Doctors know that any medicine can be a poison if administered to the wrong patient, at the wrong time or in the wrong dose.
Similarly, economists recognise that there are serious side-effects from monetary stimulus. But few properly assess the main effects, both positive or negative. That is a mistake. With the evolution of economies over time, there are some countries for whom cutting interest rates from already very low levels is likely to suppress, rather than stimulate, demand.
This is now the case for major developed nations. The latest round of monetary easing, likely to continue with the European Central Bank on Thursday and the Federal Reserve next week, may make the global economy weaker rather than stronger.
During the global financial crisis, central banks, led by the Fed, acted as lenders of last resort and steadied a fragile financial system. In this critical role they were imaginative, aggressive and very effective.
In the decade since, they have implemented unprecedented monetary stimulus, both conventional and unconventional, in an effort to boost aggregate demand.
However, these latter efforts have been largely ineffective and may even have been counterproductive.
This is not a commentary on the central banks’ intentions, which were good, but rather on the impact of the evolution of the global economy and the low existing level of interest rates. These forces, combined, have diminished the positive effects of monetary stimulus and have enhanced its negative effects.
Consider the six broad ways in which lower interest rates affect demand. There is a price effect: lower rates make it cheaper to borrow, thus encouraging investment and discouraging saving.
There is also a wealth effect, through which lower rates boost asset prices and thus promote consumption by making people better off. There is a currency effect too, as lower rates cause a currency to fall, boosting exports.
On the negative side, though, lower rates reduce income for savers, potentially more than they cut expenses for borrowers.
There are also psychological impacts. These include a confidence effect, where consumers and businesses worry when they see a central bank being forced to cut rates to support the economy. There is an expectations effect too, whereby borrowers assume that rate cuts today mean further rate cuts down the road, and thus wait for lower rates before borrowing.
Because of these offsetting effects, the overall impact of monetary stimulus has always been mixed. To the extent that the three negative effects are more powerful than the three positive ones, then the medicine has turned to poison.
In the US, for example, the shrinking importance of the manufacturing sector — which has fallen from over 30 per cent of employment in the 1950s to less than 9 per cent today — has reduced the benefit of lower rates in spurring capital spending.
In addition, a very low starting level of interest rates makes other factors such as downpayments and credit scores more important in qualifying for a mortgage, which means that lower rates are less effective in stimulating the housing market. The wealth effect has also become less potent over time, because of an increasing concentration of assets among upper-income households who are less likely to spend stock market windfalls.
Fed easing can still help boost exports by pushing the US dollar down, but this does not work if other central banks are trying to do the same thing.
Meanwhile, households’ rising levels of interest-bearing assets — which include bonds and savings accounts, and are about 50 per cent larger than interest-bearing liabilities — magnify the negative effects of lower rates for savers. Moreover, because so much US consumer debt is in the form of fixed-rate mortgages, many of which have already been refinanced to very low payments, rate cuts do not have much of an effect in reducing interest expenses.
Finally, the psychological effects from monetary easing are also largely negative, as consumers take signs of Fed easing as a reason to worry about recession and to delay borrowing until rates fall further.
From today’s starting point of already super-low rates, then, the net economic impact of further monetary easing on the US economy may well be negative. This is likely also the case in Japan and the eurozone.
Central bankers including the Fed take a different view, and will probably continue to respond to recession fears with monetary stimulus next week and beyond, as they try to offset the negative impacts of heightened trade tensions and slower global growth. Further out, policymakers will probably continue to deploy both conventional and unconventional monetary stimulus.
To the extent that they do, they are contributing to an era of continued slow growth and low inflation.
David Kelly is chief global strategist, JPMorgan Asset Management
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