What is the Global Monetary Policy End Game?

Furthermore, despite the Fed’s attempt at normalizing rates last year, the economy appears too weak to endure more than one token rate hike.

Incremental monetary policy measures appear to not be working – or at least growing increasingly ineffectual and “irrelevant.” Maybe Quantitative Easing (QE) only works if you are the only country doing it? The United States was able to meaningfully increase employment during the Fed’s multiple rounds of QE. Yet since 2014, real economic growth and inflation haven’t been able to push north of 2%.

The global experience with QE and negative yields is less optimistic. The European Central Bank is buying the equivalent of $90 billion a month of securities with its deposit rate at -0.40%, the Bank of Japan (BoJ) is buying the equivalent of $70 billion a month of securities with its deposit rate at -0.10%, and the Bank of England (BoE) is buying $14 billion a month of securities with its deposit rate at 0.25%. Each of these central banks is expected to further expand their balance sheets and further lower their deposit rates. Meaningful economic growth and inflation are not expected in Europe, Japan, or England. Monetary policy alone cannot address the many, longrun structural factors impeding growth. These factors include excessive debt levels, poor demographics, onerous regulations, misallocation of capital and income inequality. Yet, how can we escape misguided monetary policy measures on a global scale?

The Optimal End Game – Prosperous Economic Growth
If economic growth (and to some degree inflation) were to return to pre-financial crisis levels, then central banks could declare victory, raise rates and shrink their balance sheets. To achieve this, fiscal stimulus could take on more of the heavy lifting. This is a theme that many are predicting globally, as Prime Minister Abe in Japan likely prepares for increased fiscal spending and the U.S. could see a fiscal spending package floated following November’s Presidential election. While projects improving outdated infrastructure should be economically beneficial, the degree to which fiscal spending will bring about higher growth depends on an unknown fiscal multiplier effect. Regardless, hopes for growth are tempered as the global economy has continually underwhelmed expectations since 2009. To the degree that QE and negative rates pull growth from the future to smooth out current growth, then there should be less growth to be expected in the future. The harmful, unintended side effects of QE and negative rates could also be limiting growth. Negative rates destroy the “positive float” business models of many industries, they erroneously address the level of credit as opposed to the willingness to borrow, they deliver pernicious economic signaling effects as things must be very bad for them to be implemented in the first place, and they crush banks who are unable to pass the charges on to depositors – despite these banks being relied upon to lend to jumpstart the economy. Why, then, don’t central banks just abandon these policies?

The Unlikely End Game – A Global Re-Think
Central banks are constrained by the mandates they are given. Specifically, they are mandated to pursue stable inflation (price stability) and economic growth (full employment or an implicit assumption). Their mandates do not provide clauses to abort the mission due to extraneous circumstances. Thus, despite the global awareness that fiscal policy should be doing more heavy lifting and monetary policy should be less relied upon – if at all, political leaders are not mandated towards action like central bankers are. The only way that these policies can be exited without achieving said targets is if policy makers consciously decide to abort their mandates. Central bank chairs Kuroda, Draghi, Carney, and Yellen would all have to relent at the same time. This is a classic example of a prisoner’s dilemma. While there is nothing preventing increased cooperation in the game theory of global monetary policy (possibly at a G-20 meeting), it is extremely unlikely that these central banking institutions would all agree to reject the current status-quo. Thus, we appear to be trapped in a sub-optimal outcome.

The Undesirable End Game – More of the Same
If central banks are waiting on strong growth and inflation to exit their monetary policies, and their policies are to some degree inhibiting as opposed to facilitating these conditions materializing, then that leaves them in a stalemate. This results in a vicious circle of prolonged negative rate expectations. The market is priced for this, as global rates curves are not pricing in hikes by the ECB, BoJ, or BoE in the next 5 years. While the Fed is the exception to the global norm currently, any weakness in the U.S. economy could lead to the Fed quickly falling back in line with other global central banks. Furthermore, despite the Fed’s hawkish talk, the U.S. rates curve is extremely dovish in its hiking expectations. The first full Fed hike is not priced until mid-2017.

Conclusion:
When businesses fail to innovate, they quickly become zombie corporations. When central banks fail to innovate, they move the stated goal posts and keep doing more of the same. With most developed market economies enduring negative rates and bloated central bank balance sheets amidst inadequate economic growth, global central bank policy makers should increasingly question their actions and think about their mandates within a bigger economic picture. Yet, barring a stronger global economy that allows for a graceful exit from these policies, the most likely near-term outcome appears to be more of the same.

Brian Smith – Senior Vice President U.S. Fixed Income – TCW