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Are central bankers beginning to see sense?
Since the onset of the financial crisis central bank policies of near-zero interest rates and dollops of quantitative easing have penalised savers and favoured those in debt. It is galling to many of us that central bankers cannot see how misguided and harmful their policies are proving to their economies as a whole. Despite a complete lack of evidence that low interest rates and monetary stimulus are having any positive effect, they persist, as if somehow they will miraculously succeed next time.
Recently, however, a few dissenting voices have emerged among the central banking community. In the United States, Dallas Federal Reserve Bank president Richard Fisher is one. “I firmly believe that the Federal Reserve has already pressed the limits of monetary policy… U.S. banks and businesses are awash in liquidity. Adding more is not the answer to our problems.”
James Bullard, president of the Federal Reserve Bank of St. Louis, is another. “We’ve constantly felt that there would be light at the end of the tunnel and there’d be an opportunity to normalise but it’s not really happening so far.”
Without low interest rates, savers would be saving the American economy
In an intriguing research report William F. Ford, once the president of the Federal Reserve Bank of Atlanta, has pointed out that cutting the income of savers has had a profound adverse effect on the economy. “The prolonged and abnormally low interest-rate structure… has made life particularly difficult for retirees and others who depend on conservative interest-sensitive investments. But the negative effects do not stop there. They spill over into the overall performance of the economy… By lowering interest rates to historically unprecedented levels, the Fed’s policy deprives savers of interest income they normally would have earned on the interest-sensitive assets they hold. Thus, there is an income channel that no one is talking about, and its negative impact can be powerful.”
“Low interest rates are costing the US economy an annual $371 billion in spending, 3.5 million jobs, and 2.53% of GDP.”
His team have calculated that, even on conservative estimates, low interest rates are costing the US economy an annual $371 billion in spending, 3.5 million jobs, and 2.53% of GDP. As he points out, “This is a sizable effect, given that during this time GDP grew by only 2.33 percent and the economy added only 870,000 jobs. With the additional jobs that might have been created by higher interest income levels, the unemployment rate could fall to 6.8 percent. And output could grow more than twice as fast as it has. The resulting GDP growth rate of 4.86 percent would then be closer to the average second-year growth rate of the past nine recoveries, and the U.S. economy would be well on its way to a vigorous recovery, rather than struggling as it is now.”
Canadian economist William White is one of the few who anticipated the financial crisis, warning about it back in 2003. He has just published a paper entitled “Ultra Easy Money Policy and the Law of Unintended Consquences”. Although he believes central bank actions have bought time, he does not think they will create strong, sustainable growth. Pointing out that the fall in interest income hurts savers more than lower rates help borrowers, he is concerned that central bankers are now worsening our economic problems, not helping. Their actions will “create malinvestments in the real economy, threaten the health of financial institutions and the functioning of financial markets… encourage governments to refrain from confronting sovereign debt problems in a timely way, and redistribute income and wealth in a highly regressive fashion.”
Low interest rates do not discourage saving
White does not feel that monetary stimulus is as effective in stimulating demand as is commonly believed and explains why, contrary to the Bank of England’s view, record low interest rates do not necessarily discourage saving or persuade people to spend more and businesses to invest more heavily. “To the extent that such measures are unprecedented, indeed smacking of desperation, they could actually depress confidence and the will to spend.” He understands the plight of many savers, too: “Suppose that savers have a predetermined goal for the minimum amount of savings they wish to accumulate over time. This would correspond to someone wishing to purchase an annuity of a certain size upon retirement, at a desired age. Evidently, a lower interest rate always implies a slower rate of accumulation. But, if in fact the accumulation rate becomes so low that it threatens the minimum accumulation goal, the only recourse (other than postponing retirement) will be to save more in the first place.”
Perhaps the most surprising comments – given their source – have come from Spencer Dale, the Bank of England’s chief economist and a member of the MPC. His recent speech “The Limits of Monetary Policy” was hardly a complete volte face. He still believes that we are in a “period of deficient demand” and that monetary policy should therefore encourage us to “borrow more and save less”. But there is much within it that does make surprisingly good sense.
“Economists and central bankers don’t understand how the economy functions”
He displays a degree of humility utterly lacking in his “Nothing to do with me, guv” boss Sir Mervyn King. “Surely one lesson we have learnt from the financial crisis – perhaps the most important lesson – is that economists and policymakers know far less about the economy and its behaviour than many might have liked to believe”. Dale points out that “we don’t fully understand the structure of the economy or the behaviour of households and companies within it. Not even close.” In that case, he wonders, “Is there a danger that we might do more harm than good?”
“If the handbrake on your car is stuck, putting your foot further and further down on the accelerator won’t get you very far before the car starts to overheat.”
If economists don’t understand the economy, you might expect him to conclude that the central bank should interfere less but he does not quite go that far. He recognises, however, that more QE might do harm, particularly if the diagnosis of what is wrong with the economy is incorrect, as he feels it might be. “In this case, further demand stimulus may run up against supply capacity relatively quickly and so largely result in higher inflation. If the handbrake on your car is stuck, putting your foot further and further down on the accelerator won’t get you very far before the car starts to overheat… The Pavlovian-like response of some commentators to call for more monetary stimulus each time they observe weak growth is not sensible.”
He recognises that inflation and the erosion of household incomes could be having a recessionary effect while low rates and QE might be persuading investors and institutions to seek out riskier ways of getting a yield on their money. “The prolonged period of low interest rates and enhanced support may delay some of the rebalancing and restructuring that our economy needs to undertake. Underlying balance sheet problems can be masked, tempering the incentives to address them. Inefficient firms may remain in business for longer and so slow the reallocation of capital and labour to more productive uses. Low interest rates and the associated forbearance might even explain part of the puzzling weakness in productivity.”
“The Bank of England must focus on its inflation target”
Dale is not blind to the dangers of ignoring inflationary pressures. “In the UK, we saw firsthand in the high and variable inflation rates of the 1970s and 80s, the cost of monetary policy taking its eye off the ball.”
He appreciates that unwinding QE, which has seen the Bank buy 40% of conventional gilts, could be tricky and risks unsettling the government bond market and crowding out fundraising for the private sector.
Dale concludes: “There are limits to how much we should ask of monetary policy. We need to remember how little we know about the economy and how it works. Beware confident economists… We need to consider the potential costs as well as benefits of further policy easing. We are in unchartered – and potentially dangerous – waters. Above all, we need to remain firmly focussed on hitting our inflation target.”