The Breakdown of Faith in Unconventional Monetary Policy

We are witnessing a breakdown of faith, outside central banks, in unconventional monetary policy (UMP). In recent days and weeks, the attack on UMP has intensified from a wide array of analysts including current and former monetary officials as well as highly regarded financial market commentators. 

Inside central banks, faith remains strong, as witnessed at the Jackson Hole meetings in August, where the keynote speaker, Fed Chair Janet Yellen concluded,

New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns. 

As unconventional policy comes under attack, central bank credibility is eroded and diametrically opposing views are forming over what direction monetary policies should take next. 

Opponents of UMP favour a gradual unwinding of unconventional monetary policies of key central banks, namely the US Federal Reserve, the Bank of Japan (BoJ) and the European Central Bank (ECB), including quantitative easing (QE) and negative interest rate policy (NIRP).

Supporters of UMP favour even more aggressive use of these policies, by both the BoJ and the ECB to combat slow growth and deflation now.  Some advocate going further to implement "helicopter money" or monetary financing of new fiscal stimulus. 

Which of these policy scenarios plays out over the next few years will dramatically influence both economic and financial market outcomes, not only in the economies of the central banks employing unconventional policies, but across the global economy as the spillovers from the policies of the major central banks reverberate through global financial conditions.

The Critique of Unconventional Monetary Policy

Perhaps the most damaging critiques of UMP have come from current and former monetary officials.

In July, Claudio Borio, Head of the Monetary and Economic Department at the Bank for International Settlements (BIS), along with his colleague Anna Zubai, published a paper titled "Unconventional monetary policies: a re-appraisal". The paper traces the use of UMP and reviews the evidence on the impact of such policies. Borio and Zubai wrote,

They were supposed to be exceptional and temporary – hence the term “unconventional”. They risk becoming standard and permanent, as the boundaries of the unconventional are stretched day after day.

Following the Great Financial Crisis, central banks in the major economies have adopted a whole range of new measures to influence monetary and financial conditions. … But no one had anticipated that they would spread to the rest of the world so quickly and would become so daring.

[T]his development is a risky one. Unconventional monetary policy measures, in our view, are likely to be subject to diminishing returns. The balance between benefits and costs tends to worsen the longer they stay in place. Exit difficulties and political economy problems loom large. Short-term gain may well give way to longer-term pain. As the central bank’s policy room for manoeuvre narrows, so does its ability to deal with the next recession, which will inevitably come. The overall pressure to rely on increasingly experimental, at best highly unpredictable, at worst dangerous, measures may at some point become too strong. Ultimately, central banks’ credibility and legitimacy could come into question.

In August, just as central bankers were congregating at Jackson Hole, Wyoming for their annual get-together, former Federal Reserve Governor Kevin Warsh published another, more strongly-worded, broadside against UMP in an op-ed in the Wall Street Journal.

The conduct of monetary policy in recent years has been deeply flawed. 

The economics guild pushed ill-considered new dogmas into the mainstream of monetary policy. The Fed’s mantra of data-dependence causes erratic policy lurches in response to noisy data. Its medium-term policy objectives are at odds with its compulsion to keep asset prices elevated. Its inflation objectives are far more precise than the residual measurement error. Its output-gap economic models are troublingly unreliable.

The Fed seeks to fix interest rates and control foreign-exchange rates simultaneously—an impossible task with the free flow of capital. Its “forward guidance,” promising low interest rates well into the future, offers ambiguity in the name of clarity. It licenses a cacophony of communications in the name of transparency. And it expresses grave concern about income inequality while refusing to acknowledge that its policies unfairly increased asset inequality. 

At the Jackson Hole meeting, Christopher Sims, the influential Professor of Economics at Princeton University, attempted to answer the question of why unconventional monetary policies, including negative policy interest rates, have been ineffective in boosting growth and returning inflation to target levels, with the following assessment:

Reductions in interest rates can stimulate demand only if they are accompanied by effective fiscal expansion. For example, if interest rates are pushed into negative territory, and the resources extracted from the banking system and savers by the negative rates are simply allowed to feed through the budget into reduced nominal deficits, with no anticipated tax cuts or expenditure increases, the negative rates create deflationary, not inflationary, pressure.

These critiques from current and former monetary policy insiders, give added weight to the arguments against UMP that have been coming from private sector analysts for years. To quote a few recent examples,

James Grant, Publisher, Grants Interest Rate Observer: 

What is new is the medication of markets through this opiate of quantitative easing year after year after year following the financial crisis. I think that this kind of intervention has not only not worked but it has been very harmful.   

 John Hussman, President, Hussman Econometrics Advisors:

By driving interest rates to zero, central banks intentionally encouraged investors to speculate long after historically dangerous ‘overvalued, overbought, overbullish’ extremes emerged. In my view, this has deferred, but has not eliminated, the disruptive unwinding of this speculative episode. By encouraging a historic expansion of public and private debt burdens, along with equity market overvaluation that rivals only the 1929 and 2000 extremes on reliable valuation measures, the brazenly experimental policies of central banks have amplified the sensitivity of the global financial markets to economic disruptions and shifts in investor risk aversion. 

The Fed has insisted on slamming its foot on the gas pedal, refusing to recognize that the transmission is shot. So instead, the fuel is instead just spilling around us all, waiting for the inevitable match to strike. We can clearly establish that activist monetary policy - deviations from measured and statistically-defined responses to output, employment and inflation - have had no economically meaningful effect, other than producing a repeated spectacle of Fed-induced, speculative yield-seeking bubbles. 

Russell Napier, Strategist and Co-founder of the Electronic Research Exchange (ERIC)

Negative interest rates could, if filtered through into deposits in any significant way, lead people to prefer the banknote to the deposit. That used to be called a bank run.

"Policy Singularity" refers to the time when monetary and fiscal policy can no longer be distinguished. It is the final step in Bernanke’s famous helicopter speech. Briefly, the steps [taken by central banks] included quantitative easing; effectively pegging the yield curve; providing forward guidance; putting up the inflation target; and foreign-exchange intervention. The Bank of Japan has run through the entire range of Bernanke’s recommendations apart from the last one, which he calls helicopter money.  

At this moment I still fret more about the outbreak of deflation than inflation, but such concerns would have to be abandoned if ‘helicopter money’ were implemented. The likelihood of their eventual implementation grows by the day as the failure of monetary policy becomes more evident. ‘Helicopter money’ will produce higher levels of broad money growth and inflation. Crucially, the state will not respond by lifting policy rates to control such inflation. Crucially, the state will not allow the yield curve to reflect rising inflation expectations or debts, particularly short-term debts, cannot be inflated away. Crucially, the state will not allow the private sector to gorge itself on credit, the natural reaction when inflation is higher than interest rates. ... This analyst meets few investors who don’t see that financial repression, the process through which the state manipulates the yield curve to below the rate of inflation, is the policy of choice for the developed world.

A summary of the critique of Unconventional Monetary Policy would include the following points:

1. There is little evidence (according to the BIS and others), that the UMP implemented since the Great Financial Crisis has provided a significant, lasting boost to either economic activity or inflation.
2. There is strong evidence that UMP has had a significantly inflated real and financial asset prices. This has contributed to the widening inequality of income and wealth.
3. Even if there are short term benefits of UMP, these are subject to diminishing returns and raise the risk of fuelling speculative bubbles. When such bubbles burst, the dislocations tend to feed through to the real economy, possibly triggering recession and/or deflation. 
4. Increasingly aggressive UMP narrows the room to maneuver of central banks and risks leaving them with limited policy choices for dealing with the next recession.
5. When the next downturn comes, central banks will be under political pressure to experiment with even more dangerous forms of UMP, including helicopter money (money financed fiscal stimulus).
6. Central banks' independence is reduced as monetary policy becomes the servant of fiscal policy and the objective of targeting inflation gives way to the imperative of financial repression as the government requires that interest rates be held below the rate of inflation so that government debt can be inflated away.
7. Breakdown of faith in UMP threatens central bank credibility and legitimacy.

What is the Future of UMP?

Just because thoughtful people outside of central banks are losing faith in UMP does not mean that the decision-makers of the major central banks are planning to change their approach to monetary policy. On the contrary, it seems that advocates of UMP are committed to taking even more aggressive actions if their targets for economic growth and inflation continue to be unmet.

The central bankers and academics who gathered at Jackson Hole, perhaps anticipating and responding to the growing criticism of UMP, made the theme of their symposium "Designing Resilient Monetary Policy Frameworks for the Future". Fed Chair Janet Yellen left little doubt that, in her opinion, UMP will play an important and possibly increased role in future monetary policy. In the event that the current expansion falters and the economy moves toward a recession, Yellen suggested that the tools of UMP would be resorted to once again: 

In addition to taking the federal funds rate back down to nearly zero, the FOMC could resume asset purchases and announce its intention to keep the federal funds rate at this level until conditions had improved markedly--although with long-term interest rates already quite low, the net stimulus that would result might be somewhat reduced.

Despite these caveats, I expect that forward guidance and asset purchases will remain important components of the Fed's policy toolkit. ... That said, these tools are not a panacea, and future policymakers could find that they are not adequate to deal with deep and prolonged economic downturns. For these reasons, policymakers and society more broadly may want to explore additional options for helping to foster a strong economy.

On the monetary policy side, future policymakers might choose to consider some additional tools that have been employed by other central banks, though adding them to our toolkit would require a very careful weighing of costs and benefits and, in some cases, could require legislation. For example, future policymakers may wish to explore the possibility of purchasing a broader range of assets. Beyond that, some observers have suggested raising the FOMC's 2 percent inflation objective or implementing policy through alternative monetary policy frameworks, such as price-level or nominal GDP targeting.

In fact, Chair Yellen while solidly behind UMP measures adopted to date, was far from the most enthusiastic UMP advocate at Jackson Hole. Professor Marvin Goodfriend of Carnegie-Mellon University argued that, "It is only a matter of time before another cyclical downturn calls for aggressive negative nominal interest rate policy actions". The aforementioned Christopher Sims called for helicopter money financed fiscal stimulus as follows, "What is required is that fiscal policy be seen as aimed at increasing the inflation rate, with monetary and fiscal policy coordinated on this objective". Finally, Bank of Japan Governor Kuroda, who has overseen the most aggressive UMP to date, has no qualms about pushing ahead even further,

Looking ahead, the Bank of Japan will continue to carefully examine risks to economic activity and prices at each monetary policy meeting and take additional easing measures without hesitation in terms of three dimensions -- quantity, quality, and the interest rate -- if it is judged necessary for achieving the price stability target. QQE with a Negative Interest Rate is an extremely powerful policy scheme and there is no doubt that ample space for additional easing in each of these three dimensions is available to the Bank. The Bank will carefully consider how to make the best use of the policy scheme in order to achieve the price stability target of 2 percent, and will act decisively as we move on.

The Risks That Lie Ahead

With a developing professional view that UMP has gone too far, is subject to diminishing returns, and that short term gains from such policies are likely to give way to long term pain, there are significant risks to both the economy and financial markets no matter what path central banks decide to pursue. 

With the US economy having performed relatively well in the disappointing global expansion since the GFC, the Fed is in the strongest position to begin to remove unconventional monetary stimulus. Indeed, the Fed has already begun to do so by tapering quantitative easing, by lifting the policy rate by 25 basis points last December, and by providing forward guidance that the policy rate would continue to rise. However, each of these steps have caused corrections in global markets for risk assets and sharply increased volatility. The greatest volatility has come in China and other highly-geared emerging markets as the promise of tighter US financial conditions has spilled over into tighter global financial conditions. In response to this volatility and to slowing economic growth, the Fed has pushed back the timing of it plans for hiking the policy rate and eventually reducing the size of its' balance sheet.

Meanwhile, in an environment of slowing global growth and deflationary pressures, the adoption of negative policy interest rates, as well as continued large scale purchases of government bonds, by the BoJ and the ECB have pulled global bond yields down. At the low point in global bond yields, as much as US$13  trillion of government bonds had negative yields. Despite the Fed's intentions to reduce monetary stimulus, US bond yields fell to near record lows. In Canada, where the BoC has been sitting on its hands for over a year, the effect of foreign central banks' UMP has pushed bond yields to new lows, with the 10-year Canada bond yield falling below 1%. 

The fall in global bond yields has had three effects: it has reduced mortgage borrowing costs which has boosted prices and encouraged speculative activity in housing markets; it has caused investors to reach for yield in risky investments; and it has encouraged even highly-indebted governments to relax fiscal discipline by boosting debt-financed infrastructure spending plans.  

As consumer, corporate and government debt all continue to grow faster than nominal GDP, it becomes increasingly dangerous for central banks to remove monetary accommodation. Monetary policy increasingly becomes hostage to the need for financial repression, that is for interest rates to be pegged below the rate of inflation so that debt can be inflated away. Inflation targeting becomes less attainable and politically less popular.

Pushing further into unconventional monetary policies, say by moving towards "helicopter money", also known as central bank financed fiscal stimulus, might provide some short-term gain (as has resulted from other less drastic forms of UMP), it is also likely to result in even more long term pain.