Update Magazin II/2019 Download the complete magazine

1 Monetary policy instruments

As a general rule, the monetary policy options currently available (in theory) can be divided into two categories: on the one hand, the use of conventional or unconventional instruments; on the other hand, changing or adjusting monetary-policy objectives.

The scope for using conventional monetary-policy instruments is clearly limited at the present time. This also applies to the Federal Reserve – which, admittedly, raised the fed funds target rate in nine steps since the end of 2015 to a range of 2.25% to 2.5%, before cutting the rate again by 25bp at the 30–31 July meeting of the Federal Open Market Committee. However, this rate is still low by historical standards, and below what we estimate to be the “neutral” level. Yet before, during and after past recessions, the Fed needed to – and was able to – reduce the key interest rate by considerably more (around 5%) in order to revive economic growth. The situation is different in Europe and Asia: in the euro zone, the main refinancing rate stands at 0%, while the UK base rate is just a little higher at 0.75%. Of course, central banks can cut their interest rates to below 0% – as seen, for example, in Japan (–0.10% or –10 bp), Switzerland (–75 bp) or Sweden (–25 bp today, but –50 bp between 2016 and 2018). However, there is an “effective lower bound”, which is currently estimated at around –1% to –1.5%. If interest rates fall below this effective floor, private individuals and companies withdraw money from their accounts and hold large amounts of cash.

In other words, if a recession occurs in the major industrialised countries, conventional interest rate cuts are de facto only available as a monetary-policy instrument in the US – and even there only to a limited extent.

As a second conventional instrument, central banks could carry on making large – or even unlimited – amounts of liquidity available to the banking sector. Another option, albeit an unconventional one, is to offer cheap liquidity to the financial sector over the longer term, perhaps linked to lending to the private sector. This is being done by the European Central Bank (ECB) – which, starting in September, will offer two repos to banks with a maturity of two years as part of the “TLTRO 3” (targeted longer-term refinancing operations) programme. These will be offered at an attractive interest rate up to 30 bp below the general repo rate, provided banks expand their loan portfolios. However, it is doubtful whether this measure will succeed. Banks are already “swimming” in surplus liquidity – not just in the euro zone, but worldwide. They don’t need this liquidity injection.

Can and should central banks revert to the unconventional instrument of asset purchases that was eventually used by all the major central banks in the wake of the financial crisis? This would of course be possible in theory, but there are institutional, legal and monetary-policy limitations. On the one hand, this is because purchase programmes by priceinsensitive central banks run the risk of drying up liquidity in the markets. This is true not only of less liquid market segments such as corporate bonds. In Japan, trade in Japanese government bonds has even come to a standstill several times in recent years – and no wonder: the Bank of Japan (BoJ) now holds significantly more than 40% of all outstanding Japanese government bonds. The ECB also comes up against a legal problem. Admittedly, the European Court of Justice did not impose a ceiling on purchases of government bonds, and regarded previous purchases as an instrument of monetary policy. But at the same time it clearly stressed that unlimited purchases of government bonds are not allowed, as it would be illegal for the ECB to finance budget deficits. Could central banks also buy equities? The BoJ is already doing this in the form of purchases of exchange-traded funds. Although there are legal concerns for the ECB and the Fed, the consensus is that the legal hurdles are not insurmountable. Rather, monetary policy and practical considerations may prevent the Fed and the ECB from using this instrument. It is doubtful whether purchases of equities would really have the desired “portfolio-balance effect”. This means that financial-market participants invest in increasingly risky assets, and ultimately stimulate credit growth, because the expected returns on less risky assets have become unattractive due to asset purchases by the central bank. However, equities are already a risky asset class, and the effect would probably be much smaller than buying government bonds. Corporate-governance considerations – the question of whether a central bank as a shareholder should have a direct or indirect influence on corporate decisions – is another reason why we think it unlikely that equities will become part of an asset-purchase program, or that the corporate-bond purchase program will be expanded significantly. Including bonds issued by banks in the asset-purchase program, too, is difficult to conceive: as central banks are involved in supervising banks, a conflict of interest might arise.¹

An extreme form of liquidity provision would be the use of “helicopter money”. This involves central banks injecting massive amounts of liquidity directly into government coffers or private households. Indeed, it has been and continues to be advocated by economists, including Ben Bernanke, as a solution to Japan’s low nominal growth. However, most economists reject this idea because it would seriously jeopardise confidence in the monetary system.

Another unconventional policy option that has been used for years is “forward guidance” – that is to say, communication by central banks about the future level of interest rates. This instrument is unlimited both in theory and in practice, since central banks can extend the time window for which they give a commitment for as long as they want. (On the other hand, tying interest rates to the trend of economic variables, such as the rate of unemployment, encounters limits sooner or later.) Ultimately, the effectiveness of the forward guidance depends on how credibly the central bank commits to its own targets.

A/ Global key central bank rates

Source: Refinitv-Datastream
Past performance is not a reliable indicator of future returns.

2 Redefining policy objectives

Beyond the use of monetary-policy instruments, central banks could also readjust their monetary-policy objectives. The Fed is in fact reviewing its monetary-policy strategy until the end of 2019, with the eventual aim of anchoring long-term inflation expectations.

Options include setting a multi-year average inflation goal or aiming for a price-index target. This means that if the inflation target is temporarily undershot, an overshoot will be allowed in the future. But this is precisely the problem with these “make-up strategies”: as noted in academic literature, they are generally “time-inconsistent”. Their success depends on the private sector having confidence that the strategy will be implemented, even if inflation exceeds the target. Moreover, it is also unclear from an ex ante perspective whether the mere announcement of a changed definition of the inflation target will influence the expectations of companies and households.

Another option would be simply to raise the inflation target. Here, too, the question is how credibly this can be communicated and, moreover, whether a higher inflation target of, say, 4% would be at all desirable. Current prevailing doctrine puts the ideal rate of inflation for developed industrialised countries at 2%.

Over the medium to longer term, there is a risk that an excessively expansionary monetary policy will also lead to a misallocation of resources, and an increase in financial-stability risks.

3 The costs of further monetary stimulus

Goods-price inflation in almost all countries has been below the central banks’ long-term target for years, and this has created a tendency to ignore the costs of permanent monetary stimulus. Indeed, in the public debate over the need for further monetary stimulus, the adverse side-effects of expansionary monetary policy are usually neglected.

Besides the aforementioned problem of the “zero lower bound” – ie, the lower limit of interest rates, which is the reason why central banks have resorted to unconventional measures in the past – an extremely loose monetary policy has further drawbacks, especially when adopted over a prolonged period.

For example, it is difficult for the banking system to pass negative interest rates to private households: the deposit rate for private individuals is de facto “underpinned” on the downside at 0%. Lending rates are reduced along with the general level of interest rates, thereby shrinking banks’ interest margins and profit potential. Yet profits are the most important way for banks to generate equity capital. A prolonged period of negative interest rates thereby runs the risk of jeopardising the stability of the banking sector, and limiting growth opportunities for the economy. Pension funds and insurance companies are also suffering from the low-interest-rate environment, as the present value of obligations rises with declining yields.

Over the medium to longer term, there is a risk that an excessively expansionary monetary policy will also lead to a misallocation of resources and an increase in financialstability risks: if interest rates stay below the “neutral” level for long, investors will become more willing to take risks, and private-sector debt will increase. It also becomes possible to finance less productive projects, since the price of capital is artificially low. Real estate booms and bubbles are the best examples of this. Indeed, we note that the private-sector debt ratio (companies and households) climbed last year to a record level of around 150% of global GDP. At the same time, real-estate prices again rose sharply worldwide.

In the United States in particular, corporate-sector debt has reached new highs, while the quality of debt instruments has fallen significantly – as shown by the historically high proportion of bonds rated BBB. The rise in leveraged loans – ie, loans to highly indebted companies – is a particular cause for concern. Companies can of course continue to service even high levels of debt, as long as interest rates stay low and growth remains steady. But this is no argument for complacency: when the economy slows down, debt sustainability usually deteriorates quite quickly.

Would macroprudential measures (such as countercyclical capital buffers for banks) be a suitable way to curb growing risks to financial stability? They undoubtedly make sense as supporting measures. However, there is still insufficient empirical data to determine how much regulatory counteraction is necessary. It is also difficult to see why monetary policy should seek to stimulate credit growth while, at the same time, regulation aims to achieve precisely the opposite.

Rising debt in the private sector can also have other consequences. Studies by the Bank for International Settlements and Organisation for Economic Co-operation and Development have demonstrated the structural increase in the proportion of companies with low productivity and high debt – so-called “zombie companies” – in recent decades. This is due to the phenomenon of “evergreening” loans – that is to say, the renewal of bank loans even for weaker companies. The low-interest-rate environment has clearly favoured this trend. The low productivity growth observed over many years can therefore be explained, at least in part, by expansionary monetary policy.

Against this background, it would make more sense in the long run to normalise monetary policy – ie, to raise interest rates to a neutral level – rather than to continue or expand monetary-policy stimulation.

4  The need for fiscal stimulus

Since the use of monetary-policy instruments is limited for various reasons – in addition, their effectiveness is clearly limited in the current environment, and adverse side effects also have to be taken into account – fiscal policy should play a greater role in demand management.

This is especially true in the current global economic slowdown caused by factors such as the US-China trade war and Brexit. Both factors increase business uncertainty, depress sentiment and consequently dampen investment activity worldwide. If the current weakness of aggregate demand leads to a recession, it would be appropriate to implement governmentspending programs and tax cuts, rather than just relying on “automatic stabilisers”. This is particularly true for countries with fiscal policy leeway – ie, with moderate public debt and low budget deficits (or even budget surpluses). The only problem is that many industrialised countries have limited fiscal-policy scope – public debt in industrialised countries averages around 120% of GDP. Empirical studies show that high public debt can cause lower potential growth in the long term. In Europe, moreover, deficit ceilings also limit most countries’ ability to use fiscal-stimulus programmes.

Advocates of “modern monetary theory” (MMT) see no problem with this. They argue that fiscal leeway is ultimately inexhaustible, as the central bank, being a public institution, can buy an unlimited volume of government bonds. However, MMT ignores the fact that such a policy undermines long-term confidence in the currency.

5 Structural policy is imperative

Both monetary and fiscal policy can address weaknesses in overall economic demand. But they are not a way to increase the productivity of an economy; in the worst case they are literally counterproductive, as explained above. Structural reforms, an efficient competition policy, financial support for start-ups, smart investment in education and, in particular, greater openness to international markets can all help to boost overall productivity.

Empirical studies show that high public debt can cause lower potential growth in the long term.

B/ Global government debt

Sources: AllianzGI, Refinitiv-Datastream, BIS, Data as at 2018.
Past performance is not a reliable indicator of future returns.

6 Implications for investors

At the end of January, the Fed took us and the markets by surprise by hinting at a relaxation of monetary policy. The market is now even discounting interest-rate cuts of 100 bp by the end of 2020. The Fed itself speaks of possible interest-rate cuts as a preventive measure (an “insurance rate cut”) to guard against recession. Other central banks have followed suit. The ECB will launch a new long-term tender (TLTRO 3) in September, and members of the ECB’s governing council have also raised expectations of interest-rate cuts and bond purchases in the near future. In addition, the Bank of England’s (BoE) recent communications have been “dovish”. Equity markets greeted this actual or anticipated monetarypolicy stimulus with price gains. Will this remain the case in the future? Here are some points to bear in mind²:

1. The prices of risky assets usually react positively to a loosening of monetary policy if economic data improve at the same time. However, this year the data flow has been fairly weak throughout the world. Our leading indicators that look two to four quarters ahead also point to a somewhat difficult growth environment going forward. US recession risks in 2020 are mounting.
2. The relationship between easy monetary policy and equity prices is less clear-cut than one might think. Major setbacks frequently occur even in periods of low interest rates. They can be triggered by growth concerns (eg, in 2015/16, even though there was no recession) or by high valuations (eg, in 2007/08). We think that US equities are currently ambitiously valued.
3. There is still leeway for monetary policy in general terms, but less than there was before the financial crisis. Moreover, the effectiveness of monetary policy is limited in the current environment.
4. Monetary-loosening measures may possibly extend the current cycle. More than a decade of loose monetary policy also means higher risks to financial-market stability. The rising private-sector debt levels are a case in point.
5. Fiscal stimulus measures could relieve pressure on monetary policy in the event of a recession. At present, however, there are few signs of global and coordinated fiscal relaxation. The longer-term growth outlook is strongly dependent on a successful structural policy with a positive impact on productivity growth.

From our perspective, this means that many factors besides changes in monetary policy are relevant when it comes to making portfolio decisions – especially for us as an active asset manager.

C/ Policy options

Source: AllianzGI. For illustrative purposes only

Equity markets greeted this actual or anticipated monetary-policy stimulus with price gains. Will this remain the case in the future?

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