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Rethinking monetary policy

Rethinking monetary policy

Moritz Sterzinger Weekly bulletin November 2019
The idea that lower interest rates stimulate demand is so deeply entrenched in the models used by central banks that it is almost an axiom. Conveniently, it also makes central banks key actors in managing the economy. By lowering or increasing interest rates they directly affect demand and through this inflation, bringing the economy back to equilibrium after an external shock.

So goes the theory, but it increasingly appears to be at odds with reality. During the last decade of unprecedented monetary stimulus, output growth and inflation have been muted. And so, a debate about the effectiveness of the central banks’ actions has rightly emerged and keeps intensifying. Alternatives to the current practice of inflation targeting – including average-inflation targeting and nominal GDP targeting – are coming to the fore. At the same time, more radical proposals, such as helicopter money and the outright monetisation of government debt, are being given a serious hearing. Eventually a new policy paradigm may emerge.

Do low interest rates really boost demand?

The shape of the new landscape will depend on the answers to the crucial question of how economic agents react to changes in interest rates. Low interest rates stand accused of boosting asset prices and encourage financial engineering rather than physical investment that results in increased demand for capital goods. Then there is the question of how much of the monetary stimulus actually passes through to potential borrowers. Whereas interest rates for corporate and real estate borrowers have decreased dramatically since the financial crisis, the effect on consumer loans, credit cards and overdrafts hasn’t been as pronounced.

And what about demographics? If the expected return on savings decreases, how does an ageing society that is putting money aside for retirement, react? It does sound plausible that low interest rates cause people to save more for their pension. If that is indeed the case, low interest rates might depress present consumption rather than boost it, just like high interest rates would. Negative interest rates seem particularly pernicious in this regard as they act like a tax on savers and retirees, further eroding their purchasing power.

The effectiveness of negative interest rates has been increasingly challenged in recent months. They are a drag on banks’ profitability as they struggle to charge deposit holders negative interest. This in turn reduces their ability to lend – potentially a drag on growth. It is therefore telling that the Swedish Riksbank is now slowly reversing its negative rate policy, after five years of below zero rates, despite a worsening economic outlook. A sign of things to come in other currency areas with negative rates such as the Eurozone, Denmark or Switzerland?

More government spending, less central bank action

Whatever the outcome of the debate on the efficacy of rock-bottom interest rates, it seems almost certain that fiscal policy will play a bigger role going forward. Mario Draghi admitted as much when, during his last press conference, he begged the German and Dutch governments to finally give up on their self-imposed austerity and start spending on infrastructure projects. The IMF has also turned markedly Keynesian and is now increasingly of the view that government spending and taxation need to be more central to demand and inflation management.

We might well be moving towards a new paradigm with increased coordination between monetary and fiscal policy – a potential challenge to central bank independence. Once the unwanted side effects of “easy money” and low interest rates are better understood, central banks might become less interventionist and more measured when it comes to applying monetary stimulus. And with that, an era of (sub)zero interest rates could come to an end.

For more information, please contact Moritz Sterzinger, Director at JCRA, at moritz.sterzinger@jcrauk.com.


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