Economics

Can Central Banks Save the Economy Again?

5 Min Read

Since the financial crisis, we've seen central banks using both conventional and unconventional monetary policies at unprecedented levels. But, what knock-on effect will these have on the ability of the central banks to cope with future negative situations?

We'll focus on the US Federal Reserve in this article, but the same points can be applied to most major central banks.

How Policy Was Used

The Federal Reserve used three main policy responses to tackle the financial crisis.

The first policy was to slash interest rates to record low levels of near-zero.

Since the crisis was much bigger and deeper than originally anticipated, lowering the short-term rates on their own only provided a limited boost to the economy and it soon became obvious that it just wasn't enough.

Therefore, an unconventional measure was used instead, which was to begin the process of quantitative easing (QE). This would have a more lasting impact since it would effectively be like lowering long-term interest rates.

We also know that central banks use forward guidance to encourage specific reactions in the economy. Alongside QE, this was also designed to lower long term rates by the Fed. By clearly defining their motivations and targets, it allowed the markets to know a bit more about what to expect.

What About a Future Recession?

Recessions take place because we can't have a perfect tightening cycle (raising rates or unwinding the quantitative easing).

Typically the short term debt cycle is every 7 to 8 years. We are now over 10 years into the current cycle and should, therefore, be thinking about what the next steps could be for central banks.

However, this is where there is a potential issue, as there are some big obstacles due to the current monetary policy.

To start with, interest rates are still at historical lows. In the last three recessions, the Federal Reserve had to cut rates by at least 5%.

What's concerning this time, is that the Fed is only expecting rates to hit 3%. This means they'll be extremely limited when it comes to lowering rates further and the sort of impact it may have.

Secondly, quantitative easing has already had a maximised effect. The Federal Reserve has said that asset purchases would only have a limited effect in battling the initial downturn of the next recession.

That means the Federal Reserve and other major central banks are going to have to experiment with unconventional monetary policy in order to push the economy in the right direction. Which is mainly unknown territory

What unconventional monetary policy tools could central banks make use of?

Janet Yellen, the former Federal Reserve chairwoman said she believes forward guidance should be used much more aggressively and quickly in the next downturn.

In her opinion, the Federal Reserve should bring down long-term rates substantially. This can be done by using forward guidance to assure the markets that short-term rates will stay low for a very long time; much longer than with a typical monetary policy response.

Another unconventional policy a central bank may use is negative interest rates. It would be a first for the Federal Reserve, however, they have been used by other central banks, such as the ECB.

On the surface, It may seem ridiculous to think that people would pay for banks to hold money or for investors to buy a government bond with a negative yield, but the bank may be able to encourage investors to shift to something more productive than government bonds. Maybe something that could have a greater impact on stimulating the economy.

Many people believe the Federal Reserve isn't going to implement negative rates unless it was as a last resort. It would receive a lot of push back, as it would put stress on bank profit margins and prolong a credit crunch.

Janet Yellen also has her concerns over how effective negative interest rates would be in the US, but believes it's an option that should remain on table. In the end, the Federal Reserve may be left with no choice but to go through with it.

Other Unconventional Options

If it ever came to it, there are other, more extreme, unconventional policy measures that central banks could use. This includes helicopter money, which got a lot of attention during the financial crisis since it was something Ben Bernanke, the Federal Reserve chairman at the time, had suggested.

Helicopter money is similar to quantitative easing, except instead of asset purchases, banks make direct payments to individuals or the private sector. However, central banks would be reluctant to implement these concepts, since they are unknown territory and could have adverse and unforeseen side effects. At the moment, it is just a theory.

Since monetary policy is going to be very limited in the next recession, there may need to be more of a reliance on fiscal policy to jump-start the economy.

This brings its own problems, as many developed countries are still holding huge amounts of debt. This could mean there would be a lack of political willingness, therefore limiting fiscal policy and making matters even worse.

Could it be that the next downturn lasts even longer due to these issues?

That's something that Ray Dalio believes. He expects the next downturn to be more of a slow burn and to last much longer than the previous recession, which was more like a big bang.

Every day that goes by, we could be getting closer to finding out.