Short Read

Lessons from the crash and today’s trends in Western monetary policy

The coronavirus pandemic, and the ensuing economic crisis, has provoked unprecedented responses from policy makers, no more so than from central banks. The Federal Reserve’s major actions include purchasing up to $750 billion of investment-grade corporate debt and lowering its discount window rate to 1.5% – lower than it ever was in the GFC. This makes the Fed’s additional pledge to buy $700 billion in government-backed securities (Treasuries and MBS) – what would otherwise be an astonishing policy move – seem trivial. Other central banks in OECD countries have promised similar moves. Some CBs have even floated the idea of directly purchasing corporate equity. Few would question the Fed’s actions in this crisis – indeed some would say it hasn’t gone far enough. However, these actions nevertheless represent the continuation of a dangerous trend in central banking in Western countries (particularly the Fed, BoE and ECB): monetary policy is becoming ever looser.

Before exploring the negative consequences of such a trend, we must first convince ourselves of its existence. That this ‘easing’ trend exists is immediately intuitive when considering where base rates currently lie. For example, even before the virus-induced economic crisis, the ECB bank rate was 0%. Central bankers would argue that macroeconomic conditions, such as weak aggregate demand and relatively low inflation, have called for easy monetary policy. However, the two graphs below show how, historically, interest rates are very low, even when taking into account tepid growth and inflation. This can be seen by looking at the gap between the effective fed funds rate and the rate of GDP growth/ inflation. In both cases, this gap has, on average, narrowed over the last thirty years and, for the last 10 years, the funds rate has been substantially, and unusually, below both GDP growth and inflation.

Figure 1 – graph of the effective federal funds rate and US inflation rate over the last 65 years – the last 20 years have seen roughly 15 years when the inflation rate was higher than the fed funds rate, a situation otherwise rarely seen in the last 65 years
Source: https://commons.wikimedia.org/wiki/File:Inflation_compared_to_federal_funds_rate.jpg
Figure 2 – graph of the effective fed funds rate and US real GDP growth over the last 65 years – the last 20 years have seen roughly 15 years when the GDP growth rate was higher than the fed funds rate, a situation otherwise rarely seen in the last 65 years
Source: https://seekingalpha.com/article/4308697-weekly-economic-release-summary-federal-funds-rate-is-too-low

Furthermore, not only are interest rates historically low, but the range of other tools used to stimulate the economy is historically high. This can be seen with by observing the Fed’s balance sheet:

Figure 3 – graph of the Fed’s assets, broken down by type, over the last 20 years (this graph does not include purchases made in 2020) – since 2008, the range and quantity of assets held by the Fed have risen sharply
Source: https://www.brookings.edu/blog/up-front/2019/05/17/the-feds-bigger-balance-sheet-in-an-era-of-amplereserves/

Indeed, 15 years ago, the idea of QE would have been preposterous – now, it has become standard policy. This current economic crisis has seen a further expansion of central banks’ toolboxes, with the Fed, for example, buying stakes in high-yield corporate debt ETFs. While central bankers insist these actions are temporary, the continuation of QE post the 2008 recession has taught us that these new tools are likely here to stay.

It is evident that monetary policy in Western countries, such as the US, has on average trended looser since 1985, with the last decade seeing extremely loose policy by historical standards. Standard economic theory would hold this should boost AD and stimulate the economy in the shortterm. However, there are serious long-term unintended consequences of ever-loosening policy, and consequences which evoke memories of 2008-09.

The first is that of moral hazard, especially in financial markets. If market participants believe that central banks will always stabilise markets and provide support to boost credit and asset prices, this can lead to moral hazard, in the same way as the ‘too big to fail’ philosophy created moral hazard in the 2006-08 subprime crisis. Nor have central banks dispelled this notion – in January 2019, for example, a sharp fall in US equity prices led almost directly to the Fed reversing its policy. With financiers often referring to the existence of the so-called ‘Powell put’, moral hazard is clearly prevalent. The result of this is artificially high asset prices – a bubble – since downside risk is not effectively priced in.

Secondly, low interest rates can lead to a rise in the number of zombie companies. These are companies that are heavily leveraged and are only solvent because debt is cheap. One survey estimates that 12% of publicly traded US companies may fall under this classification. These companies are the Freddie Macs and Fannie Maes of corporate debt, full of low-quality debt waiting to explode. As the 2008 financial crisis showed us, a combination of moral hazard, easy lending conditions and a high amount of low quality debt can be a toxic cocktail.

Finally, and even more worryingly, if monetary policy continues on an ‘easing trend’, it reduces the effectiveness of monetary stimulus. There are two reasons for this. Firstly, if market participants expect monetary policy to trend looser over time, then the stimulus effect will be somewhat negated, since it is already expected. Secondly, if base rates are already at 0%, there is very little scope to lower them further. The only way for central banks to continue to ease monetary policy is to employ new tools. In the 2008 recession, it was QE; today, it is the purchasing of barely investment-grade corporate debt; who knows what it will be in future crises?

It is very unlikely that the immediate future will see a reversal of easy policy. That is justified: with the IMF predicting the worst global recession since the Great Depression and with 22 million people having been rendered unemployed in America in the last few weeks, not even the most hawkish would advocate for tighter policy. However, there are very real consequences of allowing monetary policy to stay very loose: US nonfinancial corporate debt, for example, stands at 48% of GDP (in 2008 Q3 it was 44%) and it is not difficult to see parallels with the subprime lending bubble. More scarily, monetary policy may be even less effective this time in cushioning the crash.

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