There are several tools in the monetary policy box. Since the financial crisis erupted in 2008, central banks around the world have used zero interest rates, negative interest rates and quantitative easing, or QE, to combat the downturn in terms of growth and inflation.
Now the world’s four largest central banks look set to modify their monetary policies before the end of the year, albeit in different directions.
In December, the Federal Reserve is expected to raise its benchmark interest rate for the first time in nine years, whereas the European Central Bank, Bank of Japan, and the People’s Bank of China will likely further relax monetary policy.
Economists have begun to question whether expansive monetary policy is achieving the desired effects. They are concerned that even more quantitative easing could even yield negative results.
In contrast, many of us – myself included – believe we would be in a deep recession without the measures taken by central banks to date. We also believe the world economy still needs to be stimulated through monetary policy.
The world economy still needs to be stimulated through monetary policy.
There are three main arguments to support the claim that the monetary policy has been ineffective.
First, the poor performance of risky investments and the renewed decline in inflation expectations in recent months are frequently cited as signs that cheap money has lost its magical effect.
There are also doubts over whether loose monetary policy can continue to drive up asset prices, because high-risk investments like stocks and bonds are already valued at significantly higher levels than at the height of quantitative easing in the United States.
Finally, monetary easing by central banks in countries and regions with current account surpluses, like the euro zone and China, in contrast to monetary easing in countries with a current account deficit, like the United States and the United Kingdom, could have deflationary effects globally.
In particular, I doubt that the poor performance of risky investments and declining inflation expectations in the last few months say anything about the lack of efficacy of monetary policy.
Instead, I see this as a consequence of uncertainties over China’s economic outlook and the exchange rate. Another source of uncertainty is the Fed’s first potential rate increase in years and fear of the market turbulence associated with it. The Fed’s “phantom rate increase” in the course of this year has triggered a chain reaction in the prices of financial investments.
If fears of the Fed tightening its monetary policy pushes down asset prices, why shouldn’t a further easing of interest rates help drive up prices?
The second argument – that it is more difficult to drive up valuations even further with monetary policy – sounds convincing. However, both stocks and bonds have become significantly “cheaper” recently. And I consider it unlikely that prices would decline if the ECB or the BOJ announced a substantial expansion of their respective programs.
This leaves the third argument: QE in “producing” countries like the euro zone could have a global deflationary impact because of the exchange rate effect, while QE in “consuming” countries like the United States tends to stimulate the global economy.
If everything else remains constant, QE in a country that is a relatively large consumer and importer will indeed stimulate the world economy more strongly, through higher exports to that country, than QE in a country that is a relatively small consumer and a larger exporter.
However, as their currencies appreciate, other central banks are likely to react and also relax their monetary policy. This should have an inflationary and not a deflationary effect on the global economy.
The bottom line is that the upcoming monetary easing by the ECB, as well as the Japanese and Chinese central banks, will likely overcompensate for the Fed’s potentially modest rate increase.
Although there are good reasons why every yen or euro invested in quantitative easing today produces less counter-value than in earlier rounds of easing, the results will likely be positive on balance. In my opinion, the declining effectiveness is even an argument to do more instead of less in the future.
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