Shrinking central bank influence ends decades of business as usual

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<pre><pre>Shrinking central bank influence ends decades of business as usual

This era is coming to an end. In many countries, interest rates are so low and even negative that central banks cannot lower them further. Lukewarm economic growth Low inflation means that they cannot raise interest rates either.

Since the Second World War, every recovery has started at lower interest rates when the Fed tried to boost growth. Each recession was preceded by higher interest rates as the Fed sought to curb inflation.

With interest rates now stuck at zero, central banks remain without their main lever over the business cycle. The eurozone economy is slowing down, but the European Central Bank, which has cut interest rates below zero, cannot or will not do more. Since 2008, Japan has had three recessions with the

Bank of Japan.

Having set interest rates around zero largely limited to the sidelines.

The US may not be far behind. "We are a recession far from connecting Europe and Japan to the monetary black hole of zero rates and with no prospect of escape," said the economist at Harvard University

Larry Summers.

The Fed typically cut short-term interest rates by 5 percentage points in a recession, he said. However, this is currently impossible with interest rates below 2%.

Workers, businesses, investors and politicians may need to prepare for a world in which the business cycle rises and falls largely without the influence of central banks.

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"The business cycle we are used to is a bad guide for future business cycles," he said

Ray Dalio,

Founder of Bridgewater Associates LP, the world's largest hedge fund.

Fed chairman in November

Jerome Powell

warned Congress that "the new normal now is lower interest rates, lower inflation, probably less growth … around the world." As a result, the Fed is exploring ways to change its strategy and develop tools that can work when interest rates come in. Rates are approaching zero.

Fed chairman Jerome Powell on Capitol Hill in November.

Photo:

Sam Corum / EPA / Shutterstock

Central banks are calling on elected officials to use taxes, spending and deficits to fight recessions. "It is high time that fiscal policy takes responsibility"

Mario Draghi

said in September shortly before his resignation as ECB president.

There are serious doubts that new instruments can restore central bank influence or that countries can overcome obstacles to more robust fiscal policies, particularly political opposition and high levels of debt.

The economic cycles of the future could be similar to those of the 19th century, when there was no monetary policy. According to the National Bureau of Economic Research, the academic research group that dates business cycles, the United States had 15 recessions from 1854 to 1913. Many were difficult. A collapse lasted from 1873 to 1879, and some historians claim that it continued until 1896.

Fed fading influence

Recessions in the United States occurred more often before the Federal Reserve took control of interest rates. They used it as a lever to slow inflation or boost the economy. Low interest rates weakened the central bank by leaving little room for further rate cuts.

Recessions and interest rates

1913: Federal Reserve created

1863: National Bank Act passed, creates uniform national currency

1933: Gold standard left in the US

1935: Fed governance revised

1946: Labor law passed

Prime

commercially

paper rate

The Fed's impact on the economy was also weakened by a decline in interest-sensitive production and the durable construction sector, as well as growth in services that are not.

Industrial value added as a share of GDP

Non-interest sensitive sectors †

Interest-sensitive sectors *

Recessions and interest rates

1863: National Bank Act passed, creates uniform national currency

1913: Federal Reserve created

1933: Gold standard left in the US

1935: Fed governance revised

1946: Labor law passed

Prime

commercially

paper rate

Industrial value added as a share of GDP

The Fed's impact on the economy was also weakened by a decline in interest-sensitive production and the durable construction sector, as well as growth in services that are not.

Non-interest sensitive sectors †

Interest-sensitive sectors *

Recessions and interest rates

1863: National Bank Act passed, creates uniform national currency

1913: Federal Reserve created

1933: Gold standard left in the US

1935: Fed governance revised

1946: Labor law passed

Prime

commercially

paper rate

The Fed's impact on the economy was also weakened by a decline in interest-sensitive production and the durable construction sector, as well as growth in services that are not.

Industrial value added as a share of GDP

Non-interest sensitive sectors †

Interest-sensitive sectors *

Recessions and interest rates

Prime

commercially

paper rate

1863: National Bank Act passed, creates uniform national currency

1913: Federal Reserve created

1933: Gold standard left in the US

1935: Fed governance revised

1946: Labor law passed

Industrial value added as a share of GDP

No interest

sensitive sectors †

interest sensitive

Industry sectors *

There were many reasons for business cycles.

Wesley Claire Mitchell,

An NBER founder wrote in 1927: “The weather, the uncertainty that tarnishes all plans for the future, the emotional variations that business decisions are subject to, the innovations that are characteristic of modern society, and the 'progressive' character our society age, amount of savings, construction of industrial facilities, "general overproduction", business activity of banks, cash flow and management at a profit. "

He did not mention monetary or fiscal policies because they practically did not exist. Until 1913, the United States had no central bank except for two short periods. As far as fiscal policy is concerned, US federal spending and taxes were too low to play a role.

No monetary policy was in place when the central banks were founded, meaning that interest rates were adjusted to counter a recession or to curb inflation. Many countries were on the gold standard, which prevented persistent inflation by tying currency supply to gold.

The Fed was founded in 1913 to act as a lender of last resort and to provide funds to commercial banks that lacked cash to help them cope with inflation or unemployment. This only changed with the global economic crisis.

In 1933

Franklin D. Roosevelt

The US dropped the gold standard, which gave the Fed much more discretion in interest rates and money supply. Two years later, Congress centralized the Fed's decisions in Washington to better equip it for the overall economy.

Acting President Franklin D. Roosevelt signed the Gold Reserve Act in January 1934, which incorporated the FDR's 1933 steps into legislation to free the United States from the gold standard.

Photo:

Bettmann Archives / Getty Images

modern times

Macroeconomics, the study of the economy as a whole instead of individuals and companies, was born from the work of a British economist

John Maynard Keynes.

He showed how individuals and companies that act rationally can spend too little to keep everyone busy.

Under these circumstances, monetary or fiscal policy could increase demand for a country's goods and services, Keynes argued. Just as a dam regulates river flow to counter floods and droughts, monetary and fiscal policy makers need to try to regulate the flow of aggregate demand to counter inflation and recession.

British economist John Maynard Keynes.

Photo:

Gordon Anthony / Hulton Archive / Getty Images

The Employment Act of 1946 required the US to use fiscal and monetary policies to maintain full employment and low inflation.

The next quarter of a century followed a textbook script. In post-war America, rapid economic growth and falling unemployment led to rising inflation. The Fed responded by raising interest rates and reducing investments in buildings, equipment and houses. The economy would slide into recession and inflation would fall. The Fed then lowered interest rates, investment would recover and growth would resume.

The textbook model began to disintegrate in the late 1960s. Economists believed that low interest rates and budget deficits could permanently lower unemployment if inflation rose only slightly. Instead, inflation accelerated and the Fed caused several deep and painful recessions to lower it again.

New challenges emerged in the late 1990s. One was a good thing at first. Inflation was both low and unusually stable and barely fluctuated in response to economic growth and unemployment.

The second change was less beneficial. Regular prices were more stable, but asset prices were weaker. The 2001 and 2008 recessions were not due to the Fed's rate of increase. They resulted from a boom and bankruptcy in asset prices, first in technology stocks, then in property prices and mortgage debt.

After the last bankruptcy, the Fed kept interest rates close to zero from 2008 to 2015. The central bank also bought government bonds with newly created money – a new monetary policy tool called quantitative easing – to lower long-term interest rates.

Despite these aggressive impulses, economic growth was slow. Unemployment has dropped to a 50-year low, but inflation has remained below the Fed's 2% target. The situation is similar abroad.

Unemployment is at historic lows in Japan, the UK and Germany. Despite short and long-term interest rates near and sometimes below zero, growth is subdued. Since 2009, the average inflation rate in Japan has been 0.3% and in the euro area 1.3%.

The monetary policy textbook model barely works, and economists have spent the past decade trying to figure out why.

Richard Clarida, Fed chairman, during a television interview last year.

Photo:

Al Drago / Bloomberg News

One explanation focuses on investments that are the main driver of long-term economic growth. The investment is financed from the savings. If investments are high in relation to saving, interest rates rise because more people and companies want to borrow. If the savings in relation to the investments are high, the interest rates will be depressed. This means that structurally low investments combined with high savings from companies and aging households can explain both slow growth and low interest rates.

Richard Clarida,

The Fed's vice chairman gave another reason in a speech in November. Past investors have requested an interest rate premium for the risk that inflation will be higher than expected. Investors are now so confident that central banks are keeping inflation so low that they don't need this premium. The success of central banks in removing inflation fear is partly responsible for the low interest rates that are currently restricting their power.

The Fed's influence on growth and inflation may wane, but it may still affect markets. Indeed, according to Dalio, the central bank's main lever for sustaining demand was its ability to raise asset prices and debt to finance assets, known as levers. Since the 2008 crisis, low interest rates and quantitative easing have increased the prices of stocks, private equity, corporate debt and real estate in many cities. When prices rise, their returns, such as bond or dividend yields, decrease.

This dynamic, he said, has reached its limits. Once yields close to those of cash or comparable products such as treasury bills, “there is no incentive to lend or invest in those assets.” From then on, the Fed can no longer stimulate spending.

Less than zero

A central bank can always raise interest rates to the extent that growth is slowed down to seek lower inflation. However, they cannot always be lowered enough to ensure faster growth and higher inflation.

The European Central Bank has tried to cut interest rates to below zero in order to burden savers. The key interest rate fell from minus 0.4% in September to minus 0.5%. At this meeting, and since then, resistance within the ECB against even more negative interest rates has increased due to fear that bank lending may decrease or have other side effects.

In December, the Swedish central bank, which introduced negative interest rates in 2015, ended the experiment and reset its base rate to zero. Fed officials have virtually ruled out ever introducing negative interest rates.

In a new research report, Mr. Summers, who served as President Clinton's Treasury Secretary and President Obama's chief economic advisor, and

Anna Stansbury,

a Ph.D. Economics students at Harvard say that very low or negative rates are "at best only weakly effective … and at worst counterproductive".

You gave several reasons. Some households receive interest from bonds, money market funds and bank deposits. If interest rates become negative, this source of purchasing power shrinks. Some people approaching retirement may save more to offset the erosion of their capital through very low or negative interest rates.

In addition, the economy has changed in a way that has weakened its response to rate cuts. The two most interesting economic sectors of the economy, the production of durable goods such as cars and the construction industry, decreased from 20% in 1967 to 10% of national production in 2018, which is partly due to the fact that the aging population in America is less for Houses and cars. Over the same period, the far less sensitive areas of financial and specialist services, education and healthcare grew from 26% to 47%.

They concluded that employment's response to interest rates fell by a third, which means that the Fed has a harder time building a boom.

The two most interesting industries in the U.S. economy, construction and durable goods manufacturing, decreased from 20% in 1967 to 10% of national production in 2018.

Photo:

Bloomberg news


Photo:

Associated press

The US should not plunge into another financial crisis like 2008, Dalio said as long as interest rates remain close to zero. With such low interest rates, households and businesses can easily refinance their debts.

More likely, he said, are flat recessions and slow growth, similar to what Japan has experienced – what he called a "big slack".

Former Fed chairman

Ben Bernanke

This month, the US Federal Reserve estimated that through quantitative easing and forward guidance, which is committed to keeping interest rates low until certain conditions are met, it could deliver three percentage points in addition to two to three regular rate cuts to counter most recessions.

However, Mr. Clarida warned that quantitative easing could suffer from falling yields in the next recession. In addition, the next recession is likely to be global, he said this month, and if all major countries weakened at the same time, interest rates would be driven to zero everywhere. That would make it more difficult for the Fed or another central bank to support its own economy than if only one country were in trouble.

Tax embarrassment

Given the tense situation of central banks, economists must believe that fiscal policy must be the main means of tackling recessions.

History shows that aggressive fiscal policies can boost growth, inflation, and interest rates. The United States borrowed a lot of money in World War II. With the help of the Fed, which bought some of the debt and kept interest rates low, the economy was able to overcome the global economic crisis. As soon as controls on prices and interest rates were lifted during the war, both rose.

Today, academic economists are again recommending higher inflation and deficits to escape the low-growth, low-interest trap.

Fed chairman Jerome Powell speaks at the Federal Reserve headquarters in Washington in October.

Photo:

Win McNamee / Getty Images

Proponents of so-called modern money theory say that the Fed should create unlimited money to finance government deficits until full employment is reached. Some economists are calling for the introduction of "automatic stabilizers" that will boost federal spending in times of downturn through payments to individuals and governments, as well as through infrastructure investments.

However, fiscal policy is not decided by economists, but by elected officials who are more motivated by political priorities that conflict with the needs of the economy. In 2011, when unemployment was 9%, a Republican-controlled Congress forced Obama to agree to deficit cuts. In 2018, when unemployment fell to 4%, President Trump and the GOP-controlled Congress cut taxes and increased spending, causing the budget deficit to rise sharply. Mr. Trump has pressured Mr. Powell to further lower interest rates and resume the quantitative easing that the Fed chairman has opposed.

Fiscal policy in the euro area is hampered by rules that limit the debts and deficits of its member countries. It is also burdened by different interests: Germany, the country that is the easiest to borrow, needs it least. In recent years, it has refused to open the taps to help its neighbors.

Still, Mr. Dalio predicted that a weakened Fed would eventually join the federal government to boost demand by directly funding deficits.

Once central banks have agreed to fund the deficits politicians want, they may have trouble saying no when the need has run out.

Experience abroad and in the past of the United States suggests that inflation often follows when politics leads monetary policy. In the 1960s and 1970s, Presidents Johnson and Nixon pressured the Fed to raise interest rates, paving the way for the inflation surge in the 1970s. Such a scenario seems far away today, but it doesn't always have to be that way.

Write to Greg Ip at greg.ip@wsj.com

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