Central Banks Can't Do Much More

Surprise stimulus programs can only work so many times.

Rather pleased with himself.

Photographer: Tomohiro Ohsumi/Bloomberg

On Friday, the Bank of Japan stunned financial observers by announcing a new negative interest rate. Governor Haruhiko Kuroda got the result he intended: The stock market rallied and the yen depreciated, making exports more competitive and giving the economy a boost.

The direct effect of the change in policy will be slight. The central bank set an interest rate of minus 0.1 percent on additional reserves -- a small cut applied to a narrow category. But the move to less than zero has symbolic weight and nobody had expected it, so the effect on investors was powerful.

The European Central Bank is in a similar bind: struggling to persuade markets that it can push inflation back up to target, with interest rates about as low as they can go and a huge bond-buying program already in place. After the bank's most recent policy meeting, President Mario Draghi announced no change in policy, but stressed he still had options for providing further stimulus and was ready and willing to use them. That worked too. Investors were surprised. The euro moved down.

A current paradox of monetary policy is that central bankers are trying to stabilize expectations of inflation by dispensing periodic surprises: Stability through instability. Whenever investors begin to question the authorities' will or means to push demand and inflation back up, the remedy is a hint of recklessness and "Whatever it takes." (Kuroda likes that phrase as much as Draghi.)

Just days before the announcement, Kuroda had said negative rates weren't in his plans. Weak figures for household spending and industrial production maybe justified a rethink. In any event, if you're looking to surprise people, contradicting yourself in the space of a week is a good approach. The Bank of Japan's vote in favor of the change was close, as well, at 5 to 4. That added to the sense that something dramatic had happened.

The problem is that these mostly rhetorical surprises are, so to speak, a depreciating currency. It's theater that works well for a while, but then you need actions to make it believable. That's getting harder. The next policy announcements from the Japanese and European central banks are especially keenly awaited. Markets will be asking, "So what have you got?"

Less Than Zero

Making interest rates a bit more negative is one possibility. It turns out that the zero lower bound is a misnomer: As Denmark, Sweden, Switzerland and the euro area had already shown, the floor for nominal policy rates is a bit less than zero. But central banks can't move very far into negative territory without encountering serious financial and political obstacles.

To sustain significantly negative rates, paper money would have to be dethroned as the fundamental monetary standard. Another adjustment might seem even stranger. The idea that borrowers pay savers is pretty well entrenched; with significantly negative rates, savers pay borrowers. (Try explaining that on the stump.) The economics is correct. It could be done, and a lot of smart economists think it should be done -- but it wouldn't be easy, least of all for a central bank acting on its own initiative.

The alternative is to further expand the two banks' bond-buying programs. But they're already huge, their effectiveness is beginning to be questioned, and the consequences for financial stability give grounds for concern. Again, at best, it's a case of diminishing returns. How much bigger would these quantitative-easing programs need to be to provide the next supposedly stabilizing jolt?

Europe's QE Quandary

If demand and inflation fail to get back on track in Japan and Europe -- and if the disappointing fourth-quarter figures for U.S. gross domestic product are a sign that America's recovery is failing too -- monetary policy won't be enough. The shock that's required is hybrid macroeconomic policy, meaning an approach that explicitly combines fiscal expansion with monetary accommodation.

The idea is for governments to run bigger budget deficits -- with tax cuts and/or higher public spending -- then finance them not with borrowing but with newly created money. The most eye-catching variant is direct cash payments by central banks to households, or so-called helicopter money.

In ordinary times, such a policy would be reckless in the extreme -- it's a classic formula for letting government spending and inflation surge out of control. But when demand is persistently weak and the usual tools for boosting it aren't working, more spending and higher inflation should be part of the remedy.         

Compared with negative interest rates and ever-expanding QE, the economics of printing money to pay for fiscal stimulus is simple. There's little doubt such a policy would raise total spending and get you out of a persistent low-demand trap. Sufficient popular support seems achievable. Institutional resistance to the idea is strong, though, because it overthrows the hallowed principle of central-bank independence. In effect, the policy puts the central bank under the control of the finance ministry, an arrangement that often ends badly.

Again, in ordinary times, it would be a terrible idea -- but these aren't ordinary times. Political resistance would be intense in the U.S., and in Europe "direct monetary financing" is forbidden by EU rules that would be hard to change. Perhaps Japan is better placed. Since Kuroda likes surprises, he might reflect on the case for springing this one.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.