While I was pursuing a graduate degree programme in public administration and international development at Harvard over a decade ago, a professor of mine advised that when designing policies to respond to potential future events, rather than designing them to respond to what “should happen”, it would be better to have them respond to what likely “will happen”. These words have offered a useful lens to examine government and central bank policy responses since the 2008 financial crisis, including the current situation faced by global central banks.
With various large economies such as those of China and Europe slowing down and inflation continuing to miss targets set by central banks (e.g. in the US, Europe and Japan), central banks are examining how best to meet their policy objectives, if not change them altogether.
After pursuing unconventional monetary policies since the 2008 financial crisis, including adopting negative interest rates (e.g. in Europe and Switzerland), controlling longer-term interest rates (e.g. in Japan), and various forms of asset purchases, including quantitative easing and now purchases of Treasury bills (in the US), economists and central bankers have questioned the continued efficacy of these policies.
Central to their concerns are the diminishing returns of continuing to do more of the same, unmet inflation targets and negative consequences arising from unconventional policies. As a case in point, Sweden’s Riksbank recently stated, “If negative nominal interest rates are perceived as a more permanent state, the behaviour of agents may change and negative effects may arise.” In other words, if people believe that negative interest rates are here to stay, they may save more to offset future anticipated negative interest charges and therefore spend less.
Lower spending due to negative interest rates could perversely tip an economy into recession. This should give pause to those advocating for negative interest rates in the US, where consumption represents some 70% of GDP.
Central banks, cognisant that they alone cannot meet their policy objectives, have urged governments to step in and stimulate economic growth through public investments and other forms of fiscal stimulus.
In her first speech as European Central Bank president in late November, Christine Lagarde echoed comments made by outgoing President Mario Draghi and indicated that monetary policy “cannot and should not be the only game in town”. The Organization for Economic Co-operation and Development has also urged governments to spend, and in addition to fiscal stimulus, has recommended making longer-term investments to tackle more structural issues such as climate change and digitalisation of the economy.
This is where thinking about what potentially “will happen” rather than what “should happen” becomes critical.
While governments “should” make public investments that address structural challenges in their economies, the reality is that they will need incentives to act, with votes serving as powerful incentives. In Germany, where the government has amassed budget surpluses over the last several years, balanced budget policies such as Schwarze Null, or black zero, make it difficult for the government to accrue large short-term deficits to make longer-term structural investments. While the slowing German economy (Europe’s largest) is increasing pressure on government officials to act, until elected officials feel the pressure from voters to change their spending policies, it will be difficult for them to take action.
A deeper economic downturn and asset price corrections – unhappy outcomes, of which there could be others – would prompt voters to apply more pressure. Indeed, economic uncertainties caused by Brexit are prompting the Labour, Liberal Democrat, and Conservative parties in the UK to include greater public spending as part of their election platforms ahead of the 12 Dec. election. Even in the US, where economic growth has been higher, rising inequality is causing some voters to demand increased government spending. Democratic candidate Elizabeth Warren, for example, plans to increase taxes to help finance the construction of affordable housing, if she becomes president.
It is perhaps safe to predict, however, that until a sufficiently large number of voters or influential groups of them feel pain, fiscal policy will play a limited role in helping central banks achieve their mandates.
What choices do central banks have when government spending may not immediately come to the rescue, as it arguably should?
While the jury is still out on the consequences of negative interest rates, and central banks may choose to reverse them even if inflation remains below target, absent trade uncertainties being resolved, or labour productivity growth somehow accelerating, or both, it is unlikely that major developed-world central banks will be in a hurry to raise interest rates to much above zero.
Further supporting this view are insights from an International Monetary Fund technical paper on the fiscal multiplier (i.e. the ratio of a change in economic output to a discretionary change in government spending or tax revenue). The paper highlights that even in scenarios where governments implement fiscal stimulus, central banks still have an important role to play and can in fact help to amplify the impact of government spending by adopting accommodative monetary policy stances such as keeping interest rates near zero.
To be convinced of this, imagine if fiscal stimulus generated higher growth within an economy and the central bank raised interest rates in response to higher anticipated growth and inflation. In this scenario, the currency would likely appreciate, for example due to more attractive interest rates being on offer, and imports would therefore be cheaper to buy.
Spending more on imports would cause the benefits of increased fiscal spending to leak to exporting countries, or in other words, the fiscal multiplier would fall. For countries with high public debt-to-GDP levels, such as Italy, higher interest rates, combined with higher investment-fuelled deficits, could also lead to concerns over the country’s credit risk and therefore reduce private sector investments. Thus, higher interest rates, whether leading to a stronger currency or increasing credit risk, for example, could offset the impact of government spending.
Having presided over the IMF prior to her current role at the ECB, it is likely that Lagarde will pay attention to these factors as she deliberates monetary policy decisions along with her peers. It is therefore not hard to foresee interest rates remaining low and quantitative easing continuing in Europe. Similarly, low rates are likely to persist in the UK while the potential impacts of Brexit unfold. With interest rates potentially remaining low in many large economies, it is unlikely that the US will be able to adopt much higher interest rates. This is evidenced by the Federal Reserve’s ‘mid-cycle adjustment’ of three rate cuts in 2019, which some argue reversed the policy mistake of four rate hikes in 2018, and which occurred when central banks in Europe and Japan kept rates on hold.
It is therefore fair to conclude that even if fiscal stimulus arrives and governments do what they should, significantly higher interest rates are still a distant prospect, especially if central banks choose to help support fiscal multipliers. Liability-driven investors, such as insurance companies and pension funds, should take note and prepare for low government bond yields and investment returns until the factors hampering economic growth abate.
In the meantime, let us hope that governments will do what they should.
Zafrin Nurmohamed is a senior portfolio manager, Asset Management, at Butterfield Bank (Cayman) Limited.