Following the financial crisis our main central banks (to keep it simple let’s stick with ECB, BoE and the Fed) needed to get real interest rates (the difference between the nominal interest rate minus inflation) down.
This is the normal playbook that a Central Bank should use and even more so after the global financial crisis. They needed to get money moving again not only to the real economy but also within the financial system which was not only broken but was on the brink of collapse and without too much exaggeration could have brought down capitalism with it.
But the conundrum coming out of the financial crisis was why inflation did not significantly rebound given the spectacular amount of stimulus in place. As inflation has remained low and even went negative again across the developed world in 2015 the Central Banks kept reducing interest rates and buying bonds – the ECB is still negative and is still increasing the balance sheet to keep these real rates as low as they can without causing too many negative side effects.
The reasons why inflation has been lower than you would have expected will probably become a popular dissertation topic amongst Economic students in the coming years. I imagine these papers will cover globalisation, online shopping & tech, demographics and the breakdown of the Philips curve to name but a few. Also I don’t think we should ignore the impact of Shale and the fall in commodity prices over this period.
These are mainly structural changes, but monetary policy is a cyclical tool – and here is the problem. We have policy at what is without doubt emergency levels which has not had the desired effect (apart from one time impacts from falls in the currency) and what it has caused is inflation in asset prices – housing, equities and bonds, not in the real economy and certainly not in wages (which you could argue are structural issues).
Should Central Banks perhaps place more emphasis on growth, employment and wages (which the BoE have explicitly targeted post-Brexit) rather than inflation? Or should that be the job of the Government? Is that the pertinent question – have our governments collectively failed to adapt to this changing world?
All of which leaves monetary policy in a tricky place. There are strong arguments coming to the fore that the emergency levels of accommodation should now be removed, not because inflation is becoming rampant, but because perhaps it was an ineffective tool against the structural challenges we face; or maybe Central Banks just need rates to get high enough so that they can cut them again in preparation for the next down turn (confidence is also a tool). The Fed have raised rates 4 times since December 2015, the ECB will be running out of bonds very soon and there are signs the BoE are becoming twitchy (three out of eight voted for a rate hike this week).
For all their failings, at least the Central Banks tried to do something. They were trying to create an environment where ultra-cheap money could foster growth and self-sustained inflation could flourish. Unfortunately if you were not in those assets that have gone up then all it has done is create greater wealth inequality; and while fiscal spending has been absent it is no wonder that we are starting to see political unrest. For example, it seems inevitable in the UK that the current government will have to provide their own stimulus to the population, where nothing is off the table, or the people will vote for a party that will.
James Lynch is fund manager of the Kames Absolute Return Bond funds