Central banks – when the exception becomes the monetary policy rule

Almost a decade after the start of the financial market crisis, the big industrialised nations still find themselves in an exceptional situation when it comes to monetary policy. In view of weak economic growth, ongoing disinflation and shocks exogenous to the market, such as the Brexit vote, three of the four major central banks are relying on “extraordinary” monetary policy measures – the ECB, BoJ and BoE. Criticism has been voiced that the central banks’ decision to take extremely expansionary measures is not purely the result of external circumstances. The central banks’ asymmetrical response functions (to economic cycles) are also said to have favoured these developments. The duration and scope of QE measures mean that they hardly deserve the attribute of “extraordinary” any longer. Instead, it looks like they might become the new monetary policy rule.

The US central bank already stopped taking unconventional measures two years ago. Nonetheless, the Fed’s monetary policy also remains far from what can be considered normality. Unlike earlier rate-hike cycles, the Fed has been far more cautious. This prudent approach was evident again this week when the US central bank left key rates unchanged once more, a whole nine months after what has been the only hike since the financial market crisis. If we apply the Taylor rule as a measure of the degree of monetary policy impetus, the Fed’s actions have continued to be very expansionary. Although some market players expect a change in interest rates to be announced at the next meeting in December, it would not come as a surprise if the Fed chose to wait with its next key rate hike until the end of the first quarter of 2017, and not just because of the forthcoming US presidential election. No acceleration in the pace of key rate hikes is currently anticipated beyond that date either. If the economic upward trend was to end, the Fed would probably be forced to act and possibly take extraordinary measures once more, given that the current interest rate level is significantly lower than in previous economic cycles.

How long the assumed “state of emergency” could continue was illustrated by the frightening example of Japan. The country’s central bank used the instrument of quantitative easing for the first time as early as 2001, a phase when there were no signs of the current financial market malaise. The Bank of Japan has not just been a precursor with regard to the dimension of time. It has also taught us about the limits of monetary policy in that neither an ultra-expansionary liquidity supply via a wide range of channels nor a large number of innovative instruments guarantee a self-sustaining upturn and lasting escape from the deflationary spiral. This week’s decision seemingly delivers a new monetary policy framework (focus on the yield curve and controlling interest rates rather than focusing on the monetary basis). Yet, our assessment is unchanged that Japan’s central bank will remain caught up in a highly expansionary policy in the near future without it being foreseeable how and when the BoJ will be able to exit this crisis mode.

Equally, no end to the extraordinary monetary policy measures is foreseeable in the Eurozone. The ECB is likely to maintain its bond purchasing programme open-ended beyond March 2017 in view of the fact that the rate of price increases will not be approaching the central bank’s inflation target before 2019 at the earliest. At the same time, doubts are increasing within the EMU about the success of the ECB’s policy. The Harmonised Index of Consumer Prices (HICP) has been practically unchanged at around 1% since the start of government bond purchases in March 2015. The ECB has meanwhile complained that the EMU countries must also take the necessary action to overcome the impact of the EMU sovereign debt crisis by implementing structural reforms. However, the criticised governments face growing domestic political opposition to reforms and austerity policy. In addition, they benefit from the downward distortion of market yields that has resulted from the ECB’s policy. With monetary policy failing to succeed on a broad scale and attitudes towards austerity changing, it is hardly surprising that calls for fiscal expansion are now getting louder. In this respect, it is worth looking again at the example of Japan where spending programmes have neither produced sustained price stability nor growth. If the answer to disinflation in Europe really is Keynesian demand policy, there is a risk that debt ratios, which in many European countries have persisted at record levels, will increase further. The prospect of countries successfully funding themselves independently in the market without ECB intervention would then be affected. In the worst case scenario, joint efforts to combat deflation and stagnation may even result in the ECB and the EMU countries becoming mutually dependent on one another in the long term.


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