“People will always try to stop you doing the right thing if it’s unconventional,” so said Warren Buffett in an interview for Time magazine in 2008. Buffett wasn’t referring to monetary policy specifically, but there’s some truth in his adage if we apply it to the more controversial tools that central banks have used since then. Successful though it may have been in meeting its aim of averting economic depression, non-traditional monetary policy has not gone without criticism. Now, ten years from the start of the financial crisis, the debate has turned to whether unconventional methods have had their day.
Traditionally, central banks control inflation and economic growth by setting short-term interest rates. But in this instance, once those rates reached zero (or thereabouts), more inventive tools were needed. Among the unconventional policies used or considered by the world’s largest central banks over the past ten years have been: negative interest rates; quantitative easing (QE); funding for lending schemes; yield-curve control; forward guidance; and, in extremis, “helicopter money” – giving cash directly to the public.
The US is widely expected to be the first economy to wind down unconventional monetary policy. Our analysis suggests that US economic growth has been above potential since 2014, closing the output gap and resulting in rising core inflation. The Federal Reserve is therefore in the process of raising interest rates from rock-bottom levels, and has recently mooted the idea of reducing its balance sheet, which has swollen to $4.2 trillion as a result of its bond-buying activities under QE.
Those who believe unconventional monetary policy is coming to an end might endorse the US as a bellwether for all of the developed markets. Growth and inflation in Europe and Japan are not as strong as in the US, but at least they appear to be on an improving trend. Moreover, in these economies, there are concerns that central banks may now be doing more harm than good, driving interest rates so low that it is no longer profitable for banks to lend. This would disrupt the very flow of credit that these strategies are supposed to encourage.
All this would seem to suggest that unconventional monetary policy has had its day.
On the other hand, the naysayers would argue that there has been little convincing evidence of an improvement in core inflation across the developed markets as a whole. For seven years, the average rate of developed market core inflation has been hovering a little below 2%. Economists can never observe output gaps directly, but the inflation data are not yet consistent with them being closed across the developed markets.
“…unconventional monetary policy could become increasingly conventional in the years and decades ahead”
More fundamentally, the forces (lower trend growth rates, adverse demographics, rising income inequality, a global savings glut and a lack of investment, to name but a few) that combined to push interest rates close to zero, making unconventional monetary policy necessary, have not gone away. Such drivers are, for the most part, structural and have not disappeared simply because of a period of cyclical strength in the world economy. Indeed, unconventional monetary policy could become increasingly conventional in the years and decades ahead, as short-term interest rates hit zero and central banks are forced to deploy radical tools to stimulate their economies.
Part of what makes this topic so engaging is that there are strong arguments on both sides. In short, while the world economy does seem to be inching towards the end of unconventional monetary policy, it may be a case of “so long, but not goodbye”.