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Have central banks run out of ammunition?

COLUMN: The ECB will be holding a long-awaited interest rate meeting on Thursday – but what exactly is the role of the central banks, and what can they do now to kick-start growth? Danske Bank's investment strategist, Lars Skovgaard Andersen, examines these issues.

If central bank bosses are the global economy’s supermen, falling growth and low inflation are their kryptonite. Put simply, the primary role of central banks is to maintain stable prices and stable growth by their actions in the financial markets – but getting the desired effect is proving elusive.

Europe, the US and Japan are awash in low and often negative interest rates as a direct result of the central banks having done all in their power to stimulate the economy; first by lowering policy rates since the financial crisis in 2008/09 and subsequently by cranking up the money supply and buying up government and corporate bonds.

Yet, since the financial crisis, it has been incredibly difficult for the central banks – especially in Europe and Japan – to get inflation up to the desired target of around 2%, which is estimated to be the most favourable for economic growth and stability.

Image: Lars Skovgaard Andersen, Investment Strategist, Danske Bank 

What the toolboxes look like 

Central banks have traditionally had two tools to adjust, steer and stabilise the economy, depending on whether it was overheating or running cold:

  1. Policy rate, which dictates which interest rate banks such as Danske Bank can borrow money from the central bank at. The lower the interest rate, the cheaper it is for banks to borrow and thus pass the money on to companies and consumers.

  2. Reserve requirement, which dictates how much liquid holdings the banks should have in order to weather economic storms. The lower the reserve requirement, the more money banks can send out into the economy in the form of corporate loans, housing loans, etc. which support growth.

However, since the financial crisis, the European Central Bank (ECB) and the US central bank (Fed) have expanded their toolboxes and carried out what we could call ‘market operations on steroids’ in the form of so-called quantitative easing (QE) on a scale the world has not seen before.

Logic of QE 
Quantitative easing involves the central banks buying bonds from banks, which thereby get more money to dispense to companies, consumers, etc. – and the more money they have available, the less interest the banks will charge for lending. Since the end of 2008, the ECB and the Fed have together pumped out an amount equivalent to more than DKK 43,000bn into the economy, which in turn has sunk interest rates to levels previously unheard of.

The Japanese central bank has in fact the longest history with non-traditional monetary policy. Policy rates in Japan were already at zero by February 1999, and the central bank commenced QE in March 2001, buying up not only bonds, but also equities.

What will central banks do now?

But it has all seemingly been no real help – or perhaps it just hasn’t helped enough. Growth is still low in Europe and Japan, and inflation is still below target in many countries. So naturally the big question is: what can central banks possibly do now to boost growth and inflation? While there is no single answer to that question, we nevertheless see some potential actions for central banks going forward – and they will probably be a mix of old and new:
    • Restart QE

      We expect one of the first things central banks will do is to restart and intensify buybacks of the most secure government and corporate bonds. This will pump more liquidity into the economy and help lift bond prices and thus sink yields further – or at least keep them low for a long time yet.

      We expect the European Central Bank to announce the restarting of its buyback programme at its meeting on 12 September.
    • Lower policy rates

      We expect the ECB to cut interest rates by 20 basis points at the September meeting, and that the US Fed will cut rates five times over the next five interest rate meetings between now and March 2020.
    • ‘Tiering’ or differentiated interest rates.

      One of the major problems with negative interest rates is that the banks actually have to pay the central banks to have their reserve requirements on deposit, which increases the banks’ costs and paradoxically the level of uncertainty in the bank sector.

      We expect the ECB will discontinue the negative rate on the reserve requirement and only maintain it on the money that the banks deposit in the central bank in addition to the reserve requirement. (When banks have a deposit surplus, ie, when deposits are greater than lending, banks may need to place money in the central bank). 
    • Helicopter money.

      Very simply this means the central banks depositing money directly into your account and my account in order to stimulate consumption. This would again kick-start the economy and lift inflation. This is a very unusual tool, but it has attracted increasing attention in recent years because the current tools of the central banks do not seem to work sufficiently well.

      Just how much out-of-the-box thinking the wise ones at the central banks can come up with is anybody’s guess. However, one thing we are quite sure about at Danske Bank is that the role of the central banks should not be underestimated – and we expect to see vitamin infusions from the central banks continuing for quite some time yet in order to support growth and inflation.
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