What if monetary policy fails?

Tracey McNaughton

Escala Partners

I came across a person in the street wearing a t-shirt that had printed on it “What if Google was wrong?” It was unnerving. Google is the answer to every question from the most mundane to the most complex. Comfort and certainty come from assuming Google is the definitive arbiter of what is right. It is with the same level of angst and trepidation that I ask: what if monetary policy fails?

Monetary policy has been a cornerstone tool of economic management ever since the Bank of England was created in 1694. Back then the central banks’ role was to print notes and back them with gold.

The appeal of having a gold standard was that it removed the power to print money from the hands of imperfect human beings. The physical quantity of gold acted as a limit to how much money could be printed. President Herbert Hoover famously said in 1933, "We have gold because we cannot trust governments".

The switch to a fiat system changed all of this. Suddenly, the amount of money that could be printed was not limited by any physical commodity. The move to fiat currency meant that we now had to trust governments. Fiat money was legal tender by way of government decree.

Trust and monetary policy have been closely intertwined ever since. Indeed, the principal transmission mechanism for monetary policy to flow through an economy is via the credit channel. The Latin root word for credit is “trust”.

Developed market central banks have always been careful to protect their credibility. Legislating central bank independence, introducing inflation targeting and forward guidance, and carefully scripted communication was all part of boosting the credibility of the central bank.

Biggest test for monetary policy

Arguably, the biggest test that monetary policy has ever confronted was dealing with the Global Financial Crisis (GFC). Dysfunctional politics within governments essentially meant that monetary policy was “the only game in town” to quote Mohamed El-Erian. Central banks were called upon to perform miracles to get economic growth going again.

Not surprisingly, monetary policy has fallen short. After cutting interest rates to 0.25% from 5.25%, the US Federal Reserve introduced quantitative easing (QE) in December 2008. By buying bonds, yields were pushed down and valuations on all risk assets improved. The idea was this would increase asset prices and create a wealth effect that would ultimately lead to higher consumption and a self-sustaining economic cycle.

While it did lift the US out of recession and extend the cycle, the outcome underwhelmed. The US economy is about to clock up a record 10 years of uninterrupted growth. But it has also been the weakest period of uninterrupted growth on record. Since it began in Q4 2009 to today, US GDP has averaged just 1.9%, well short of the post-war average of 4.4% (Chart).

The shortcomings of monetary policy alone to drive economies out of their post-crisis funk have been known for some time. Way back in 2015, then Governor of the Reserve Bank of Australia (RBA) Glenn Stevens said: 

“Monetary policy alone can’t deliver everything we need and expecting too much from it can lead, in time, to much bigger problems”. 

That prescient comment came almost a year to the day before the referendum in the UK that would lead to a populist revolt we now know as Brexit.

Relying on monetary policy alone not only failed, it made the situation worse by increasing income and wealth inequality (underpinning the rise in populism). While wages for the top 1% of US households have increased by over 150% over the past 40 years, real annual wages for the bottom 90% have risen just 20%. And yet, Lamborghini sales have been hitting record highs each and every year since 2014 (Chart).

Governor Stevens went on to say “at this point, monetary policy’s power simply to summon up more demand with lower interest rates could be less than it used to be”. The RBA then estimated 1% was as low as the cash rate could be cut after which unconventional tools will need to be considered. This is just two 25bpts rate cuts from where we are today.

So, if conventional monetary policy is once again close to its limits and quantitative easing has been shown to be ineffective, what is the answer?

Enter Modern Monetary Theory (MMT)

The deeper down the road of unconventional monetary policy we progress, the more the line between fiscal and monetary policy becomes blurred.

On the one hand, MMT says if an economy prints its own currency, why can’t its government increase debt? It can never run out of the currency it prints and it can use this debt to more directly boost growth through targeted fiscal measures. It was these targeted fiscal measures that was missing from the (US and EU) policy tool kit post the GFC. The level of bond issuance can be controlled with the central bank purchasing the bonds directly from the government – à la QE.

Opponents of MMT would argue that this weakens the independence of the central bank and increases the risk of inflation by granting unfettered access to the printing press by imperfect governments.

A long list of well-respected economists both in academia and in financial markets are behind the idea of MMT as a way or re-dressing the shortcomings of monetary policy operating at or close to 0% interest rates. It is building on the ideas of pre-eminent economists such as Hyman Minsky who believed that prolonged periods of economic stability breeds complacency, and complacency leads to excessive risk taking which ultimately leads to vulnerability. Sound familiar?

Whatever you want to call it, there is a need for government to step in to address income and wealth inequality. Without more income equality there is no gain in wages. Without wage gains there is no consumption. Without consumption there is no inflation. If monetary policy has failed, as it appears to have, then government needs to play a greater role.

We are happy to maintain a neutral position on bonds despite the recent rally of the past 5 months. In the absence of inflation, and with rate hikes off the agenda for now, we expect bond yields to trade in a relatively narrow range in the near-to-medium term. 

Tracey McNaughton
Tracey McNaughton
Chief Investment Officer
Escala Partners

Tracey was appointed Chief Investment Officer at Escala Partners in November 2019. In this role she has responsibility for strategic and tactical asset allocation and manager selection across all multi-asset funds, and is Chair of the Escala...

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