What to do when monetary policy no longer works
The inexorable drift towards lower and lower interest rates is upending many assumptions; from the role of monetary policy in lifting the economy through to where investors look for yield. Australia and the US have positive rates for now. However, as growth slows further, inflation persistently undershoots central banks’ targets and governments prove unwilling to lift spending, rates are being forced closer to zero. This has raised speculation over non-traditional measures like negative rates, as already in place across Europe, as well as quantitative easing in order to move central banks’ key objectives back towards their targets. At Pendal’s recent Lighthouse event, the Bond, Income & Defensive Strategies (BIDS) team shed some light on the conundrum facing policymakers and what the future may look like when monetary policy is no longer effective.
Monetary means at their limits
Central banks around the world have been progressively targeting inflation since 1989, with our friends across the Tasman at the Reserve Bank of New Zealand the pioneers of its modern form. Over this time the policy setting boards have presided over the structural shift to lower interest rates, lower inflation and considerable economic expansion.
Since the 1990s we have seen a few economic cycles, with each changing the nature of policy effectiveness. Our Australian rates manager, Tim Hext, has experienced many over his career and notes every cycle has lower and lower interest rates. In Europe, several countries now have negative interest rates, led by Denmark, Switzerland and Sweden. They have joined Japan, where interest rates hit zero two decades ago, before turning negative.
The issue now is increasing risk aversion resulting from negative rates. Central bank tools are relatively blunt, so to obtain the desired economic response, even deeper negative interest rates will be required for Europe. This is the problem with blanket policy targeting through interest rates. When you’re a hammer, everything looks like a nail.
As such, to address the failures of the current regime there is growing recognition of need for a different policy approach. Enter Modern Monetary Theory (MMT). The thinking around this form of economic management was pioneered by American economist, Professor Bill Mitchell along with a cohort of academics and finance practitioners. MMT directly repudiates the thinking around government budget constraints which form the basis of the ideologically opposed Keynesian school of thought for economic management.
Breaking from tradition
The chorus is growing as central bankers increasingly appeal for help in the unruly task of economic management. In his last meeting at the helm of the ECB, Mario Draghi called again on greater support from the fiscal arm of policy. RBA Governor Lowe has echoed these calls amid the frugality that has characterised government spending at home, driven by a seeming obsession with obtaining a surplus.
Ultimately, if an economic crisis and recession eventuates it will drive radical political change, forcing governments to boost spending, cut taxes and pursue deeper structural reform. This may include elements of MMT, which we can interpret more as a framework, than a set of individual policies.
At the core of MMT is an ideology that upends the traditional view that considers the economy as separate from individuals, who seek to maximise their utility from it. Rather, MMT essentially sees the economy as the people and in turn, works for us as a collective.
Another conventional perspective which is uprooted by MMT is that governments should operate like households. This is an idea perpetuated by our personal experience with budgeting and debt. Simply, if we live beyond our means, there is a deficit which requires debt to finance. We then project this idea onto how governments should operate. As such, we have the notion that governments must raise revenue through taxes in order to spend, otherwise they will run a deficit and accumulate debt.
MMT takes an alternative view under a few assumptions, including that governments have control over their currency. This means a government could create money to finance spending, rather than raise it through taxes or a combination of deficits and debt. Such an approach can be followed when there is excess capacity in the economy and the need for stimulus.
What creates inflation?
The notion of creating money for spending may raise some eyebrows, given concerns over the idea of money printing resulting in inflation running out of control. However, such worries require consideration of the force behind money creation. As has been proven by the recent era of massive central bank stimulus efforts, inflation is not purely supply-driven. It does not matter how cheap money is to borrow or how much is available, ultimately it depends on demand and a borrower’s ability to borrow.
Government spending can stimulate this demand and taxes can reduce it. In the MMT world, a key policy that can be used as part of this mechanism is a job guarantee program. If economic activity is weak with low inflation, jobs can be created to absorb idle capacity, and as capacity becomes stretched, inflation will rise. True inflation can only emerge once full capacity is reached. As inflation rises, the government can cut spending and raise taxes to bring the economy back towards balance. In this way the policy acts as an automatic stabiliser.
Such a job guarantee program also supports an idea that anyone who wants to work will work. If the private sector can’t absorb them, then the government will. It will guarantee you a job. There are plenty of public services that are needed – building public facilities, cleaning community spaces or whatever host of other productive activities.
A new New Deal
In the US a similar style policy was implemented in the form of the Civilian Conservation Corps – one of the most successful New Deal reforms introduced by Roosevelt in the 1930s. Looking at the debate in the US now, Tim believes it is not a matter of when a form of MMT arrives, but who will move first – when will they do it, how they do it, and who will then follow.
“For example, you could have a 50-year infrastructure project, which you break down into 5-year, short term projects. This can be slowed as inflation rises. And if inflation rises too far, taxes can be hiked”, he says. “The currency may take a hit, initially, but as growth kicks in, that will flow through to the currency.”
Tim highlights the case of Japan, which has struggled to stimulate growth, but boasts one of the lowest unemployment rates in the world; “everyone’s got jobs, everyone is happy. Why do you need GDP growth if everyone is happy? It begs the whole question of why do you need GDP growth for GDP growth’s sake.”
Looking elsewhere, the UK is likely growing closer to adopting some form of MMT. Their economy is really weak now. And once you see job guarantees coming, then others will follow. Tim notes “You won’t announce we’re doing ‘modern monetary theory’, but you will announce job guarantees. The first implementation will be the UK. The US will follow at some point.”
Investing in an MMT world
With significant experience in rates markets as Head of the boutique, Vimal Gor believes secular stagnation is a problem that is likely to persist for a long time to come. In the medium-term and for the practicalities of investing, the baton of policy stimulus will likely not be passed completely from the current hands of central banks to governments. Arguably, even within an MMT world with more of the heavy lifting done by government spending, we will remain in an environment of structurally lower yields over the long-term. The need for rates to remain low or lower represents further opportunities for bonds as we see the race to the bottom continue. Bonds will also continue to offer investors the important safe-harbour that is critical when risk-assets like equities suffer and as such, will remain a vital part of an investor’s portfolio.