Monetary policy: a bridge over troubled waters?

Thinking Aloud

“The European Central Bank’s actions can only build a bridge to the future. The project must be completed through decisive actions by governments – both individually and collectively – to address the underlying causes of our current challenges.”

– European Central Bank President, Mario Draghi, September 2012.

Eurozone:  And friends just can’t be found

Mr Draghi has repeatedly called for politicians to employ fiscal stimulus and supply side reforms to help find a way to calmer waters. It is increasingly clear, however, that monetary policy – no matter how imaginative and ready, willing and able you are to implement it – can create as many problems as it seeks to solve. The boost it gives to financial assets, for example, tends to exacerbate existing trends for income inequality and investors’ decisions on where to commit their savings become increasingly esoteric and often outside of their home countries/areas. Ultimately, monetary stimulus is more likely to find its way to more flexible economies than Europe; ones that have a well-functioning transmission mechanism – i.e. the US and (barring a Brexit slowdown) the UK.

I’m on your side, oh, when times get rough

A fiscal boost, on the other hand, has the advantage of being able to be targeted at a broader swathe of the population. This would ease somewhat the inequalities of the last eight or nine years, while perhaps taking the wind out of the sails of political extremists. If the European Community relaxed its fiscal rules – perhaps adjusting them by the size of a country’s output gap in the Eurozone – Spain, Italy and Portugal could see significant boosts and would hopefully continue to reform their labour markets in a period of growth rather than one of austerity.

A move towards more fiscal flexibility, however, is very likely to be scuppered by politics in Europe. German memories of hyper-inflation are deeply ingrained, and northern European economies are keen to avoid the socialisation across the rest of Europe of the debts in the southern periphery.

UK:  And pain is all around

The UK is similar in some respects, but there are also some important differences. Continuing to take the stimulus strain, the Bank of England’s Monetary Policy Committee announced a ‘bazooka surprise’ at its latest meeting including a Bank Rate cut to 0.25%, a Term Funding Scheme (TFS) to provide funding for banks at interest rates close to Bank Rate, the purchase of up to £10 billion of UK corporate bonds and an expansion of the asset purchase scheme for UK government bonds of £60 billion.

Again, however, the impact of more monetary stimulus on the broader economy is likely to be limited, especially while Brexit uncertainty is still with us. Encouraging lending is a sensible stance for the Bank of England to take; however, companies and individuals need to want to borrow. And for stimulus to be effective from a corporate perspective, such companies must be based in the UK with UK hiring plans.

The fiscal side in the UK could offer some hope, though. Settling the uncertainty around Brexit with higher spending plans could conceivably provide a route to some stability as that exit is negotiated. But that would be a stabilisation at a choppier level of low to small negative growth. The recent suggestions of a European Economic Area as a safe harbour after Brexit, with a seven-year freeze on immigration to give the UK time to sort out a plethora of trade deals, is encouraging. Further sensible proposals such as this could, just maybe, provide a light to guide us out of the low-growth era.

US:  I’ll take your part, oh, when darkness comes

When it comes to the US, the forecast is for fog – a divisive presidential campaign through to 8 November, and an interest rate path that is starting to diverge from the Eurozone, Japan and the UK. There are no questions about expanding the government’s fiscal footprint – although you can expect a lot of noise surrounding the country’s fiscal stance along the campaign trail. It is still worth remembering that Congress proposes tax and spending legislation, and it face its own election cycle in November.

Without any clarity around the fiscal side, Janet Yellen and the Federal Open Market Committee will continue to focus on what it can see. The problem is that in the current post-Brexit environment, the committee is as uncertain about the validity of its own forecasts as everyone else is. The seemingly unstoppable rise of the US dollar may ultimately mean a longer period at the current deposit rate. Perhaps Dr Yellen’s upcoming speech at the Jackson Hole symposium may provide a little more confidence about the direction of US monetary policy with a lot more data on the economy’s reaction to this change of confidence available.

I will comfort you

So the outlook is rather dreich, as we say in Scotland. But is there anything that could cause the sun to shine once more? Possibly. But it is an option that even a few years ago economists would have dismissed as theoretical rather than practical. The idea of “helicopter money” was introduced by Milton Friedman in his 1969 essay, The Optimum Quantity of Money as a vivid thought experiment for stoking inflation.

Any implementation of the idea would not involve dropping money from the skies. Instead, it would take the form of direct transfers of money to the general public. If this were executed by central bank money printing, it would be seen by many as “fiscal policy by the back door”. Again, though, political considerations might preclude such an action. After all, it’s difficult to see the German public going for an idea that will remind them of the Weimar Republic.

When tears are in your eyes, I’ll dry them all (all)

We would suggest two distinctly different proposals we have to re-accelerate developed market growth.

1. Raise interest rates to a level that encourages saving over borrowing. This would in all likelihood be very painful for a number of years as economies transitioned through “creative destruction” periods. That said, one suspects levels of debt have become too large for this to be politically feasible.

2. Alternatively, governments need to step forward and do what they ask the non-government sector to do. The public sector needs to spend rather than save. Governments should expand their fiscal deficits, increase infrastructure spending, encourage jobs growth with labour market reforms, reduce VAT, and perhaps even reduce tax.

Like a bridge over troubled water

We’ve been highlighting the clear dysfunction between monetary and fiscal policy for quite some time now. Yet if the politicians don’t step up soon, monetary policy is going to have less of a resemblance to Simon and Garfunkel’s uplifting Bridge Over Troubled Water, and more to Talking Heads’ depressing Road to Nowhere.


By Luke Hickmore, Senior Investment Manager, at Aberdeen Asset Managers Limited.  This article was  first published on 19 August 2016 on the Aberdeen Assest Management ‘Thinking Aloud’ blog.