Prudent or Pernicious? Central Bank Policy in a Time of (un)Certain Growth

Since the 2008 global financial crisis, central banks across the globe have taken unprecedented steps to ensure the viability of the global economy. With a stable recovery finally setting in, these steps have begun to be reversed, at the expense of economic stimulus. In this context, central bank independence has come under threat in recent months. In India, Prime Minister Narendra Modi’s campaign of political pressureon the Reserve Bank of India was rewarded with stimulative interest rate cuts in time for his reelection and the resignation of his top monetary official. Likewise, in the United States, President Donald Trump called the Federal Reserve his “biggest threat”to economic growth; his criticisms of the Fed represent the first time a sitting president has openly pressured the Fed since George H. W. Bush almost thirty years ago. In all, elevenmajor central banks, on six continents, have recently faced intense attacks to their independence. While certainly the desire for a government to keep economic policy accommodative is not new, are central banks really a danger to the global economy or is the pressure indicative of a precarious position in which central banks have found themselves?

One year ago, in late January, the wealthy and powerful met in Davos, Switzerland for the World Economic Forum. The prognosisfor 2018 heralded a breakout year for economies around the world, which would finally get the recessionary monkey off their back. Indeed, business confidence was at its highest in six years and the IMF was hailing global surges in growth. Governments could finally see some daylight.

Thus, in such great circumstances, central banks around the world decided it was the optimal time to return to a post-crisis ‘normality’. The severity of the 2008 recession had forced central banks to undertake massive expansions in operations and tactics. A central bank’s favored tool, the interest rate, had been lowered to virtually zero by the beginning of 2009, as lower interest rates theoretically make investment and current consumption less costly. However, interest rates cannot be lowered past zero, meaning central banks had reached what is called the ‘zero lower-bound’, where conventional monetary policy becomes ineffective. Thus, new programs like quantitative easing (QE), the purchasing of assets by the central bank to keep markets from stagnating, were greatly expanded to the tune of trillions of dollars worldwide.

Ultra-low interest rates and QE, although necessary for reviving the economy, are dangerous to keep far into the future. Such policies encourage accelerated inflation by increasing the use of money in the economy and, if another recession were to hit, would afford a central bank almost no room in which to operate (even the central bank has a limit to how much money it can spend). Thus, like Pavlov’s dogs hearing a bell, central bankers began to salivate at the uptick in inflation and growth. While the European Central Bank (ECB) endedits QE program and the Bank of England raised interest rates, the most aggressive policy in 2018 camefrom the Fed in the form of four rate hikes. However, while the Fed was “bullish” on outlooks for US growth and the ECB was “undeterred” by weakening growth in mid-2018, markets were not so convinced. The Fed’s last hike in 2018 set US stocks up for their worst Decembersince the Great Depression, ahead of an expectedthree more hikes in 2019.

Indeed, the end of 2018 was a harbinger for a change in the wind for 2019. IMF entered January issuing a report titled “A Weakening Global Expansion”,in which the international economic group predicted that risks such as China’s slowing growth, Brexit uncertainty, and increased trade tensions would lead to a decline in growth for the next two to three years, especially in advanced economies. In Davos, a year later, formerly-optimistic businessmen were greeted with a Toblerone and newsthat global manufacturing activity was at a two-and-a-half year low. Deutsche Bank broadcastedthat the US economy, the crown jewel of the economic recovery, could be pushed into recession if trade tensions with China and Europe escalated. People also began to rememberthat some countries, especially in southern and eastern Europe, are almost no better off now than a decade ago.

Thus, it may not be a surprise that by the end of January, the Fed had issued a moratorium on any future rate hikes in 2019, a major reversal in the policy from the past several years. The Australian central bank chairman said his next rate movement may even be downwards. Jerome Powell, the chairman of the Federal Reserve, cited“a contradictory picture of generally strong U.S. macroeconomic performance, alongside growing evidence of crosscurrents” as a reason to become patient. However, it seems that the Fed had arrived late to the party: markets had already been worried about these concerns several months and several rate hikes ago.

Image courtesy of Wikimedia, © 2017, some rights reserved.

Is it then that poor policy by the central banks became a threat to the economy? Mohamed El-Erian, chief economic adviser at Allianz, says that the sudden change in global central bank policy is due to central banks realizing that they had become “overly bullish”and over-reached with rate hikes at a time when the global economy was still fragile. To El-Erian, the Fed, perhaps desperate to get some distance between itself and the zero lower-bound and forever looking over its shoulder for the phantom of rampant inflation, raised rates in the face of less-than-favorable general economic indicators. Surprisingly, James Bullard, the president of the St. Louis Federal Reserve Bank, echoes El-Erian; Bullard callsthe current rates in the US restrictive and damaging to the credibility of the Fed. Evidently, experts and politicians are beginning to agree that the central banks have had a hand in damaging the current state of the economy.

However, while in hindsight many may be able to criticize the central banks for too many rate hikes, the central banks can only operate on the set of constraints it faces at any given time. In early 2018, encouraged by consistent economic growth, central banks would find it sensible to raise rates as fast as they safely could. Experts believedat the 2017 level of rates, the Eurozone would not be prepared for another recession. Norway’s central bank governor saidthat if there was a downturn, it would be extremely difficult for the ECB to give necessary support to the economy. Thus, in the face of uncertainty with Brexit and US-China trade relations, it was prudent to raise rates and give some breathing room. At the outset, central banks did not believe the hikes were high enough to significantly slow the economy.

However, the constraints on central banks have obviously changed since early 2018. Economic concerns that were on the radar at Davos 2018 were upgraded to legitimate threats at Davos 2019. With a weakening economy, the path of rate increases could not be feasibly kept, at least in the short term.

Further, rather than reckless monetary policy being the cause of economic strife, it may be reckless fiscal policy on the part of the government. In the United States, Trump’s trade war with China, which has already shaved off .4%from US growth, is coinciding with the lapse of his huge pro-cyclical stimulus package,  business and individual tax cuts passed in 2017. While the tax cuts have boosted the US economy (and inflation) for the past two years, it may have also entered the decision-making of the Fed. To keep inflation at a reasonable level, the Fed can decide to increase rates; thus, the tax cuts may have only made the Fed more likely to follow their chosen path. Now, the US economy faces the double risk of decreased stimulus in the economy with the deleterious impact of trade tensions with China and Europe, constraining Fed policy in the opposite direction.

Nevertheless, while market analysts may have you believe the bell of the New York Stock Exchange may be tolling the death knell of the current global expansion, the decision of central banks around the world to take a pause may be only just that: a pause. Janet Yellen, the former chairwoman of the Federal Reserve, came to the aid of Powell with her explanationthat the economy has reached its peak in the tightening portion of the business cycle. Consequently, this may be as bad as it gets. If central banks can weather the risks to growth that the IMF outlined and no severely negative shock hits the global economy, greener pastures may still be ahead. However, monetary policy is complex, and the unconventional monetary policy that has become the new normal is even more so. A central bank must be prepared for any of several possible outcomes, and this is where banks like the Fed find themselves now. The decision to continue to raise rates comes at the expense of potentially extra strain on an economy plagued by both structural and manufactured threats to growth. The decision to not raise rates comes at the expense of constraining future policy options in the case of another recession. Monetary policy is not as clear-cut as raising interest rates equaling lower growth, no matter how much Trump tweets that. While central banks are certainly not free from error, they find themselves in an extremely constrained position with no easy answers; their independence and prudence may be the saving grace rather than the fatal flaw.

Banner image courtesy of OECD via Flickr, © 2019, some rights reserved.

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