Philip Arestis and Malcolm Sawyer
The conventional wisdom on monetary policy from the early 1990s through to the financial crises of 2007-2009 favored inflation targeting operated by an “independent” central bank. This approach to monetary policy was widely accepted by academics and central bankers, and widely implemented by the latter. In a relevant contribution, we questioned the effectiveness of this approach to monetary policy along many lines (Arestis and Sawyer, 2008). These included the weakness of the supposed link running from policy interest rate to the level of demand in the short run, and to the rate of inflation in the medium to long run; and hence that the central bank did not have an effective policy instrument to control inflation. Further, we questioned whether the lower inflation experienced during the late 1990s and early 2000s could be attributed to the adoption of inflation targeting, as non-inflation targetters appeared to do as well as targetters, if not better in some cases (see, also, Angeriz and Arestis, 2007, 2008). The promotion of inflation targeting was based on a flawed model of the economy (the “New Consensus Macroeconomics”).
There were some attempts by central banks to respond the surge in inflation in 2007-2008, but since much of the source of that inflation was rises in commodity prices, this served to illustrate the ineffectiveness of the use of interest rates. Raising the domestic interest rate can have little effect on global inflation. In the aftermath of the financial crisis, inflation targeting through interest rate manipulation was in effect quietly dropped—interest rates were not raised as inflation rose in 2011-2012, and then when inflation threatened to become deflation further reductions in interest rates were not feasible. However, achieving a target inflation of 2 percent was now to be achieved through “unorthodox” monetary policies, essentially Quantitative Easing and near zero interest rates and in some cases negative interest rates (the ECB and the Bank of Japan, for example).
A major lesson which should be learned from the experiences of the 2000s is that one of the key assumptions of inflation targeting, that price stability would be necessary and sufficient for financial and macroeconomic stability, does not hold. Interest rates, which were intended to be set to pursue price stability, have effects on asset prices and on financial stability. There is little reason to think that these “side effects” of interest rates used for inflation targeting will be benign.
In the aftermath of the financial crises and the “Great Recession,” the main responses of the monetary authorities have been a combination of historically low interest rates and quantitative easing. Policy interest rates have been held well below 1 percent now for eight years by the U.S. Federal Reserve, ECB, Bank of Japan, and Bank of England. Such low interest rates have persisted for longer than anyone could have imagined when introduced, and indeed reinforced in the past few years as interest rates have further declined.
The low interest rates, often negative in real terms and sometimes in nominal terms, pose serious difficulties, and may have effects on financial stability and be unsustainable. One is the potential negative impact on the banking system. Commercial-bank profitability is determined by the difference between the interest rates they pay on deposits and receive on loans. If lending rates fall more than deposit rates, which would happen more so in the case of negative interest rates, in view of the fear of the banks that depositors would respond by withdrawing their cash, then the profitability of the commercial banks suffers and the performance of the financial sector is undermined.
Negative interest rates have also hurt life insurers, pension funds, and in more general terms they have put financial institutions, and investors/savers, under strain. As reported in the Financial Times (21 May, 2016), the Fitch credit rating agency estimates show that $10 trillion negative-yielding government bonds cost investors annually around $24 trillion. It is also the case that German banks have accused the ECB for punishing savers and their business model with negative interest rates; and Japanese banks raised the issue of ending their sales of government debt to the central bank (Financial Times, 9 June, 2016). Whether the low interest rates are perceived a matter of concern depends on how the recipients of the interest payments are regarded. Interest payments which underpin pensions would attract more sympathy than interest payments received by the super-rich. On the other side, though, governments have not taken advantage of low interest rates to expand their investment programmes through borrowing. There also appears to have been little effect on investment.
Various forms of “quantitative easing” have been pursued—the essential feature of which is that the central bank purchases a range of financial assets (a list which has gradually been expanded) for the issue of central bank money. Central Bank reserves held by the banking system expanded significantly as the private sector sold its financial assets to the central bank. Looking back over eight years of quantitative easing indicates its ineffectiveness. Some commentators saw the increase in the reserves of banks as foretelling inflation—a monetarist interpretation of inflation. In the outturn, deflation has been more an issue than inflation. Quantitative easing and the various conventional and unconventional forms of monetary policy have done little, if anything, to boost the level of nominal economic activity. Monetary policies have been very ineffective in restoring a robust recovery as the proponents expected. The enormous expansion of the monetary base has had little effect on the broader monetary and credit aggregates, let alone on the level of nominal economic activity. Governments should avoid their continuing over-reliance on central banks and monetary policies, which are increasingly constrained, to single-handedly stimulate economic growth. Governments need to join central banks to undertake more economic policies to boost growth rates.
The challenges facing monetary policy are multiple. The lessons from the recent past indicate, firstly, the need to promote financial stability as the key objective of central banks. Secondly, the failures of quantitative easing should throw the emphasis of macroeconomic policy onto co-ordinated fiscal, financial-stability, and monetary policy, with central banks supporting fiscal expansion.
References
Angeriz, A. and Arestis, P. (2007), “Monetary Policy in the UK,” Cambridge Journal of Economics, 31(6), 863-884.
Angeriz, A. and Arestis, P. (2008), “Assessing Inflation Targeting Through Intervention Analysis,” Oxford Economic Papers, 60(2), 293-317.
Arestis, P. and Sawyer, M (2008), “The New Consensus Macroeconomics: An Unreliable Guide for Policy,” Revista Análise Econômica, vol. 26, no. 50, September/2008 pp. 275-297.
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