Monetary policy: Is the tide turning?
02 December 2016 | Markets and Economy
Commentary by Qian Wang, PhD, Vanguard Chief Economist, Asia-Pacific.
Until recently, much of the developed world had been in an easy monetary policy environment, leading to a degree of complacency among investors.
Any time there was some negative market or economic news, people didn't need to worry too much because they always knew central banks would come and cut interest rates further, or, in the case of the United States Federal Reserve, delay the necessary tightening. So despite ongoing concerns about issues such as Brexit and stagnation in Europe or the economic slowdown in China, the corrections we experienced in financial markets were relatively short-lived and volatility was relatively low.
But the tide might be turning. Central banks in some countries are starting to stay on the sidelines and not provide further easing to meet inflation targets, even in countries like Japan, which is getting dangerously close to deflationary territory. Since implementing negative interest rates, the Bank of Japan disappointed the market in April and again in July before introducing a new policy framework, in September, that didn't really provide further easing. Meanwhile, the European Central Bank and US Federal Reserve kept rates on hold in September.
An exception is the Bank of England, which cut its policy rate from 0.5% to 0.25% in August in an effort to stave off a Brexit-triggered recession, signalling that a further cut is possible later in 2016.
Why aren't most central banks cutting rates to boost inflation?
Central banks have provided so much monetary easing that the benefits are becoming marginal and the costs are rising. Now they are weighing the benefits versus the costs of further monetary easing.
While cutting interest rates can help meet inflation targets, it also leads to problems in the financial sector. Look at what's happening in Europe and Japan with negative rates – it's not only hurting bank profitability, it's also affecting pension firms and insurance companies, which can't get decent returns to cover their liabilities. And even in the US, where interest rates are in positive territory, keeping monetary policy easy for too long could create a bubble effect in the economy and financial markets.
As global economic growth picks up, banks are becoming less concerned about economic fundamentals and more tolerant of low inflation.
So further aggressive easing from the ECB or Bank of Japan appears unlikely before the end of the year, although the ECB may have to address the sustainability of its quantitative easing program, which will expire in March 2017, and face up to the bond scarcity problem. Meanwhile, the US Federal Reserve remains on course to hike rates only once this year, in December.
Can fiscal stimulus really kick-start economic growth?
At the moment I would characterise the role of monetary policy as providing downside insurance, as there's nothing seriously wrong happening in the global economy.
If concerns about economic growth or inflation emerge down the road, central banks will have to ease again, until monetary policy approaches the limit of its effectiveness. Beyond that, the government must consider other tools. We've already seen fiscal stimulus in Japan, Korea and China. Some European countries have slowed the pace of fiscal consolidation, and President-elect Trump has promised increased fiscal spending in the United States, especially in infrastructure.
It's true that people look at the Japanese experience and point out that Japan's economy is still very weak despite 20 years of fiscal stimulus. But there's more than one way to stimulate economic growth. There are three main types of fiscal policies:
- Giving people money to boost short-term economic growth through consumer subsidies like consumption vouchers and government spending.
- Boosting long-term growth and productivity through policies such as infrastructure investment, corporate tax cuts and research-and-development spending.
- Allocating growth more effectively among different groups to reduce income inequality.
The first type of "sugar fix" can provide a short-term economic boost, but isn't sustainable. What we really need are more effective long-term fiscal policies and structural reforms to boost potential growth in the long term. However, we are unlikely to see aggressive progress on either front in the near term, given the elevated government debt levels and objections from vested interest groups.
What does this all mean for the markets?
If central banks become reluctant to ease more aggressively, or if fiscal stimulus takes the driver's seat, the markets will have to price that in. So government bond yields have some room to go higher, which could trigger further volatility in risky assets. That's something investors should be cautious about down the road.
Despite the volatility, in the long term I think there's limited scope for substantial increases in yield as we're still expecting a low-growth, low-inflation, low-interest-rate and low-yield environment, with central banks remaining generally accommodative.
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