Growing pains: Why is central bank policy failing?


Quantitative easing and other extraordinary monetary policy have been administered as the remedy for the global economy progressively since the global financial crisis. But as with all medicine, repeated doses increasingly lack the same hit.

Early QE ‘shots’ had the rousing effect of boosting confidence and raising stock markets, while dampening bond yields and domestic currency markets, but the impact of subsequent central policy has notably diminished over time. Is the solution more shots? Or does this risk unwelcome addiction?

The most prominent example of these diminishing returns has been Japan. When the country decided to impose negative interest rates on the accounts it holds for commercial banks at the start of this year, it had some surprising consequences. Not only did it prompt elevated demand for Japanese government bonds, it created a surge in the yen, which hit 18-month highs against the US dollar. Central bankers had hoped that lower rates would prompt bigger banks to plant more excess capital in the money markets, creating liquidity, but trading in Japanese money markets melted away.

In other words, it produced the opposite effect to that expected by the market, or intended by the Bank of Japan. This may have been instrumental in Bank of Japan chair Haruhiko Kuroda’s more recent decision to keep rates on hold, flying in the face of market expectations of further easing. However, this too had a negative effect. The yen surged and the Japanese equity market slumped. Kuroda would be forgiven for feeling he is damned if he does and damned if he doesn’t.

Impact of the Fed
Of course, it is not quite that simple. Kuroda had been helped out by the decision of the US Federal Reserve the previous day to keep rates on hold. Equally, he maintains that he was simply waiting to see the impact of the move to lower interest rates. This may be true, but in the meantime, data showed the country had fallen back into deflation for the first time since 2013, suggesting the easing measures to date have failed to produce self-sustaining growth.

The problem, as Mark Hargraves, manager of the Axa Framlington Global Opportunities fund, points out, is that Japan has a unique demographic structure, which makes certain types of monetary stimulus less effective. He says: “Domestic demand is not picking up as expected. The labour market is tight, wages are increasing, but domestic demand remains subdued. The trouble is that wage increases don’t go to retired people. For them quantitative easing undermines confidence.”

Similar doubts have been raised about the efficacy of Eurozone quantitative easing, with growth still slow and ongoing pressure on the banks. Inflation has failed to lift above 0 per cent in any of the past three months, although core inflation and economic growth have been marginally stronger. While quantitative easing appeared to lift the US economy out of recession and back to strength, it is not having the same impact in the Eurozone.

Martin Feldstein, professor of economics at Harvard University and president emeritus of the National Bureau of Economic Research, points out that there are real differences between the Eurozone and US economies, which may make quantitative easing less effective in the Eurozone.

He writes: “Because Europe lacks the widespread share ownership that exists in the US, quantitative easing cannot be used to stimulate consumer spending by raising household wealth. Instead, a major if unspoken purpose of the ECB’s low interest rate policy has been to stimulate net exports by depressing the value of the euro. The ECB succeeded in this, with the euro’s value falling by some 25 per cent – from $1.40 in the summer of 2014 to $1.06 by the fall of 2015.”

Although the fall in the value of the euro has stimulated the eurozone’s net exports, the impact on its members’ exports and GDP has been quite limited.


“One reason for this is that much of the eurozone countries’ trade is with other eurozone countries that use the same currency. Moreover, exports to the US don’t benefit much from the decline of the euro-dollar exchange rate,” says Feldstein.

He also points out that there has been relatively little increase in either business or household lending. It is the usual conundrum, just because central bankers make it easy and cheap to borrow doesn’t necessarily mean anyone wants to do so. Monetary policy remains an indirect tool.

Feeling the side effects
Similarly, just as medicines lose efficacy over time, they also have unintended side-effects: The same is true for the other ‘accidental’ problems associated with quantitative easing.

Bryn Jones, lead manager on the Rathbone Strategic Bond fund, highlights the phenomenon of zombie companies. “Quantitative easing and negative rates encourage ‘zombification’. Lots of companies that should have gone bust, didn’t. UK companies can borrow at zero interest rates in Europe, so they have little incentive to improve their return on equity. If you increase the cost of capital, you encourage companies to target a higher return on equity,” he says, adding that this is why many economies are still stuck with significant spare capacity.

This is a particular problem in Japan and is part of the reason why growth is still so weak. In other words, quantitative easing might not just be ineffective, it may be contributing to weaker growth.

Equally, the cost of intervention is rising because markets are becoming complacent. Paul O’Connor, co-head of multi-asset investment at Henderson Global Investors, says: “The Bank of Japan owns around 80 per cent of the Japanese government bond market and is looking to own more and more. This has an effect on liquidity and on the functioning of the market.”

Negative interest rates are controversial. Jones points out that if a bank can use a safety deposit box to store money cheaper than it costs them to keep it in the bank, they will do so. Munich Re recently announced that it would store at least €10m ($11m) in two currencies so it wouldn’t have to pay banks to hold its cash under the European Central Bank’s negative interest rate policy. This would seem to put a floor on what can be achieved with a negative interest rate policy.

Jones points out that the ECB is sufficiently worried about this phenomenon that it has removed the €500 note from circulation.

A secondary side effect from the negative interest rate policy has been bank profitability. JP Morgan said: “Even if the portion of reserves subjected to deeply negative rates is limited, banks are not immune to a reduction in net interest income, especially if interest rates move deeper into negative territory.

“This is because banks seem unable or unwilling to pass negative deposit rates to their retail customers, leaving them with few options to offset costs.” As the health of banks has an impact on the financial system, this is worrying for everyone.

“Certainly, policymakers are not reacting with the urgency that markets want.”

Henderson’s O’Conner says: “The Eurozone policymakers underestimated the adverse effects on the profitability of the banks.” He suggests that the first quarter of 2015 really represented the ‘last hurrah’ for monetary policy. He believes this shows that the current monetary policy is fatigued, if not yet fully exhausted. “The current set of policies is reaching its limits,” he adds.

To be fair, these risks were always well-understood. In his blog, former Federal Reserve chair Ben Bernanke says: “So long as people have the option of holding currency, there are limits to how far the Fed or any central bank can depress interest rates. Moreover, the benefits of low rates may erode over time, while the costs are likely to increase. Consequently, at some point monetary policy faces diminishing returns.”

What are policymakers to conclude? Is extraordinary monetary policy likely to be effective from here? Jane Davies, manager of the HSBC Multi-Asset portfolios, urges market participants not to be too quick to judge unorthodox monetary policy a failure: “It is very difficult to quantify the effects of quantitative easing. There are so many variables. Certainly, large scale asset purchases have been effective in decreasing bond yields, but there is an ambiguity about other areas.”

“Some of its impact comes from the implicit guidance on the future path of monetary policy and that has depressed short-term interest rate expectations, particularly in Europe and Japan.”

She believes that policymakers – and market watchers – should look longer-term: “What can look like unintended consequences – such as the strengthening of the yen – could be a short-term outcome.”

Equally, it is clear that policymakers are learning as they go along. Many of the measures announced in the latest round of ECB easing looked to address the impact of negative interest rates on the banking sector. The new series of TLTROs [Targeted Long Term Refinancing Operations] are designed to contribute to the easing of credit conditions for banks in the Eurozone. Analysts at Deutsche Bank have suggested that take up could be over €500bn.

Getting more creative
From here, central bankers appear to have two main choices: to admit that quantitative easing and/or extraordinary monetary policy is no longer working and leave their creaking economies to try and grow on their own; or to undertake more and more creative policies to try and stimulate growth.

The majority believes that central bankers have gone too far to give up now. Anthony Rayner, manager of Miton’s multi-asset fund range, says: “A lot of the question of whether central bankers ‘give up’ is to do with credibility. If they said they were going to abandon extraordinary monetary policy, it would have to be because they saw an improving in economic conditions. It is politically easier to say, ‘this hasn’t worked, but we plan to try something more creative”.

Cédric de Fonclare, manager of the Jupiter European Opportunities fund, says that there is reasonable evidence that quantitative easing isn’t working: “Consumers may be benefiting from lower mortgages, but they are not using it to invest. I’m not sure its working, but there are strong signals that they will carry on.”

O’Conner says the key problem is in Japan, but the knock-on effects of the weakness of a large global economy could be important as well: “Japan is at a critical juncture. This is where monetary policy has become most exhausted. Europe has taken some fiscal measures, and then did quantitative easing on top. In Japan, monetary policy has been left to do the heavy lifting.”

“They are torn between two scenarios: Japan runs out of bullets and slips back into deflation. All the structural negatives for the country reassert themselves. Certainly, policymakers are not reacting with the urgency that markets want. Alternatively, they could do some of the things that the ECB has done – on the banks, on the credit markets,” he says.

If central bankers were to do more, what could they do? Plenty, argues Kevin Lilley, manager of the Old Mutual European Equity fund: “They are unlikely to cut interest rates further, but they could extend the magnitude and length of asset purchases, and extend them to different asset classes, such as equities.”

Jones agrees: “In the UK and Europe, they didn’t have to do much in the way of asset purchases, simply announcing it provided a backstop for the credit market.”

However, many argue that not a lot can be done without some fiscal stimulus, though this is controversial. Bernanke says this is the next natural step: “Fiscal policy provides a potentially powerful alternative—especially when interest rates are “stuck” near zero. However, in recent years, legislatures in advanced industrial economies have for the most part been reluctant to use fiscal tools, in many cases because of concerns that government debt is already too high.

However, there are ramifications to fiscal stimulus. Rayner says: “Fiscal stimulus, such as helicopter money [see below], is easier in places such as Japan, where they haven’t got the scars of rampant inflation. It is more difficult in Europe.”

Cuts or spending
This fiscal stimulus would generally come in two forms, says Rayner: either a chunky tax cut, or infrastructure spending. The former would certainly be a politically complex option. At a time when austerity has hit the poorest in society, any perception that governments were giving the wealthy a free lunch via tax cuts would be politically uncomfortable.

Equally, exacerbating the gap between the rich and poor would create significant social division. It may not achieve the right effect economically either. In general, inequality does not help growth because rich people have less propensity to spend. Poorer people tend to spend far more of their income. In this way, tax cuts might target the wrong people and could therefore be counterproductive.

Rayner believes infrastructure spending is an easier option, pointing out that there is plenty of infrastructure development to be done in the UK, Germany or the US. However, once again, the economy in which it is enacted will make a big difference: “The US, for example, has a big multiplier and will respond well to fiscal stimulus.”

He believes it is already happening in some places, adding: “Germany is loosening the fiscal purse strings a little.” Germany’s fiscal balance is due to halve this year in response to spending on the refugee crisis, according to a group of influential German economic institutions, Ifo. The group also urged the German government to use its remaining budget surplus to support economic growth. Eventually, the government may bow to the pressure.

A lack of longer-term economic reform is undoubtedly still an issue in many countries. Jones says: “In the US, UK and many other countries, they acted quickly to get rid of the risks in their banking system. This still hasn’t happened in Europe. There are vast swathes of non-performing loans in the European banks, particularly in some of the Italian banks and measures to tackle the problem have barely scratched the surface. It needs to be sorted out.”

Equally, while the Japanese authorities have taken steps to tackle some of the corporate governance issues at the heart of Japanese businesses, there is still some way to go.

Follow the leader
The question for investors is how all this unusual monetary policy is going to impact financial assets. It has generally been right to ‘follow the Fed’, betting in favour of central bank policy rather than against, often at the expense of fundamentals in recent years.

Of course, the real impact would depend on the asset chosen to be included in part of the programme, but in general HSBC’s Davies believes it can be beneficial to follow central bankers’ lead. She is currently overweight Europe and Japan in the group’s multi-asset income funds and says: “It certainly helps you out at the margin if policy direction is well known. There are plenty of studies that demonstrate that it has tended to be good news for equity prices.

“That said, it is difficult to be precise and our overweight position in Japan and Europe is more a function of the better outlook for earnings and better valuations. Supportive monetary policy is just part of the thesis.”

If ‘helicopter money’ or other forms of central bank monetisation were to happen, it should raise inflation expectations, says Rayner: “That will be good for those sectors in equity markets that are sensitive to the economic cycle, rather than defensive sectors. It might be that more cyclical and industrial companies do well. Bond yields may pick up. As ever, it will depend how it is received.”

As O’Conner puts it, “monetary policy is not exhausted, but it is fatigued. There are other options open to central bankers, but they have quite high hurdle rates.” Monetary policy tends to operate with a lag, but these are big problems it needs to solve and central bankers may need to come up with an alternative drug. The trouble is that none of the others are quite as palatable.

Helicopter money

The concept of helicopter money was introduced by famed economist Milton Friedman in 1969. He said: “Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.”


The idea is that the central bank pays for an expansionary fiscal policy, such as an increase in infrastructure spending or a tax cut. Instead of the cost being borne by taxpayers directly, or by issuing more government debt, the central bank credits the Treasury with the money and those funds are used to pay for new spending and the tax rebate. The idea is that it is a one-off response to a crisis situation, rather than a permanent reduction in taxes, or increase in spending.

But in his blog, former Federal Reserve chair Ben Bernanke, says: “It has the attractive feature that it should work even when more conventional monetary policies are ineffective and the initial level of government debt is high. However, second, as a practical matter, the use of helicopter money would involve some difficult issues of implementation.”