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Central Banks: Outta Ideas But Not Outta Ammo!

Written by: Julius Probst

Last week on our blog, I wrote that the current economic and financial meltdown due to the spread of Corona could be a nasty one. The week was bad, as stock markets declined even further and global interest rates kept falling. Now, it looks like this week will be a total bloodbath in financial markets again; not only are stocks and commodity prices crashing, but US long term bonds are plunging towards the zero lower bound like there is no tomorrow! 

I argued that there is a small chance that a financial meltdown and economic recession could be prevented, and that a lot will depend on Central Banks’ reaction function. However, I think that we are way past that point now, as we are rapidly approaching 2008-type craziness, and maybe even worse.

In theory, massive and timely liquidity interventions (to contain a credit freeze and a financial crisis), combined with other more long-term monetary stimulus programs, could effectively offset any substantial negative demand shock that is arising from the pandemic.

This does not mean that the health crisis would have no impact on the economy. Disruptions to supply are expected as workers get sick and/or stay at home. Production chains and trade flows are currently being disrupted on a global level. As China’s PMI data clearly illustrates, shutting down a country might help to prevent the disease from spreading, but it will also lead to a substantial drop in GDP. More and more firms will go out of business as they are getting squeezed financially from falling revenues. While these supply disruptions will have a detrimental effect on real GDP growth, the demand effect now seems to outweigh the supply effect, with tumbling inflation expectations being one of several indicators of a severe negative demand shock.

I also wrote that Central Banks are currently somewhat complacent about the macroeconomic situation. Both the BOJ as well as the Fed came out with relatively strong statements at first. The BOJ stepped up its asset purchase program. Financial markets had already priced in interest rate cuts in the US, and indeed policy makers delivered. Last Monday, the Fed cut its policy rate by 50 bps. While this calmed financial markets initially and eased financial conditions, it is now clear that they should have done much more. While The ECB and the BOE are also expected to provide some further easing measures in the foreseeable future, Central Banks’ policy actions in response to this global crisis have completely disappointed so far. Financial markets seem to agree with me as they are crashing like it’s 1929.

So, let’s have a look at some Macrobond charts to see what’s in the cards in terms of short-term macroeconomic developments.

The first stylized fact that is, of course, well-known is that policy rates across advanced economies have fallen significantly in recent decades. Many Central Banks have introduced ZIRP or NIRP (zero and negative interest rate policies), and even in countries where they’re positive, rates are well-below 200 basis points right now, meaning that there is very little room to cut them further.

The following chart shows that the high, low, median, and mean policy rates for the countries selected above. One can see that the median policy rate decreased from about 5.5% to 2% after the Dot Com Crash, an easing of about 350 bps. After the global financial crisis, the median policy rate decreased by about 425 bps. This is also consistent with Fed behavior, which has historically cut policy rates by about 500 to 600 bps to combat an ongoing or upcoming economic downturn.

Macrobond Moment: Macrobonds’ cross section tool easily allows you to calculate the mean, median, percentiles, and other cross-sectional properties based on a large number of time series across countries, for example.

As one can see blow, there has been a secular downward trend in the nominal interest rate over time, a phenomenon that is global in nature. With each recession, the Fed has cut its policy rate, but in the subsequent upswing, interest rates have never reached the peak from the previous business cycle. Using our formula tool “RunLength”, I have also counted the number of months the policy rate has been above 2%. The total number of months has decreased from 39 months during the previous business cycle to an all-time low of only 11 months in 2018/2019 (between World War II and the early 2000s, the policy rate never dropped below 2%). Given this long-term pattern of falling rates, there is a very good chance that policy rates will remain lower for longer, maybe even just marginally above zero during the next economic upswing, whenever that may be.

Macrobond Moment: Macrobond easily allows you to insert recession bands into a chart. This tool is available not only for the US, but also for most other countries.

There are obviously two big questions that arise. First, what is causing the global decline in interest rates? And second, what can central banks do to conduct monetary policy when their policy tool is constrained by the ELB (effective lower bound) on interest rates?

While the answer to the first question is complex and multifaceted, I do believe that Summers’ secular stagnation hypothesis1 is pretty much on point. He points to a number of macroeconomic factors  – adverse demographics, declining investment demand, falling productivity – that have led to a long-term decline in the natural rate of interest. Laubach and Williams2 (NY Fed) have estimated the natural rate for several advanced economies. Their model suggests that the natural rate has declined by some 400-500 bps across advanced economies since the early 1960s.

This also tells you that the common narrative one hears about interest rates is completely wrong. Central banks have not “depressed” interest rates in recent decades. They are not leaders but merely followers that have to catch up to the global declining trend in the natural rate.

Furthermore, given that natural interest rates are so low, monetary policy is actually not accommodative after all. If the EA’s natural rate is at negative 1.5%, but the ECB’s policy rate is minus 40 bps and the inflation rate below 1%, then the real interest rate is above the natural rate, meaning that monetary policy is currently too tight. The only way out of this, then, is to generate a higher rate of inflation, which is of course problematic since interest rates are already constrained by the ELB. This is of course where QE comes in. Asset purchases can theoretically be unlimited and allow central banks to increase the monetary base and therefore also affect wider monetary aggregates. Remember, though, from the equation of exchange that nominal GDP is equal to the money supply times velocity, which also implies that NGDP growth is equal to money supply growth plus velocity growth:

NGDPg = Mg + Vg

So even when Central Banks boost the money supply, this does not necessarily have a major accommodative effect if velocity is falling rapidly at the same time. And, as the chart below forcefully illustrates, money velocity is highly correlated with nominal interest rates.

One can also see the completely insane drop in the 10-year yield, which is currently plunging towards the ZLB at a faster pace than the Fed’s policy rate. This tells us that monetary policy is still far too tight despite the Fed‘s recent 50 bps rate cut.

Data: I have calculated money velocity as the MZM money stock divided by nominal GDP. Zooming out on this graph to a longer time horizon shows that the long-run correlation between these two variables is insanely high.

However, there are still surprisingly many voices out there claiming that the Coronavirus is a supply shock and that neither monetary nor fiscal stimulus is therefore warranted to boost aggregate demand.

To this I can only say: Are you joking? Financial markets clearly indicate that this is a severe negative demand shock. Moreover, as the virus is spreading, several sectors of the economy are already affected by rapidly falling DEMAND.

Hotel vacancies are way up, no surprise there, and international and domestic flights are already way down as people start to avoid traveling at all cost. The global airline industry is expected to make losses of up to 113 billion USD this year, maybe more – look at what’s happening to foreign arrivals in Thailand right now. This pandemic is also going to hit the service sector very hard, such as the food industry, as people will avoid eating out and being in public.

PredictIT, a popular prediction markets, suggests that the probability of a US recession in Trump’s first term is now exceeding 60%, up from less than 25% just a couple of weeks ago. And remember that a recession is defined as two consecutive quarters of negative growth, and Trump’s first term is ending in 3 quarters. So this rapid shift in market perceptions is just another piece of pretty bad news.

In terms of policy responses, it certainly looks like both central banks as well as treasuries must become much more aggressive to combat the current economic downturn. While this blog post is already getting very long, I will quickly say that central banks theoretically have ample firepower to prevent a nasty demand-side recession.

More specifically, they would have to implement a “Whatever it takes” approach to avoid being caught in the liquidity trap forever3. Changing the inflation target towards a nominal GDP-level target4 would help here, since level targets have an automatic stabilizing property built in as central banks have to make up for their past mistakes5.

Second, central banks need to start QE on a big scale again. With even long-term yields close to zero (see below), conventional bond purchases will have little effect, but this just means that central banks need to move into riskier asset classes and buy equities and real estate, as the BOJ already does.

Finally, there is always the nuclear option, a true helicopter drop of money as suggested by Milton Friedman6. Treasuries could send every resident or taxpayer a check of 500 USD (or Euro for the ECB) and the central bank could buy this newly issued debt. And if the first 500 don’t work, do it again. With about 320 million residents in the US, the first transfer would only cost 160 billion USD, which is a tiny fraction of the previous QE programs post 2008 and such a money financed cash transfer would be much more effective in stimulating aggregate demand.   

Note: This chart has an academic and non-academic title.

Emerging markets are also starting to suffer big-time. The spectacular decline in commodity prices is hitting them hard as the oil price has crashed by some 30% over the weekend, another completely insane market movement. Get ready for some nasty currency crises if capital outflows from emerging markets continue to rally. So reading Paul Krugman’s work on multiple equilibria7 will become twice as relevant, a point that I might revisit on this blog very soon.

So, expect 2020 to be a very bad year for global growth; we are on track for the worst performance since 2009. In terms of black Swan Events, it doesn’t get much darker than this! Have a nice day!

Academic references for the interested reader:

  1. Probst, Julius. “Lawrence Summers Deserves a Nobel Prize for Reviving the Theory of Secular Stagnation.” Econ Journal Watch 16, no. 2 (2019): 342.
  2. Laubach, Thomas, and John C. Williams. “Measuring the natural rate of interest.” Review of Economics and Statistics 85, no. 4 (2003): 1063-1070.
  3. Krugman, P. R., Dominquez, K. M., & Rogoff, K. (1998). It’s baaack: Japan’s slump and the return of the liquidity trap. Brookings Papers on Economic Activity1998(2), 137-205.
  4. Sumner, Scott. “The case for nominal GDP targeting.” Mercatus Research (2012).
  5. Svensson, Lars EO. Price level targeting vs. inflation targeting: a free lunch?. No. w5719. National Bureau of Economic Research, 1996.
  6. Buiter, Willem H. “The simple analytics of helicopter money: Why it works-always.” Economics 8 (2014).
  7. Krugman, Paul. “Balance sheets, the transfer problem, and financial crises.” In International finance and financial crises, pp. 31-55. Springer, Dordrecht, 1999.

Disclaimer: We don’t usually have views and opinions about economic and financial states of affairs, (not ones that we express publicly as a company, anyway). We do believe, however, that people can and do appreciate a variety of perspectives. What you’ve just read is the perspective of the author. While we think our writers are very smart, Macrobond Financial does not expressly endorse the views presented here. And, as the old adage goes, you shouldn’t believe everything you read (not without finding the data, performing a few analyses and presenting it in a nice chart). We want to make it clear that we are not offering this information as investment advice. That being said, if you have Macrobond, you can easily check everything that’s mentioned here, and decide for yourself. If you don’t have Macrobond, now you have a great reason to get it.

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