HSBC: Central Banks Are Running Low on Ammunition

Does a "titanic" policy problem loom?

Arctic Sea Ice

Watch out for the ice floes.

Photographer: Pim Viuk

"The world economy is like an ocean liner without lifeboats." That's the headline in HSBC Chief Economist Stephen King's latest note. What he's getting at is that with interest rates sitting at or near record lows in economies across the globe, central banks could be set for major struggles if the economy starts to sour.

If another recession hits, it could be a truly titanic struggle for policymakers. ... Remarkably enough, it’s six years since the last recession, suggesting the next one may not be too far away, yet there is a total absence of traditional policy ammunition.

In past recoveries, policymakers on both the fiscal and monetary side have been able to raise rates and "replenish their ammunition," as King puts it. This recovery has proved otherwise.

King says this is a huge problem. 

In all recessions since the 1970s, the US Fed funds rate has fallen by a minimum of 5 percentage points. That kind of traditional stimulus is now completely ruled out. Meanwhile, budget deficits are still uncomfortably large and debt levels uncomfortably high: while the US fiscal position has improved, it remains structurally weak.

Although the Federal Reserve is the most discussed, it's not just the U.S. central bank that has embarked on this historical move. King notes that several other regions have similar narratives. The European Central Bank appears to be committed to quantitative easing until September 2016. The Bank of Japan is basically in the same boat. The Bank of England may not be increasing its balance, but it has yet to raise rates. Fiscal positions, meanwhile, are mostly poor, at least when compared with those pre-crisis. 

So what options do central banks actually have at this point? Here's what King's report looks at:

  • Reducing the risk of recession
  • Reverting to quantitative easing
  • Moving away from inflation targeting
  • Using fiscal policy to replace monetary policy
  • Using fiscal and monetary policy together in a bid to introduce so-called “helicopter money”
  • Pushing interest rates higher through structural reforms designed to lower excess savings, most obviously via increases in retirement age.

Regarding his first point, how exactly can fiscal and monetary policy reduce the risk of the next recession?

Well, it's not easy. According to King, new safeguard regulations such as increasing bank capital might work in a narrow sense, but not every crisis is the same. 

Higher levels of bank capital, greater liquidity buffers, more aggressive stress tests, macro-prudential policies: each of these is designed to prevent a repeat of the global financial crisis. In meeting that relatively narrow aim, they might well work. However, there’s more than one crisis, more than one recession. ... The danger for policymakers is not so much that they haven’t worked hard to prevent the next crisis but, rather, they cannot easily know in advance what the next crisis might look like. Admittedly, they can at least hope to make sure that the financial system itself will be more resilient in coming crises than it was in the last crisis, but that doesn’t alter the fact that all previous crises—whatever their cause—have been accompanied by sustained easing of monetary and fiscal policy. 

On the second point, going back to QE, King notes that this has been Japan's experience. (The BoJ introduced QE in 2001.) However, King is skeptical that this would do any good. 

There is little evidence to suggest that this first QE experiment [Japan] achieved very much: if anything, it simply reinforced the perception that raising interest rates from zero was more difficult than had originally been expected

We're starting to run out of options here. Should the Fed stop targeting inflation? King points out a big problem that arises when the U.S. central bank is so focused on a certain inflation rate, even if—in theory—targeting inflations sounds like a great idea.

Inflation targeting in theory offers precision, transparency and predictability. While that all sounds rather marvelous, there is an obvious problem: if central banks only worry about inflation—and not, for example, about asset price bubbles—the danger is that the rest of us start to take risks which ultimately lead to the kinds of imbalances that preceded the onset of the global financial crisis. 

So what about fiscal policy? This would appear to be an obvious alternative if another recession should hit and the above options do not work, or are not considered viable options. Difficulty arises hear when you look at the struggle for flexibility 

Yet, as with monetary policy, it’s difficult to argue there is a great deal of flexibility on fiscal policy—unless, that is, governments are willing and able to tolerate deficits and debt levels far higher than seen in the peacetime past. 

Perhaps fiscal policy and monetary policy together would work? King points out that it's not so easy when debt levels are high, interest rates are already near zero, and budget deficits are large. 

There is little room for policy adjustment and, given high levels of debt, policy multipliers are likely to be either very small or totally non-existent. This suggests that high levels of debt need to be tackled directly. One way to do this is to push asset prices higher in the hope that, by doing so, debts will be more willingly held, balance sheets will look healthier and the pressure to deleverage will be reduced. Quantitative easing has done precisely that but, as already noted, the increase in asset values has, to date, not translated fully into decent economic growth and higher inflation—which, in turn, suggests it might not be immediately effective in another downswing. 

In comes helicopter money, which King calls a near guarantee of higher inflation. Ask anyone from Zimbabwe, and they'll tell you it's a slippery slope.

 Here's what King had to say:

It [helicopter money] works only if the fiscal and monetary authorities work together not only to expand the supply of money but also to guarantee the extra money is spent rather than saved. ... The likelihood in the short term would be a rise in both prices and quantities. If, however, the benefits of this policy are so blindingly obvious, why has no government or central bank so far fully gone down this “irresponsible” path? The answer is simple. Monetized deficit financing can all too quickly lead to a loss of faith in the integrity of a country’s monetary and financial institutions. The risk is a mixture of currency collapse on the foreign exchanges and, eventually, a revulsion towards money that would create a world of hyperinflation. 

Last, King discusses the option of pushing interest rates higher through structural reforms designed to lower excess savings, most obviously via increases in retirement age.

Don't get your hopes up. King says this would require an "act of political bravery."

Falling interest rates are not just the result of central bank policy. ... One of those forces is an ex-ante excess of savings. ... The underlying problem is that countries with aging populations tend to suffer from slower growth yet to pay for all the extra retirees the countries need to have faster growth. ... To break out of this vicious circle, the easy answer—economically, at least—is for the retirement age to rise. This would, at a stroke, reduce the need for high savings. Faced with a longer period of work—and, hence, of earned income—the need to save to meet a retirement nest-egg objective would be greatly reduced.

King seems to favor this option because it would in turn lower savings while prompting higher levels of consumption, higher levels of demand, and higher levels of investment, presenting an opportunity to replenish the ammunition that's needed to repel the next recession. Again, don't get your hopes up. He doesn't see this as a likely outcome, due to it being unpopular politically with the exact demographic most likely to vote.

With only ineffective or unappealing options on the table, King concludes that central banks' "recession-fighting ammunition" is likely to remain low and that world economies risk being set adrift.

We will carry on sailing across the ocean in a ship with a serious shortage of lifeboats.

Many—including the owner of the Titanic—thought it was unsinkable. As its designer was quick to point out: “She is made of iron, sir, I assure you she can."

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