The policy reaction function of many of the world’s major central banks looks to have changed and a number have yet again made a dovish shift. We argue that these central banks could be “trapped” in an ultra-loose monetary policy stance and are losing their ability to normalize policy. Moreover, this extended period of super-low-for-long rates is bringing diminishing returns and rising costs. Financial markets and central banks are becoming increasingly and unhealthily interconnected, generating complicated two-way feedback loops and systemic risks. We conclude by considering a number of alternate policy paths.
While understandable – particularly given the inflation mandates of these central banks – we see declining benefits and rising risks from this policy path. Indeed, ultra-loose monetary policy can:
- increase financial vulnerability and financial stability risks, from the consequent rise in leverage;
- adversely impact potential growth and productivity by keeping “zombie” companies alive;
- similarly, misallocate capital and crowd out more efficient resource allocation;
- weaken bank profitability, potentially to the point where lending functions are impaired - the so called “reversal rate”;
- impose distributional costs, for example a) causing rising wealth inequality from the consequent boost to asset prices, and which appears to be creating backlash and support for populist policies globally; and b) lead to uneven impacts on the savings balances of retirees and the younger generation seeking to save for a first home.
We have also observed a complicated and potentially dangerous sensitivity and interconnectedness growing between central banks and financial markets. Central banks increasingly need positive wealth effects for their ultra-loose policies to have the desired impact and are incentivized to deliver “no surprises” to markets. However, this can create moral hazard and risks excessive leverage and risk-taking.
As policy-encouraged debt levels grow over time, the economy becomes less able to handle a return to historically more normal rates; we could be trapped in a low-rate world.
Is there an alternate path; how can we get out of this?
We believe that maintaining overburdened monetary policy settings (i.e., more of the same) could be helpful in the short term but increases longer-term systemic risks. A more balanced policy mix, with less reliance on monetary policy and more focus on fiscal policy and structural reform would be a better option. At a minimum, an expanded toolkit for central banks, with more control over macroprudential policy and FX management could help too. Developed market policymakers could learn from EM, as the latter has taken the lead on the successful implementation of macroprudential measures.
For more details, read our full report here.
Head of Global Macro Research and Co-head of Global Markets Research
Rates Strategist, Australia