Few people these days have not heard of quantitative easing (QE). Its seepage into everyday language serves to highlight just how conventional this once-unconventional tool now is.
The natural question, then, is: what will the monetary policy “bazookas” of the future look like? If central bankers are using QE on a routine basis, how will they respond to severe downturns of the order of the recent crash? Put another way, what will be the unconventional monetary policy of the future?
Alongside the immediate decision about whether the US growth and inflation outlook is strong enough to justify the first interest rate hike in a decade, the latest set of Federal Reserve minutes included a brief discussion of the natural rate of interest – the interest rate that is consistent with full employment and inflation at its target.
While this discussion has gone largely unnoticed, perhaps due to its technical nature, it is central to how monetary policy will be conducted in the future. In short, because the natural rate of interest is much lower now than it was in the past, future easing cycles in the US and elsewhere could see interest rates fall to zero as a matter of course. In turn, that means that formerly “unconventional” tools of monetary policy like quantitative easing will become conventional – and central banks may have to deploy new unconventional tools to stimulate the economy.
Policymakers will inevitably respond to the specific economic and financial challenges prevailing at the time.
Over the coming decades, factors such as a more subdued pace of productivity growth and a slower expansion of the working-age population are likely to depress trend economic growth and inflation – and therefore the natural rate of interest. So whereas interest rates in the US and the UK routinely reached 6%-7% during previous economic cycles, and have been as high as 20% within living memory, in the future we may have to become accustomed to rates averaging just 2%-3% over the course of a cycle. That means that during future economic downturns, central banks will have less room to cut interest rates to stimulate the economy, with rates likely to fall to zero on a frequent basis.
In turn, with interest rate cuts alone having less scope to boost the economy, unconventional tools of monetary policy such as quantitative easing (QE – large scale purchases of financial assets by the central bank, in an attempt to lower market interest rates and increase the amount of lending in the economy) and forward guidance (commitments by the central bank to keep the interest rate at rock-bottom levels until variables such as unemployment or inflation have reached certain levels, again in an attempt to lower market interest rates) are likely to be deployed as a matter of course. Indeed, rather than being unconventional tools only to be rolled out in a severe crisis, they are likely to become part of central bankers’ toolkits of conventional policy instruments.
Policymakers will inevitably respond to the specific economic and financial challenges prevailing at the time. But for now, we can make some broad-brush suggestions about what tools they might deploy.
The most obvious is to take interest rates into negative territory. Monetary policy orthodoxy had long held that interest rates were constrained by the “zero lower bound” – that, rather than providing an incentive for households and businesses to spend money, negative interest rates would just encourage the holding of excessive amounts of physical cash. But this orthodoxy has already been challenged by the European Central Bank (ECB) and others, who have been able to squeeze a little bit more stimulus out of the conventional interest rate lever by taking it below zero. In future easing cycles, the likes of the Federal Reserve (Fed) and the Bank of England could also go through the zero-lower bound.
The one tool to stimulate the economy that is likely to remain out of the reach of monetary policymakers is not a monetary tool at all: fiscal policy.
Another suggestion is that central banks may expand the scope of QE beyond purchasing their own government’s bonds. To some extent this has already happened, with the Fed buying mortgage-backed securities as part of its QE programme, while the ECB is buying debt issued by a select number of private agencies. But in the future, central banks may need to add corporate and high yield bonds, equities and even overseas assets such as foreign currencies to the mix.
An additional avenue for monetary policymakers to explore could be to alter the 2% inflation target that has become the norm across the developed markets. A higher inflation target, say of 4%, would allow the real rate of interest – the interest rate minus the expected inflation rate – to fall further below zero, creating additional stimulus. Even more creatively, central banks could target specific levels for the exchange rate, helping to stimulate inflation by encouraging the currency to depreciate and imported goods prices to rise.
The one tool to stimulate the economy that is likely to remain out of the reach of monetary policymakers is not a monetary tool at all: fiscal policy. ECB President Mario Draghi took a rare foray into commenting on fiscal policy in a speech at Jackson Hole last year when he said that “it would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy”. Officials at the Fed and the Bank of England are more circumspect, but it’s reasonable to assume that they would appreciate a helping hand from fiscal policy as well.
Ultimately, politicians are unlikely to hand over the reins of fiscal policy to central bankers as readily as they have handed over those of monetary policy – which is a shame because, when push comes to shove, fiscal policy may be the only bazooka big enough to deal with another severe downturn.