Citigroup Strategist: Central Banks Will Try to Monetize Government Debt When the Next Crisis Hits
The financial crisis was a hundred years' storm: an event so cataclysmic that it forced major central banks to flood the system with unprecedented liquidity and unconventional monetary policy.
So when the next shock hits, adding a cup of water might not be too much help.
With major central banks such as the Federal Reserve, Bank of Japan, and European Central Bank at or below the zero lower bound of interest rates, there's a dearth of traditional ammunition — in the form of further rate cuts — to throw at any problem that might arise soon.
A potential hard landing in China, which could ripple through the global economy, is the most readily identifiable impetus for an economic downturn in the near future. In the event that this does come to pass, monetary policymakers in advanced economies might have to resort to some more creative methods of stimulus.
Some of the ideas being floated include:
- Negative rates: Central banks in Europe have already experimented with them (and one monetary policymaker in the U.S. wants to try them!), but there hasn't been any evidence that an effective lower bound has been reached. As such, central banks don't really know how low they can go, but it's lower than where they're at right now.
- Higher inflation targets: By allowing inflation to increase at a faster annual rate, central banks would effectively lower the real interest rate. There's a trade-off in this regard, as higher inflation rates have some negative impacts on firms (in what is known as "menu costs," in reference to restaurants having to print out new ones in the wake of price fluctuations).
- Helicopter money: Milton Friedman conjured up the idea of printing money and dropping it out of a helicopter as a way to kick-start the economy through increased consumer spending (though this is likely best described as fiscal policy that could nonetheless be executed by a central bank).
- People's QE: an idea championed by new British Labor Party leader Jeremy Corbyn, who wants to require the Bank of England to buy bonds issued by a newly created infrastructure bank.
Steven Englander, Citi's global head of G10 currency strategy, has a novel suggestion for the course of action central banks should pursue.
While central bankers' natural instinct will be to return to further bouts of quantitative easing, Englander questions the efficacy of this policy, specifically, the transmission mechanism by which it affects real activity.
Ultralow bond yields well out the curve in some developed nations, he argued, are an insufficient condition for solid growth:
Through these asset purchases, central banks aim to maintain downward pressure on bond yields. Capping the return on these safe assets forces investors into more risky segments, including corporate bonds, thereby lowering companies' borrowing costs in an effort to promote investment. As investors rebalance their portfolios into high-grade and high-yield corporate credit as well as equities, putting upward pressure on prices, the ensuing wealth effect is also positive for investment.
"If these historically low rates were not enough to generate a durable recovery, it is unlikely that the next 30 to 50 basis points will be enough to counter a negative shock," wrote Englander.
Now, the counterfactual here is impossible — we'll never know how the global economy would have fared in the absence of QE.
But to Englander, this unconventional policy just won't be unorthodox or effective enough going forward.
What will be needed is for central banks to prod fiscal authorities into action by providing a blank check for increased spending that may, under the circumstances, be somewhat of a free lunch for the government — at least in the short term.
"Our ‘innovation’ here is to suggest that central banks will invite fiscal spending by announcing that their balance sheets will stay expanded permanently, or almost equivalently, be reduced only under extreme circumstances, and that they anticipate additional permanent expansion if targets are missed," said Englander.
Central banks that choose to go down such a road would foster more synchronicity between monetary and fiscal policy, something many economists argue was conspicuous by omission in some nations that struggled to recover from the Great Recession. Having a willing partner to deliver fiscal expansion is key, the strategist observes, as the rise in rates that would accompany the expected increase in inflation and growth would constitute more restrictive monetary policy.
The perpetual commitment to buy sovereign debt would also keep longer-dated yields in check, he contends.
"Low policy rates at the front end and balance sheet expansion preventing the fiscal injection from pushing up medium-long term rates are a powerful stimulus combination," the strategist asserts.
"Won't this invite inflation?" we hear you cry.
Yes — it would also likely help stabilize or increase inflation expectations. And that's what central bankers in developed economies, who are much more confident in their ability to damp down inflation than generate it, are after right now.
"The argument for fiscal policy via central bank monetization is that it directly injects purchasing power into the economy and will increase activity or inflation or both," wrote Englander. "QE increases the balance sheet but there is no guarantee that the increased lending and spending will result."
The strategist's proposal would therefore be open-ended like the Federal Reserve's third installment of quantitative easing, but have the added benefit of ensuring that the funds made their way into the real economy.
The implicit monetization of sovereign debt by the central bank also effectively eliminates the cost of servicing marginal expenditures, as the monetary authority hands over the interest payments it receives back to the state coffers.
While both are radical approaches, Englander's tactics differ materially from the People's QE of Jeremy Corbyn in that the central bank is rolling out the red carpet for debt-fueled ventures, rather than being forced to print money to finance a government's whims. As such, central bank independence is not necessarily infringed upon, as monetary policymakers are the ones who initiate and facilitate this sequence of events.
"Englander is regarding fiscal policy as an essential part of the central bank's armory in the event of a negative shock when rates are already at the zero lower bound," said Frances Coppola, former banker and author of Coppola Comment. "[This proposal] should be acceptable across the political divide, since it leaves the central bank in control of monetary policy while leaving the decision as to how fiscal expansion is achieved up to politicians."
Coppola added that a central bank commitment to serve as a buyer of last resort might negate the need for any sort of direct monetization to keep bond yields suppressed — in essence, a twist on the ECB's Outright Monetary Transactions (OMT) program, in which the central bank indicated a willingness to purchase the sovereign debt of a country that was in need of emergency funds, substantially reducing the perceived risk of default.
"If so, then the model is OMT, not People's QE, but conditioned on fiscal expansiveness rather than fiscal restraint and with market rather than institutional discipline," she said.
Though the potential for central banks to grease the wheels for fiscal policy to this degree sounds like a flight of fancy, Englander appears to be quite optimistic it will be deployed.
"Politically it is difficult for central banks to outright endorse monetization of government debt, but faced with another slump and armed with ineffective policy tools, we expect that central banks will quickly give the wink and nod to fiscal measures — the Fed relatively quickly, the BoJ at the drop of a hat and the ECB with an eye to warding off the growth of anti-euro political movements," he wrote.
The strategist also suggests an "Englander Rule" to guide central banks entering these uncharted waters: "If inflation is below 1.5 percent use monetized fiscal policy, between 1.5 percent and 3 percent stabilize the balance sheet, above 3 percent inflation shrink the balance sheet."
Englander references tax cuts financed by the central bank as a form of fiscal stimulus that ought to be deployed (a close cousin to and most practical form of the helicopter drop).
Coppola, for her part, noted that there is also a strong case to be made for governments to engage in investment spending in light of the tendency for fiscal multipliers — that is, the extent to which changes in government spending will alter GDP — to be larger at the zero lower bound.
Although, as FT Alphaville's David Keohane remarks, suggesting that the Federal Reserve might be able to pull off something this momentous with "a wink and a nod" is akin to assuming the can opener.
Money printing to finance government spending doesn't have the best reputation (think Zimbabwe) but in a world in which prolonged stagnation and a growing threat of deflation are the orders of the day, central bankers might just be willing to see if this radical approach bears fruit in the event that a negative shock rattles these still-fragile economies.
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