Central banks have more firepower than people think
Rate cuts can still be very effective, despite growing cynicism over their efficacy
6 Nov 2019 | Nikolaj Schmidt

THERE currently seems to be a lot of cynicism about the power of central banks to influence global growth. A growing number of people appear to believe that rate cuts are no longer as effective as they once were and that central banks are therefore effectively impotent. However, rate cuts can still be very effective, despite growing cynicism over their efficacy.

It is important to understand the context. For more than a decade, global growth has been suppressed by various phases of deleveraging, which is reducing the pace of credit growth to the level of nominal gross domestic product growth rather than reducing the overall level of credit outstanding.

The deleveraging has come in four phases: the global financial crisis; the eurozone crisis; the taper tantrum, which mainly affected ex‑China emerging market countries; and the current wave of Chinese deleveraging.

These phases of deleveraging have applied a series of powerful brakes on the global economy, one after another, over the past 11 years. As yet, there has not been any meaningful re-leveraging of the real economy to counteract them.

In addition to this, the global economy has had to contend with a series of political shocks over the past few years. Brexit, the rise of populism, trade wars - all of which have made it harder for consumers and businesses to make confident predictions about the future and has hit growth through a reduction in capex.

Faced with these powerful headwinds, it is hardly surprising that central bank rate cuts have had less of an impact on growth than we would usually expect. However, this does not mean that rate cuts have become inherently less effective - rather, they have not appeared as potent as in the past because of the context in which they have been administered.

Central bank rate cuts can still be very effective and the current phase of central bank easing has the potential to offer much stronger support to the global economy than the cynics believe. In the absence of any new shocks to elevate uncertainty, we are close to an inflection point in growth where the transmission of easy financial conditions kick in and spending on durable goods and capex follow. This should help to keep a recession at bay for a while yet - possibly for up to three years.

A recession will arrive at some point, but the next recession is unlikely to be as severe as in 2008, and it will probably be milder than in 2001 because the structural imbalances that would cause a major recession simply do not exist today.

When it comes, the next recession likely will be caused by the labour market, which is beginning to look too tight. If it overheats, profits will be squeezed and companies will, consequently, suspend capex and stop hiring. This is how the expansion peters out.

Although the next recession is likely to have less impact on the real economy, it is likely to be painful for financial markets because companies have ratcheted up debts to undertake cash distribution to shareholders through stock repurchases and dividend payments.

Central banks will have less room to manoeuvre when the next recession comes around, but this does not mean that they are impotent. Monetary policy is not primarily about the level of interest rates but rather about directing capital flows to engineer loose financial conditions.

Central banks still retain some tools to do this. Many people were convinced that the European Central Bank and the Bank of Japan were running on empty last year, but since then, the 10‑year German government bond yield has fallen from around 80bp to ‑50bp and the 30‑year government bond yield in Japan has fallen from around 90bp to 35bp, while financial conditions have been loosened substantially.

We should thus be wary of underestimating determined central banks.

Nikolaj Schmidt is the chief international economist in the Fixed Income Division of T. Rowe Price, a former director of Economic Research at Pharo Management, and also held positions at Goldman Sachs and the Danish Ministry of Finance.

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