Monetary policy: What more can central banks do to support growth?

Japan is undertaking radical measures in pursuit of growth

Figure 5 – Japan’s nominal GDP has fallen by nearly 10% since 2000, whilst gross government debt has nearly doubled

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For the first time in years, Japan is exciting the business world. After a decade where nominal GDP  contracted and government debt doubled (see Figure 5, right), Japan’s new Prime Minister, Shinzo Abe, has shown renewed determination to get the world’s fourth largest economy moving again. Abe’s “three arrows” economic strategy consists of:

  1.  a  “bold” and expansive monetary policy;
  2.  a “flexible” fiscal policy; and
  3.  structural reforms to improve long-run potential GDP.

It is the first pillar that has captured worldwide attention. The Government has increased the Bank of Japan’s (BoJ) inflation target from 1%  to 2%, and replaced its Governor with a long-standing advocate of more aggressive monetary policy. As we discussed in our March edition, these moves have already been enough to weaken the Yen by 10% against the US$ since the start of the year.

But are central banks at the limit of what they can do to support economic growth?

Figure 6 – Leading monetary policy makers are increasingly taking a more flexible approach to monetary policy than a traditional price stability mandate would allow for

“Attempting to bring inflation back to the target sooner by removing the current policy stimulus more quickly than currently anticipated by financial markets would risk derailing the recovery and undershooting the inflation target in the medium term.”

Mervyn King, February 2013, Inflation Report 

 “The Fed’s dual mandate … has the force of law behind it...So, if 5% inflation would have our hair on fire, so should 9% unemployment.”

Charlie Evans, President of the Federal Reserve Bank of Chicago, September 2011

 “To achieve a better path for the economy over time, a central bank may need to commit credibly to maintaining highly accommodative policy even after the economy and, potentially, inflation picks up. If yet further stimulus were required, the policy framework itself would likely have to be changed”.

Mark Carney, Speech, December 2012

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As the need for budgetary consolidation continues to constrain the flexibility of fiscal policy, governments continue to lean on monetary policy to do more to support growth. Central banks are responding by considering ever more expansionary measures – from the Fed pursuing an explicit unemployment target to Mark Carney (the incoming Governor of the Bank of England) touting the merits of forward commitments to keeping monetary policy very loose (see quotations, Figure 6).

But, as the limits of current policy settings are reached, any further accommodation is likely to be a step into the unknown.  Japan is at the very edge of this frontier: interest rates have been near-zero for 18 years and the BoJ is already on its eighth round of Quantitative Easing after becoming the first major central bank to pioneer the policy in 2001. In total, it has bought over ¥80 trillion of assets (equivalent to around 20% of its GDP) and purchases have been extended to commercial paper, corporate bond and ABS markets. Further options on the table may include negative interest rates, purchases of foreign debt or “helicopter money” (explicit monetary financing of government debt).

Further monetary accommodation poses both risks and opportunities for global businesses

Figure 7 – Japanese equities have reached their highest level in five years on the back of expansion plans

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Japan’s struggle with deflation is relatively unique in the global context – most major economies are trying to limit price rises rather than spur them on. However, if “Abenomics” starts to show signs of stimulating the economy, other countries struggling to deliver growth may be tempted to adopt similar measures (as signalled by the review of the UK’s monetary framework announced by the Chancellor in the Budget).

Any sustained monetary expansion could improve global business confidence: rising consumer sentiment is likely to bolster revenues whilst looser monetary conditions could lower financing costs. Equity indices in Japan have surged since Abe’s election at Christmas on the back of optimism about corporate earnings and a weaker yen (see Figure 7, right).

But the risks are also pronounced. The big fear is that excess liquidity could leak into consumer prices, pushing up inflation. And a more general move to monetary expansion can quickly turn into a series of competitive devaluations, further exacerbating global inflationary pressures. Easy money can also distort outcomes in the real economy: for example, zombie companies can be kept on life support by low borrowing costs.

All of this means that, in a world of abundant central bank liquidity, businesses should take advantage of cheap financing sources in their capital raising plans, whilst at the same time continuing to focus their investments on generating fundamental value and boosting efficiency. They should not rely on cheap money continuing indefinitely.