The Most Dangerous Idea at the RBA: Monetary Policy Doesn’t Matter

“In the end, though, firms and individuals have to have the confidence to take advantage of the situation.  They have to be willing to take a risk – on a new project, a new product, a new market, a new worker.  Monetary policy can’t force spending to occur.”

Glenn Stevens, Reserve Bank of Australia Governor, December 2013

Leading up to Christmas, Glenn Stevens probably feels that he has received an early Christmas gift in the form of a lower Australian dollar.  For more than a year, he has cited concerns about a persistently high dollar as impeding competitiveness of the non-commodity export sector.  It has finally succumbed recently; at the time of writing, it had depreciated by close to 10% against the US dollar since mid-October and by 7% on a trade weighted basis.  Whether this has been due to Mr Stevens’ jawboning is debatable.

But as Mr Stevens indulges into his Christmas lunch, he might well feel that his glass is half empty.  By his own admission during this week’s opening statement to the House of Representatives Standing Committee on Economics, growth has been below trend this year and he expects this to persist for a bit longer yet.

Nor would this week’s updated Mid-Year Economic & Financial Outlook (MYEFO) provide Mr Stevens with much reason for optimism.  On the heels of a dismal outcome for nominal GDP growth of 2.5% in financial year 2013, the Treasury downgraded growth estimates for nominal GDP to 3.5% in each of the financial years 2014 and 2015, down from the preliminary forecasts of 5% contained in the May Budget and well below the two decade average growth of 5-6%pa.  If this outlook transpires, the RBA’s nominal recession is set to extend for three consecutive years.

But his main concern appears to revolve around what he considers to be the limit of his power as the country’s top central banker; according to Mr Stevens, monetary policy cannot effectively revive animal spirits and encourage households and businesses to take risks.  Skeptikoi is shocked by this.  Yes, monetary policy cannot force spending to occur.  But what is the role of monetary policy, if not to influence people’s perception of risk and discount rates?

To better understand this, it is instructive to re-assess the concept of the neutral rate of interest, originally developed by the Swedish economist, Knut Wicksell.  Monetary equilibrium is achieved when the real rate of interest is equal to the expected real rate of economic return.  A lower real rate of interest encourages businesses to borrow and invest, which leads to inflation and conversely, a higher real interest rate is associated with deleveraging and either disinflation or deflation.

Skeptikoi believes that incorporating risk into Wicksell’s framework can better shed light on the crucial role that central bankers can play to revive the private sector’s appetite for risk.  Investment is still weak in Australia (and most other developed economies) because discount rates or perceived risks are high, which continues to pull down risk adjusted rates of economic return.  Renewed capital discipline, and high business and household savings rates across most of the developed world confirm that animal spirits remain dormant.  No wonder; October 2013 marked only the fifth anniversary of the financial crisis, the largest global downturn since the great depression.

Given the depth and breadth of the crisis, the process of healing could take a long time to play out.  A new and growing literature that marries psychology with economics and finance suggest that macroeconomic developments during a person’s formative years can shape their lifelong attitudes towards risk.  Various academic studies show that firms run by CEOs who grew up during or around the great depression had lower leverage than other firms.  And stock market participation was lower for investors who grew up during the great depression.

Against this backdrop, it is reasonable to think that financial crisis ‘babies’ (and those that have been adversely affected by the financial crisis) will remain cautious for a while yet.  People have either lost their homes or jobs, witnessed the value of their homes decline or have remain employed but with a heightened sense of job insecurity.  Consequently, people are implicitly applying still high discount rates to their stream of expected future cash flows, which is depressing the present value of their human capital.  And the household sector’s lower permanent income flows through to an underwhelming recovery of consumption and still weak investment intentions of corporate sectors around the world.

Central bankers have been on a steep learning curve in the past five years.  Concerns surrounding the liquidity trap associated with zero interest rate policies have given way to the growing realisation that monetary policy can still be effective and affect agents’ expectations, risk taking attitudes and asset prices through forward guidance and large scale asset purchases (LSAPs).  Christina and David Romer from the University of California argue that the most dangerous idea in the Federal Reserve’s history is that monetary policy does not matter.  They attribute the prolonged downturn of the great depression and the great inflation of the 1970s to policy errors committed by the Federal Reserve, stemming from an ‘unduly pessimistic view of what monetary policy can accomplish’.

The authors also draw parallels between prevailing views of monetary policy since the financial crisis with the great depression, regarding the ineffectiveness of monetary policy at the zero lower bound, as well as the costs associated with non-traditional tools.  But more recently, the Federal Reserve’s announcement of QE3 in 2012 suggests that it considers that the benefits of forward guidance and LSAPs outweigh the costs.  And other central banks have clearly reached a similar conclusion, including the Bank of Japan, European Central Bank and Bank of England.

Glenn Stevens is clearly frustrated that monetary policy’s role in promoting the recovery is not getting an assist from government policies that facilitate higher productivity.  While monetary policy is limited in its ability to affect long-run dynamics of productivity growth, it is the role of a central bank to prevent a cyclical shortfall in aggregate demand or act to prevent any shortfall from continuing.  Skeptikoi is afraid that the RBA’s timidity and its unduly pessimistic view that monetary policy does not matter, will unnecessarily condemn Australia to a prolonged nominal recession.

The Bond Conundrum and Global Saving Glut Almost a Decade On

“…the available information increasingly suggested that the economic expansion was becoming less fragile and the risk of an undesirable decline in inflation had greatly diminished…the Federal Reserve came to the judgement that the extraordinary degree of policy accommodation that had been in place…was no longer warranted and…signalled that a firming of policy was likely.”

One could be easily forgiven for thinking this passage is an apt description of recent deliberations at the Federal Reserve.  In fact it was delivered by the then Federal Reserve Chairman, Alan Greenspan, in February 2005, following an eight month period in which the target fed funds rate had been raised by 150 basis points (bps) to 2.5%.  Yet by February 2005, 10 year treasuries were yielding close to 4% significantly lower than 5% in June 2004.  Greenspan described the divergence in the fed funds rate and long term interest rates as a conundrum.

Given the ongoing decline in long term interest rates since then – US 10 year treasuries are yielding less than 3% at present – that semi-annual report to the Congress in 2005 has become amongst the most widely cited speeches from Greenspan’s chairmanship.

A month later, then Governor Bernanke attributed the relatively low long-term real interest rates in the world to an excess of desired saving over investment intentions.  The global saving glut could alternatively be thought of as inadequate or under-investment.  In a closed economy, a country’s saving imposes a constraint on the maximum funds available to the corporate sector for investment.  In the event of a shortfall in desired investment relative to the desired saving, the excess supply of saving causes the price of money (ie. the real interest rate) to decline.  Conversely, when expected domestic investment opportunities exceed desired saving, the real interest rate rises.  So in a closed economy, the current account remains in balance and the real interest rate equilibrates desired levels of investment and saving.

In an open economy, a country’s account balance is equivalent to the imbalance between investment and saving.  When a country’s investment exceeds its saving, it can borrow from abroad, so national saving does not impose a constraint on the maximum funds available for investment.  Although the country runs a current account deficit, its real interest rate is no longer governed by the supply and demand for domestic saving.  The ability to tap into foreign sources of saving lowers the real interest rate relative to a closed economy.  Conversely, a country whose investment opportunities fall short of its desired saving, runs a current account surplus and is a net lender of funds offshore.

According to Bernanke, the global saving glut had its antecedents in a wave of financial crises in emerging markets a decade earlier, which raised the precautionary motive for saving amongst those countries affected directly as well as other emerging markets unscathed.  Developing countries swung from being modest net users of capital in 1996 to being significant net lenders by 2003; according to the IMF, these countries swung from running an aggregate current account deficit of $68 billion in 1996 to a $150 billion surplus in 2003.  The size of the surplus confirms that any growth in investment opportunities during this time was not commensurate with the sharp rise in desired saving to safeguard against future crises.  In contrast, the aggregate current account deficit of developed countries had ballooned to $212 billion by 2003.

Bernanke acknowledged that the new status of developing countries as net lenders of capital to developed countries represented a role reversal from the experience of most of the 1990s and a challenge to the standard neoclassical model which says that capital ought to flow to developing countries; their low capital to labour ratios yield higher expected rates of economic return.  What the neoclassical model neglects is the role of risk.  Many developing countries have poor quality governance and institutions, including vaguely defined property rights, and relatively under-developed contract enforceability mechanisms and financial markets.  Consequently, few of these countries have successfully developed globally tradeable financial assets but have had more success in developing income producing assets.

Following the end of the dotcom boom in 2000, the associated steep decline in stock prices further reduced the appetite for capital investment in the US and globally.  According to Bernanke, “…with desired saving outstripping desired investment, the real rate of interest should fall to equilibrate the market for global saving.”  Ricardo Cabarello from MIT draws an analogy between safe assets and parking slots; a rise in the number of cars and contraction in available car parks causes the equilibrium price of parking slots to increase.

10 year treasury yields have continued to decline since 2005 and are currently yielding less than 3%.  In observations earlier this year, Bernanke attributed lower long-term interest rates primarily to a decline in the term premium with an assist from falls in the expected average real short rate and inflation expectations.  The term premium is the additional return investors demand for holding a long dated bond as opposed to buying and rolling over a series of shorter dated securities.  According to Bernanke, the lower – and at times negative – term premium has reflected among other things, the safe haven status and deep liquidity of longer dated treasuries which has attracted strong demand from foreign central banks and governments.

Those foreign central banks and governments are still predominantly from emerging markets.  Trends in current account balances confirm that developing countries continue to save in excess of their investment requirements; their aggregate current account surplus has grown to almost $240 billion from $150 billion a decade ago.  IMF data shows that the developed economies are also running a current account surplus, the first of its kind since 1998.

While Bernanke did not cite the ‘global saving glut’ in his recent speech to explain why long term interest rates are low, it is clear from developments in current account balances that the financial crisis exacerbated the global savings-investment imbalance; a heightened precautionary saving motive amongst developing (and now developed) nations, coupled with a dearth of perceived investment opportunities in developing (and now developed) countries.  Like the end of the dotcom boom, the financial crisis has ushered in a period of capital discipline and cost restraint, and raised companies’ propensity to either hoard cash or payout cash to shareholders in the form of stock re-purchases and/or dividends.

Looking forward, Skeptikoi expects the global savings-imbalance to persist and believes this can shed light on the outlook for real interest rates and monetary policy.  The depth and proximity of the financial crisis – October marked only the fifth anniversary of the collapse of Lehman Brothers – suggests that the healing process is far from over.  Worldwide, the precautionary savings motive remains strong across corporate, household and public sectors, while dormant animal spirits continue to dull the corporate sector’s appetite for increased leverage, capital investment and new hiring.  Against this backdrop, long-term interest rates are likely to remain low for an extended period.  Skeptikoi believes that monetary policies in developed countries ought to remain accommodative – through ongoing central bank purchases of debt securities and strengthened forward guidance – to revive animal spirits and encourage dissaving.

Looking through the cyclical legacy of the financial crisis, the global saving-investment imbalance will diminish only when emerging markets develop stronger institutions and governance mechanisms that reduce perceived risk and encourage investment - particularly in much needed infrastructure for rapidly growing populations.  But this thematic will take a while to play out.  The persistence of low treasury yields might no longer be a conundrum, but Skeptikoi’s view is that another decade on, the global saving glut and low real interest rates could still be with us.