence. In exchange for fiscal stimulus, governments will push central banks to keep rates low to fund their deficits.
For Main Street, the result will likely be positive. Current QE programs target the real economy only through financial markets, via the wealth effect from higher stock prices and lower refinancing costs tied to falling bond yields. But this benefited large borrowers and investors more than small businesses. The result has been industrial consolidation, lower competition and a concentration of wealth. Targeting the real economy from the bottom-up could be more effective in generating inflation and growth.
For investors, navigating this new version of monetary policy will be a tough challenge. In coordination with fiscal policy, central banks will be able to boost the economy more directly, yet this will cause even more distortions. Governments may take advantage of low rates to fund persistent deficits, increasing their credit risk over time. Inflation will likely accelerate, but asset purchases will keep a lid on bond yields, preventing savers from being compensated for increased credit risk and rising inflation volatility.
Consider the UK, where 10-year Gilts yield 0.8%, while 10-year retail price inflation is expected at 3%. Other government bonds in developed economies already yield around or less than inflation rates, forcing investors to buy debt from less creditworthy borrowers or emerging-market issuers for positive real returns. To survive in this environment, investors will need a new strategy, too.
To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Alberto Gallo is partner at Algebris Investments and portfolio manager for the Algebris Macro Credit Fund.
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