INSIGHT
VIEWPOINT
What is the Global
Monetary Policy End Game?
BRIAN SMITH | AUGUST 22, 2016
“Incrementalism leads to irrelevance over time.”
Brian J. Smith
Senior Vice President
U.S. Fixed Income
Brian Smith is a Senior Vice President
in the U.S. Fixed Income Rates group. In
conjunction with the generalist portfolio
managers, Mr. Smith helps determine and
implement duration and curve positioning
across fixed income portfolios. While
specializing in interest rate derivatives, he
also trades Treasuries, agencies, TIPS, and
futures. Prior to joining TCW in 2011, Mr.
Smith was a fixed income trader at Barclays
Capital. Previous to this, he was a fixed
income trader at Lehman Brothers. Mr. Smith
holds a bachelor’s degree in Economics and
Mathematics from Yale University.
Google co-founder Larry Page on technological innovation
Monetary Policy Incrementalism
Over $13 trillion in global debt currently trades at negative yields. Yet, despite rate
cuts into negative territory and continual central bank balance sheet expansion,
global growth and inflation both remain disappointingly non-existent. Incremental
monetary policy measures appear to not be working – or at least growing increasingly
ineffectual and “irrelevant.”
Maybe Quantitative Easing (QE) only works if you are the only country doing it?
The United States was able to meaningfully increase employment during the Fed’s
multiple rounds of QE as the unemployment rate dropped from 10% to sub-5%
amidst a weaker U.S. Dollar. Yet since 2014, real economic growth and inflation
haven’t been able to push north of 2% (discrediting the famous Phillips curve).
VIEWPOINT
What is the Global Monetary Policy End Game?
Furthermore, despite the Fed’s attempt at normalizing rates
last year, the economy appears too weak to endure more
than one token rate hike.
economic actors reducing their consumption to prepare for
higher taxes in the future and thus negating the beneficial
aspects of the fiscal spending on economic growth.
The global experience with QE and negative yields is
less optimistic. The European Central Bank is buying the
equivalent of $90 billion a month of securities with its
deposit rate at -0.40%, the Bank of Japan (BoJ) is buying
the equivalent of $70 billion a month of securities with its
deposit rate at -0.10%, and the Bank of England (BoE) is
buying $14 billion a month of securities with its deposit rate
at 0.25%. Each of these central banks is expected to further
expand their balance sheets and further lower their deposit
rates. Meaningful economic growth and inflation are not
expected in Europe, Japan, or England.
Regardless, hopes for growth are tempered as the global
economy has continually underwhelmed expectations since
2009. To the degree that QE and negative rates pull growth
from the future to smooth out current growth, then there
should be less growth to be expected in the future. The
harmful, unintended side effects of QE and negative rates
could also be limiting growth. Negative rates destroy the
“positive float” business models of many industries, they
erroneously address the level of credit as opposed to the
willingness to borrow, they deliver pernicious economic
signaling effects as things must be very bad for them to be
implemented in the first place, and they crush banks who
are unable to pass the charges on to depositors – despite
these banks being relied upon to lend to jumpstart the
economy.
Monetary policy alone cannot address the many, longrun structural factors impeding growth. These factors
include excessive debt levels, poor demographics, onerous
regulations, misallocation of capital and income inequality.
Yet, how can we escape misguided monetary policy
measures on a global scale?
Why, then, don’t central banks just abandon these policies?
The Unlikely End Game – A Global Re-Think
The Optimal End Game – Prosperous Economic Growth
If economic growth (and to some degree inflation) were to
return to pre-financial crisis levels, then central banks could
declare victory, raise rates and shrink their balance sheets.
After all, QE is only needed due to the perceived equilibrium
real interest rate being lower than it is possible to obtain
(it is difficult to implement a -2% overnight interest rate
within a fiat currency system as people can avoid it by
hoarding cash). However, if real economic growth causes
this supposedly negative real short-term interest rate to rise,
then both QE and negative rates would no longer be needed.
Central banks are constrained by the mandates they are
given. Specifically, they are mandated to pursue stable
inflation (price stability) and economic growth (full
employment or an implicit assumption). Refusing to
act towards their mandates would be a rejection of their
assigned duties. Their mandates do not provide clauses to
abort the mission due to extraneous circumstances. Thus,
despite the global awareness that fiscal policy should be
doing more heavy lifting and monetary policy should be less
relied upon – if at all, political leaders are not mandated
towards action like central bankers are.
To achieve this, fiscal stimulus could take on more of the
heavy lifting. This is a theme that many are predicting
globally, as Prime Minister Abe in Japan likely prepares for
increased fiscal spending and the U.S. could see a fiscal
spending package floated following November’s Presidential
election. While projects improving outdated infrastructure
should be economically beneficial, the degree to which fiscal
spending will bring about higher growth depends on an
unknown fiscal multiplier effect. It also depends upon the
existence of Ricardian Equivalence, which posits that the
economic boost of federal spending will be offset by private
To the degree that global monetary policies make it even
more unlikely that growth and inflation targets are met,
then the only way that these policies can be exited without
achieving said targets is if policy makers consciously decide
to abort their mandates. Central bank chairs Kuroda, Draghi,
Carney, and Yellen would all have to relent at the same
time; however, otherwise some relenting would increase
the incentive for others not to. This is a classic example of a
prisoner’s dilemma, whereby a Nash equilibrium is reached
by each participant acting in their own best interest despite
a more optimal coordinated approach being possible. While
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VIEWPOINT
What is the Global Monetary Policy End Game?
Conclusion:
there is nothing preventing increased cooperation in the
game theory of global monetary policy (possibly at a G-20
meeting), it is extremely unlikely that these central banking
institutions would all agree to reject the current status-quo.
Primarily, this is because doing so would discredit their past
work and tarnish the perceived integrity of their institutions.
When businesses fail to innovate, they quickly become
zombie corporations. When central banks fail to innovate,
they move the stated goal posts and keep doing more of the
same. With most developed market economies enduring
negative rates and bloated central bank balance sheets
amidst inadequate economic growth, global central bank
policy makers should increasingly question their actions and
think about their mandates within a bigger economic picture.
The Bank of Japan’s upcoming policy review in September
is a positive example of this, and the topic will certainly be
a focus of the upcoming Jackson Hole conference where
policy makers will grapple with how to deal with lower longrun output growth (y*), lower unemployment rates (u*) and
lower short-term real rates (r*).
Thus, we appear to be trapped in a sub-optimal, Nash
equilibrium outcome. Without cooperation, each central
bank’s mandates compel it to act in the appearance of
serving its own country’s best interest.
The Undesirable End Game – More of the Same
If central banks are waiting on strong growth and inflation
to exit their monetary policies, and their policies are to some
degree inhibiting as opposed to facilitating these conditions
materializing, then that leaves them in a stalemate. Central
banks continue to take gradually more monetary policy
actions to try to devalue their currencies and manufacture
this elusive growth and inflation through higher asset prices.
This results in a vicious circle of prolonged negative rate
expectations.
Yet, barring a stronger global economy that allows for a
graceful exit from these policies, the most likely near-term
outcome appears to be more of the same.
The market is priced for this, as global rates curves are not
pricing in hikes by the ECB, BoJ, or BoE in the next 5 years.
A German 2-year yield of -0.65% shows that there is some
expectation that the ECB will take overnight rates deeper
negative from their current -0.40% level. The Japanese 2-year
yield of -0.20% also implies a deeper negative overnight
rate from the current -0.10% level. Both Germany and Japan
have 10-year yields around -0.10% indicating a prolonged
expectation of financial repression.
While the Fed is the exception to the global norm currently,
any weakness in the U.S. economy could lead to the Fed
quickly falling back in line with other global central banks.
Furthermore, despite the Fed’s hawkish talk, the U.S. rates
curve is extremely dovish in its hiking expectations. The first
full Fed hike is not priced until mid-2017, with a shallow
hiking pace of roughly ½ a hike per year beyond that.
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