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.