As it has been argued before in this forum, the employment growth in the present conditions does not provide any useful information with regard to the vigour of economy, simply because it does not control for the greater reliance of the markets on the contingent labour. In other words, due to the prevailing uncertainty firms are shying away from investment and are aiming to utilize various tactical labour-intensive responses in order to satisfy the increased demand that they do not perceive to be sustainable over the medium to longer run. Thus, they rely on part-time workers to operate with existing machinery and equipment, introduce more overtime if necessary and lease used equipment – in short they are utilizing tactical contingent factors of production instead of investing strategically in productivity enhancing technology. By the same token the January rise in participation rate and wage rate are not reliable indicators of the labour market strength at this juncture.
All in all, the sense of panic in the global markets that has been observed since the start of the year, and was predicted in this blog last year, is well-founded. The world is getting much closer to another painful bust, not because of the slowdown in China and its $10 trillion economy, or the fact that the current so-called “recovery” has lasted for 28 quarters (as compared to the average post WW II of less than 20 quarters) or the current fragility of European and Japanese economies, but because of the global economic fundamentals that are afflicted alarmingly by the destructive effects of very low interest rates, exacerbated by other unconventional monetary policies, including QEs .
An increasing number of countries and regions are having negative rates; including Switzerland (-0.75%), Denmark (-0.65%), Sweden (-0.35%), ECB (-0.3%) and Japan (-0.1%). Others, including the U.S. and Canada have talked about the possibility of moving toward adopting negative rates if the situation warrants. After fueling the expectations of interest rate hikes, in her latest communiqué Bank of England has shown a dovish inclination, with all nine members of the Monetary Policy Committee voting to keep rates on hold. While the U.K. markets now expect the Bank Rate, at 0.5 per cent for more than six years, to remain fixed until well into 2018. The February 4th Bank of England's quarterly Inflation Report, suggested markets expect a notional rate of 1.1 per cent by the start of 2019, while in November it reported that the market expected 1.1 per cent at the end of 2016, 1.7 per cent by the end of 2017 and 2.3 per cent by the end of 2018. Thus, one cannot rule out a negative interest rate in the UK by the mid-2017. The Bank of Japan that surprised markets by adopting negative interest rates at the end of January 2016, a move aimed at boosting a stumbling economic recovery and warding off deflation has maintained that it would cut rates further into negative territory if it needed to push borrowing costs even lower. It said the policy would continue as long as needed to achieve an inflation target of 2%.
It appears that central banks have forgotten a number of basic macroeconomic facts;
i. The liquidity demand will become inelastic around the potential output, and potential output itself shrinks when there is no capital formation and plenty of uncertainty. Moreover, reducing the interest rate cannot affect the growth rate of real output when aggregate demand becomes insensitive towards changes in the policy rate. The conventional theory suggests that the impact of increased liquidity should be translated in higher inflation rates. However, this could be the case if and only if the newly created liquidity can enter into the markets, via consumption and investment which is not the case in today’s economic environment. One can argue that in today’s economy either central Banks have lost their ability to create liquidity, or to the extent that they are able to do so firms’ change of behaviour has offset it. In other words the liquidity created by central banks is hoarded by firms. Businesses are not investing, because they do not see a sustained level of increased demand, and negative interest rates cannot force them to invest because they have invented new instruments and innovative tactics in order to hoard liquidity.
ii. If central banks are aiming at a currency war, to increase their market share of exports, they must have forgotten that these wars worsen the already highly toxic trade environment. In fact, this is the classic case of ‘fallacy of composition”.
In his Marjolin lecture, organised by the Deutsche Bundesbank, Frankfurt, on February 4th 2016, Mario Draghi, President of the ECB, touched upon some of the challenges faced by central banks. Perhaps somewhat optimistically he asserted that “Today, more than 60 years [after its inception,] monetary integration in the euro area is both complete and secure.” Be it as it may, he then divided the challenges into two categories; those “that are common to all central banks in advanced economies, which are linked to a global low inflation environment (read ‘ linked to a global anemic growth’)” and those “ that are special to [ECB] in the euro area”. As for the common challenges to all central banks in advanced economies, he formulated the most fundamental question as “can our price stability mandates still be delivered?” This, of course, is a sanitized way to express the concern about ever-increasing probability of the upcoming bust. He went on to say:
And in several of those economies, long-term inflation expectations, based on market prices, remain below our numerical definitions of price stability. That has led some to question whether it makes sense for central banks to pursue expansionary policies to meet their inflation objectives. Are they fighting a futile battle against forces beyond their control?In other words, translated into a general equilibrium framework, Draghi's explanation may be reformulated to suggest that the economic growth rates in several advanced economies have remained below their equilibrium level, and this has led some to question the effectiveness of monetary policy to close their output gaps. Mr. Draghi then explored three causes of “too low inflation”, or what others have called secular stagnation.
I. The structural factors that cannot be addressed through domestic monetary stimulus. As a result, 2% inflation target is no longer realistic. Somewhat surprisingly, the conclusion from this line of argument according to ECB is that “Central banks should adjust their objectives downwards accordingly”.
It would have been nice if some references were offered for the reader to enable one to explore the logic of this conclusion. A more rational conclusion would be since monetary policy is ineffective to generate growth (and inflation) there is a need for other policies. In any event, Mr. Draghi, refers to Friedman's edict that “inflation is always, ultimately, a monetary phenomenon” and “It could thus always be controlled in the medium-term by a committed monetary authority”. However, this edict is based on two crucial assumptions that are violated in this uncertain times (a) the edict assumes that the level velocity of money remains fixed and (b) the level of potential output also remains unchanged over medium term. However, when due to uncertainty firms operate below their efficient production frontier and use contingent factors of production one cannot assume that the Fisher or Friedman quantity theory of money can still deliver the edict, as both velocity and potential output subside in response to the option price of waiting for uncertainty.
II. The positive global supply shocks eliminates the need for central banks reaction, as they can simply redefine the medium-term horizon and wait for inflation to hit the target.
Mr. Draghi correctly notes that “a succession of supply shocks, such as the steep falls in oil prices we have experienced recently can cause a downward adjustment of inflation expectations if central banks do nothing." This is because a positive supply shock would reduce the cost of production and exert downward pressures on inflation. Thus, a policy response in the form of lowering of interest rate and the resulting exchange rate depreciation would stimulate the aggregate demand, causing inflation to get back toward its target level and allowing the interest rate to return to its natural Wicksellian level, as well the exchange rate would return to its equilibrium PPP levels gradually.
However, Mr. Draghi discounts the argument that “central banks fighting disinflation are inhibited by the lower bound on interest rates”.
We now have plenty of evidence that, if we have the will to meet our objective, we have the instruments. As the ECB and others have demonstrated, the lower bound for policy rates, wherever it might be, is not at zero. And we have also shown how non-standard tools can be used to deliver monetary stimulus even without altering much the overnight rate, and produce equivalent effects. For example, the non-standard measures the ECB has taken since summer 2014 have produced a pass-through equivalent to a 100 basis point rate cut in “normal” conditions.On this issue, of course, the jury is still out and it would be too soon to celebrate under a “mission accomplished” banner. These are not normal times when central banks credibility would allow them to stabilize a volatile situation, particularly when the volatility is caused by their own action. The fact that QEs have become successively less effective is a clear sign of the restraining impacts of a lower bound. Another sign is the slope of term structure of interest rates. The slope changes when longer-term interest rates do not respond to changes in the policy rate. The central banks’ balance sheets have become far too inflated for them to act as credible provider of contingent funds in central counterparty clearing mechanisms in these abnormal times. This adds to uncertainty and inhibits capital formation, which are direct consequences of the lower bound. The purging of the central banks QE-contaminated balance sheets would not be that easy, and their longer-term adverse impacts on finance are gradually but surely appearing on the medium-term horizon. In particular, the devastating impacts of these policies would exert themselves during the upcoming bust sometime over the next two years. Of course, a bust can be triggered much sooner for instance by a geopolitical shock, rising unrest by the unemployed European youth, or a natural disaster.
III. Central banks do more harm than good. “In particular, expansionary monetary policies at home lead to the accumulation of excessive foreign currency debt or asset price bubbles abroad, especially in emerging markets. And when these financial imbalances eventually unwind, it weakens global growth and only adds to global disinflation”. These imbalances are, of course, part of the concerns in this blog too. In addition to distortions created in emerging markets we are also worried about the sectoral distortions of these policies on domestic economies. Low interest rates are fueling housing bubbles, and hampering the investment in productivity growth.
In response to these concerns Mr. Draghi asks:
what would be the alternative? Would it help emerging markets if advanced economy central banks failed on their mandates? Would that be more likely to contribute to global growth? Clearly, the answer is no. The stability of large economies is vital to their trading partners and to the global economy, and diverting monetary policy away from that aim when our economies are still fragile would not be in their interest.The problem is that there is no evidence that these policies have been contributing to stability or to a sustainable global growth. The systemic risk has been elevated stemming from a false sense of security, manufactured by central banks, that has given rise to moral hazards and adverse selection risk. However, the markets are not stupid and recent volatility is a clear indicator of such anxieties. The markets are waiting for a trigger to signal makets' bust and this time around no QEs will be capable of providing any help. We have suggested a way out of this predicament in our previous posts, based on Gustav Cassel recommendations of 1937 Brussels conference. That would be the alternative policy.
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