The Limits of Monetary Policy

by George Hatjoullis

There was nothing very surprising in Mario Draghi’s ECB press conference. He promised to ease more. There was nothing very surprising in the market response. Previous announcements of easing have been accompanied by rising asset prices. This is not illogical as the tools being deployed involve printing money to purchase assets. This has both direct and indirect (positive) effects on asset prices. Like Pavlov’s dogs that were conditioned to salivate on the sound of a bell (on expectation of food), so the markets salivate when they hear ‘more easing’. There is no doubt more easing will follow from the ECB.

The object of ECB policy is not however asset price inflation. It is goods price inflation. Asset price inflation is a channel through which the ECB hopes to influence goods price inflation. Is this channel effective? Low interest rates and Quantitative Easing have been features of the monetary policy seen globally since 2009. Asset prices have soared since 2009. Inflation is nowhere in evidence. In fact we have experienced deflation, a great deflation. Now many bankers would dispute this assertion. Inflation has flatlined close to zero but has not been negative for long periods. Moreover, measures of so-called ‘core’ inflation have been higher. All true enough but rather missing the point.

How many central banks have zero as the target inflation rate? None to my knowledge. It is more common for 2% to be the target. The verbal part of central bank mandates exhorts them to achieve ‘price stability’. If they target 2% then one must assume that this represents price stability ( and not 0%). Inflation has been persistently below 2% in major economies. Hence we have had deflation. One might also note that even ‘core’ measures have been below 2%. Why then, despite ultra easy monetary policy everywhere for 6 years, do we have deflation?

The intensity of the global inflationary shock that was caused by the 2008 financial crisis was bigger than anyone seems to have grasped. It would have been much worse had certain  actions not been take. One grossly misunderstood action was bank recapitalisation by governments. This protected the unsecured depositors and senior bond holders. Imagine a global experience like that of Cyprus in 2013. Cyprus currently has 70% loan delinquency with 59% categorised as serious. Bank shareholders globally lost money. Banks contracted staffing levels. Junior bond holders lost money. Unsecured depositors remained untouched (except in Cyprus). Today Lloyds bank shares trade above the price at which the UK government purchased them. Who got bailed out at the expense of whom? Nevertheless, the reaction of the peanut gallery to the so-called bank bailout jaundiced attitudes to banks. There was a strong reaction to ‘too big to fail’ classification of banks. All this did was put unsecured depositors potentially at risk thus instantly degrading the practice that all bank deposits are money. Insured deposits perhaps still are but unsecured deposits are simply that, unsecured loans to banks that you can access. An overnight collapse in the money stock. This exacerbated the initial inflationary shock in a less visible way.

Many dispute the materiality of the collapse in the money stock. After all QE put money directly into the system. The CB buys assets and gives cash to the holder. Many of these assets are risk free government bonds. What does the holder do with the cash? Put it in a bank as an unsecured deposit? QE removed risk free near money assets from the system just when they were most needed. How did this help boost inflation? It did reduce yields on risk free assets to very low levels and this affected the cost of borrowing. It does not however seem to have encouraged borrowing for investment in productive activity. The main effect seems to have been to boost purchases of other assets such as equities and property. Companies bought back their own stock rather than build new plant. So QE is good for asset prices but after 6 years we still have deflation.

The deflation reflects a global economy operating well below potential. It reflects a lack of demand relative to potential supply. During the boom years countries such as China grew rapidly through domestic investment in productive capacity. This encouraged investment globally in supplier industries, notably extractive industries. Initially such booms are self feeding but eventually capacity outstrips demand (much of it created by the investment itself) and overcapacity sets in. This is where the global economy finds itself today. So what is going on with demand?

Demand took an enormous hit following 2008. Deleveraging became the watchword for governments and consumers (and banks). This means more saving and less spending. Wages have grown slowly, if at all, so spending out of current income has been muted. This may seem odd with all this asset price inflation but unfortunately assets were not well-distributed. Income and wealth inequality has not diminished and may even have widened further. The world badly needs some wage growth. Indeed only wage growth, both absolute and relative, is needed. How does QE lead to greater wage growth? Do email me the answer and explain why it has not already done so to any appreciable extent.

Monetary policy within the confines of conventional policy has limits. It can make ample and cheap liquidity available to banks to lend. It cannot make them lend or people borrow to spend on goods. It can boost asset prices which can have positive effects on demand but this is constrained by the distribution of assets. Wealth inequality is large. However, even the asset price boost has limits, at least for those assets connected to real activity. These are risky assets, unlike those bought by the CB, and risk perceptions can change. If demand does not materialise nor will earnings. Sometimes the bell rings and food does not appear.