28 February 2020

Strategic Reviews of Monetary Policy

Speaker: Richard Barwell, Head of Macro Research, BNP Paribas Asset Management

Richard Barwell gave the SPE’s February lunchtime masterclass on the subject of the ongoing Fed and ECB strategy reviews and a likely review by the Bank of England under new Governor Andrew Bailey. The session was kindly hosted by Ashurst.

Richard began by noting that short term rates and also long term rates (the latter having become “policy rates” too by virtue of central banks’ use of quantitative easing) were exceptionally low. This was largely because of low equilibrium rates rather than any cyclical deviation by central banks below equilibrium. Policy space was thus very limited - lowering rates might be counterproductive (the lower bound problem) while stimulus at the long end was limited by legal (among other) constraints in the euro area.

There is more fiscal space, but this itself was limited in what it could do - after all, it had been used significantly in the last crisis, there were implementation lags, investment spending should not be used as a response to cyclical weakness and it was difficult to make future  austerity to correct for current over-spending believable today. Moreover, the fiscal outlook over the very long term looks challenging thanks to ageing demographic trends.

All of these issues are global phenomena. If authorities find it difficult to respond to crises because of limited policy space then not only might their models of the economy be wrong but there may be an increased risk of hysteresis - economies could end up being permanently damaged.

Before the global financial crisis we talked about the lower bound of interest rates being zero. While in some cases we have now broke through that, the fundamental argument remains the same - that as long as holding cash pays zero interest it is difficult to take rates much beyond zero. It is possibly to go slightly below because convenience will stop banks from liquidating reserves and holding cash. The lower rates go the greater the risk that the costs of negative rates faced by banks are passed on and households take their money out of banks.

Lower rates pose a problem for banks especially if bank lending rates are contractually linked to market rates. This could have the effect of squeezing margins for a very long time - and reducing investors’ willingness to invest in banks.

Richard points out that the reversal rate - the rate below which banks may be incentivised to reduce lending - is not static. It will vary both across countries and within countries across institutions. There are a number of reasons it can vary, including the fact that some banks can charge fees on retail deposits while others cannot, variations in the retail/wholesale funding mix (those funding via deposits find themselves in a more precarious position), the existence of contractual links, and differences in banks’ asset positions (such as the ownership of portfolios of bonds) and competition.

The Bank of England’s term funding scheme was designed to address this issue, as was the ECB’s teiring scheme. However, both plans involve some fiscal transfers and it is debatable why central banks should be able to decide that banks should get more favourable treatment through these schemes than, say, pension funds or insurance companies.

The reversal rate is not necessarily the lower bound for interest rates, Richard notes. The reversal rate is the point at which banks begin to shrink their loan books because of margin squeeze, but it may still be the case that lowering rates helps reduce the cost of sovereign funding and also FX rates. What you lose through one channel you gain through others. However, if households save more because of lower interest rates (which they may if they think such policy is a response to a weaker economic outlook) then lower rates could be counterproductive.

When it comes to forward rates they are now far lower than they were a decade ago. As a result it’s difficult to bring the curve down any more by guidance. Richard contests whether QE is a particularly useful tool in the context of guiding markets - why not just save the effort and publish a chart showing the central bank’s future rate expectations?

Yield curve control was used by the Bank of Japan precisely because they realised that they could eventually run out of space to purchase bonds. Richard argues that it’s odd that the Fed has been reluctant to go down this path on account of the fact they see it as market-distorting - that is, after all, what QE was intended to do, and it would have the advantage of pinning market rates further out on the curve, just like the Fed aims to do with short rates.

Richard then turns to the difference between Delphic and Odysseyian guidance - the former being designed to help market participants understand the central bank’s static reaction function, the latter being a rarer form and committing to a change in policy. In most models Delphic guidance is pointless, he argues - it should not move markets under rational expectations. If it does it suggests investors are not sufficiently well informed. It can only reset expectations to where they should be if they were wrong in the first place. Moreover, such guidance can easily be counterproductive, it is argued, if the information contained within it communicates something about the economy rather than the central bank’s reaction function.

In short, Richard’s main concerns about the use of forward guidance are as follows: i) the curve is flat, there’s nothing more to say, ii) moving rates 25 years forward is not particularly useful for the economy now, iii) it is difficult for central banks to say anything about rates in the long term - after all the may be many strategy reviews between now and then that may change the bank’s reaction function, iv) Delphic guidance can be counterproductive, v) it’s been done before - there is no room left for shock and awe. The result is that we have fallen between two stools - central banks should either say as little as possible or as much as possible. Instead we we are now somewhere in between these two first-best positions.

Richard concludes by talking about the “dangerous incrementalism” of monetary policy - noting the example of the BoJ which has done everything it can incrementally and yet still inflation has not risen. Monetary space globally has been used up and fiscal space is limited - authorities cannot afford another crisis as they will be unable to mop up after it. Richard’s policy prescription? If real interest rates are down 2% then inflation targets should be raised by 2pp, to 4% (globally coordinated to avoid FX shifts). This may be difficult to achieve but central banks can only give it their best shot. If one thinks that a combination of massive monetary and fiscal stimulus to achieve this goal risks creating too much growth and inflation then at least the current problem of disinflation is solvable. If not then the huge reduction in policy space associated with lower equilibrium rates will mean recession and hysteresis are now significantly higher risks.

George Buckley, Vice Chair SPE

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