Central bankers will fight the next recession with their backs against the wall

Will the weapons of the last crisis work in the next one?

Oct 11th 2018Print edition | Special report

EARLY IN 2001, while the rest of America was recovering from the holiday season, the Fed’s monetary-policy committee convened for a conference call on the state of the economy. Spooked by poor Christmas sales and rising unemployment, it moved boldly, cutting rates by half a percentage point. “I believe that the markets and the leaders of major firms…are at or near a point of psychological crisis,” said the Fed’s vice-chairman, William McDonough. “The pessimism about what is likely to happen in the economy is at a point where it can start feeding upon itself.” The economy was not obviously on the brink, and share prices remained exalted. But the Fed wanted to head off a downturn before it had begun.

As it turned out, 50 basis points were not remotely enough to do that. As America sank into recession, then limped through a fragile recovery, the Fed slashed rates from 6.5% to 1%. But at least it had the room to do that. Its rate had barely got back above 5% when, in early 2007, a collapsing housing market forced a return to cutting; in late 2008, as the full extent of the recession was only just becoming clear, rates dropped to near zero, leaving the Fed to combat the worst downturn in generations without its main weapon.

Empirical assessments of QE programmes convey mixed messages about their impact

The next recession will probably be more like that of 2001 than the one that started in 2007 in its severity and in the risk it poses to the financial system. But the central bankers who will be tackling it will start with their backs against the wall. Every step taken to restore the economy to health will be less certain to work. That uncertainty will provide room for pessimism to feed on itself and perhaps grow into something unmanageable.

Since the 1980s, advanced economies have relied on central banks to smooth the business cycle by adjusting short-term interest rates. Rate increases affect economic activity directly, by discouraging borrowing and encouraging saving, and indirectly, by signalling to markets that the central bank intends to slow growth. Rate cuts work in the opposite way. But once rates get close to zero, it is as if the accelerator of an automobile were pushed to the floor.

Much of the world is likely to have to fight the next downturn with its armoury severely depleted. Markets reckon that American short-term rates will remain below 3% until the end of 2020. Rates in Britain are expected to be no higher than 1.5% at that point, and to be barely positive in the euro area and Japan. Barring a dramatic change in circumstances, the main tool of monetary policy over the past few decades will be unavailable. Central banks will almost immediately have to rely on the much more contentious and less certain instrument of quantitative easing (QE).

Such money-funded asset purchases were used widely during and after the 2007-08 crisis; they continue in Europe and Japan. QE is thought to work in several different ways. Banks hold bonds as a safe but better-yielding alternative to cash. When central banks buy bonds, it is assumed that banks, rather than keep the cash, will buy better-yielding replacements. Those purchases should raise asset prices and reduce borrowing costs across the economy, making it more attractive to borrow and invest. By lowering rates on long-term government bonds, QE can also loosen borrowing constraints on the government and perhaps allow it to ease fiscal policy. And QE might encourage the economy’s “animal spirits”, persuading people that the central bank is committed to growth.

Yet the effectiveness of asset purchases depends on whether markets believe they are permanent or will be unwound in due course. The Fed has been allowing its balance-sheet to shrink, declining to redeploy all of the cash it is paid when bonds mature. It is probably undermining the effectiveness of future QE by indicating that most purchases are likely to be temporary.

QE will also be undermined by the low level of long-term rates, which is likely to continue. The smaller the difference between the yield on the new money, credited to bank reserves, that the central bank uses to purchase bonds and that on the bonds being purchased, the less of an incentive banks will have to hunt for other assets to replace their government bonds. Central banks could deal with this by buying more exotic assets, on which yields remain high. But that would expose them to a greater risk of financial losses, which could invite political scrutiny. In America the law explicitly authorises the Fed to buy debt securities with government guarantees, as well as foreign exchange and gold. Corporate bonds and stocks are not specifically authorised. If the Fed tried to buy them, it might face a court challenge.

The ECB faces its own constraints. If European QE ends in December, its balance-sheet will have grown from around €1.5trn ($1.8trn) before the crisis to roughly €5trn. In March 2015 the ECB intended to buy no more than 25% of an issuer’s outstanding bonds, to avoid becoming the primary creditor to euro-area governments. The threshold was raised to 33%. Germany’s shrinking debt (a result of its persistent budget surpluses) posed a particular problem; earlier this year the ECB began buying bonds issued by state-owned German banks in order to keep up the German share of purchases. Should a new downturn require the resumption of purchases, they will quickly threaten to make the ECB the main creditor of several member states and important financial institutions, or else lead to a wildly disproportionate share of purchases flowing to the most troubled states, or both. At some point the ECB may feel that it is assuming too much political risk and may ask for more explicit support from member states. That could make it cautious to restart QE or use a new programme.

Much of this is a matter of theory, however. Empirical assessments of QE programmes convey mixed messages about their impact, and are hamstrung by the difficulty of isolating the effect of one policy among many on complex economies buffeted by many forces. What is more, central banks are often less than clear on their precise intentions when beginning QE. Programmes and justifications evolve over time.

Perhaps most important, QE remains politically controversial. When it was first introduced in America, Republicans accused the Fed of courting hyperinflation. Germany sees the ECB’s asset-purchase programmes as debt monetisation: a backdoor bail-out of governments that lack the moral courage to balance their budgets. The rub for central banks is that what makes asset purchases most effective—a promise not to reverse them, paired with a commitment to reflate a sagging economy—is also most likely to rile politicians worried about fiscal moral hazard and runaway inflation.

Monetary policy works, in large part, by increasing borrowing and spending, but success depends on there being willing and able borrowers, who in times of economic trouble may be in short supply. Corporate debt has been soaring in recent years, which suggests firms will not be particularly eager to take further advantage of easier monetary policy. Firms with large cash piles could help by spending them down, but seem to have been keener to use their lucre for dividends and share buy-backs than for new investment.

Households could help, but rich-world consumers continue to carry large debt loads. Recent work by Atif Mian of Princeton University and others examines 30 countries in 1960-2012 and concludes that a rise in the ratio of household debt to GDP is associated with lower GDP growth and higher subsequent unemployment. Households might be induced to borrow more by a rise in expected income growth, but such expectations would be more likely to decline during a downturn.

That leaves the government, which picked up much of the slack during the global financial crisis. The price was a significantly higher level of public debt. Most large emerging economies must worry that large-scale borrowing could put market confidence in their solvency at risk, as Brazil has found for much of the past few years. China is in a different situation. Its tight control over its financial system gives it more freedom to borrow cheaply, and its central-government debt is relatively modest. But its public purse might have to assume responsibility for bad corporate and local-government debts, so tacking on a fiscal stimulus large enough to buoy the global economy could look too risky.

Rich countries which borrow in their own currencies have more capacity to support their economies—if politics allows. A loss of confidence in the creditworthiness of the American government is unlikely , but if the economy were to enter the next recession with a deficit of 5% of GDP and debt in excess of 100% of GDP, a large stimulus might be politically toxic. In Europe, restrictions on government borrowing adopted in the wake of the euro-area crisis complicate new stimulus.

As the next downturn approaches, the initial response will be to hope for it to blow over. If it persists, central banks will no doubt start to deploy QE, and some anxious governments might turn to fiscal stimulus. If recovery proves elusive, politicians will feel compelled to turn to more dramatic measures.