In several major economies, monetary policy is reaching its limits. It seems that every day we see headlines asking: Have central banks run out of ammunition?
The question dominates the financial markets’ discourse. Its ubiquity reflects the central banks’ unprecedented role in both stabilizing economic growth and supporting asset prices since the end of the global financial crisis. But the question also reflects disappointment. Global growth remains frustratingly fragile. Inflation has stubbornly fallen short of central bank targets.
This disappointment has led to a negative feedback loop between central banks and the markets. If central banks fail to deliver ever more aggressive stimulus, or even to begin to normalize policy, the markets react like a spoiled child in the candy aisle. Unfortunately, what risks being lost in this monetary-policy debate is the need for a stern reminder that too much candy can make us sick. Monetary stimulus has already done just about all that it should do.
Our analysis suggests that this feedback loop is creating unrealistic expectations for investors and having an unhealthy influence on monetary policy. But if monetary stimulus has already accomplished what it can, what comes next? The answer differs by region. In all cases, however, the answer suggests that it’s time to thank the central bankers for a job well done.
In the United States, the case for at least two more increases in the federal funds rate in the coming months remains strong. The Federal Reserve may—or may not—be able to preempt any outsized market reaction by making clear that a federal funds rate of 1% is both consistent with all available economic data and a likely outcome. In any case, it’s unwise to give undue weight to short-term volatility.
The U.S. economy, now in its seventh year of expansion, remains resilient. The job market has tightened to within a whisker of the Fed’s full-employment estimate, despite recent weakness (which we do not view as indicative of a trend). The once-battered housing market is recovering, and inflation and wage trends are inching upward. If investors awoke to this economy after a decade-long slumber, they would surely expect a short-term bank CD or money market fund to yield more than 1%, just as the Fed’s own models indicate.
One risk of a rate hike is that the dollar will strengthen, impeding continued economic expansion. But minutes from the Fed’s April meeting hint at a sensible plan to address this risk: Pair the rate hikes with a long pause at 1% and a further reduction in the Fed’s long-term “dots”—forecasts of the future federal funds rate—toward 2.5% or lower. The lower rate is more consistent with the long-term growth potential of a developed economy with a slowly growing labor force. It’s also a signal to global markets that there’s a relatively low ceiling on the dollar’s fair value.
In Europe and Japan, central bankers need to abandon tools that are proving ineffective and perhaps counterproductive, namely negative interest rates and increasingly aggressive quantitative easing. If cuts of several percentage points when interest rates were positive failed to boost credit growth, pushing rates a few basis points more below 0% is unlikely to do the trick. And central banks already purchase 90% of the gross government bond issuance. What’s to be gained from a move toward 100%?
Japanese corporations and households have been sitting on abundant cash reserves for decades. They have access to whatever capital they might need. After years of near-zero rates, Japanese firms and households still see few reasons to invest and spend. Additional monetary stimulus is unlikely to make much difference. On the contrary, such actions risk damaging central bank credibility as false hopes are dashed and inflation expectations fail to rise materially.
The European Central Bank and Bank of Japan have earned the right to turn to their policymaking peers and say “it’s your turn” to press forward with structural reforms that can boost long-term productivity growth. Indeed, it’s time to experiment not with helicopter drops but with reforms that can help these economies capitalize on the technological breakthroughs of the past decade. Printing money was the right response to the financial crisis, but it’s not a prescription for long-term economic growth. That’s as true in Brussels and Tokyo as it is in Buenos Aires and Harare.
The world’s central banks have been the proverbial Atlas in helping to support the global recovery the last seven years. But monetary policy is reaching its limits. The keys to continued economic improvement lie elsewhere. The time has come to give Atlas some needed relief.