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The next step for monetary policy

What happens after a country actually runs out of monetary policy ammunition? Japan and the EU are almost at that point. Australia and New Zealand are only a year away – maybe less – from ‘alternative measures’ being the next step.

The US is likely to finish the year with the Federal Reserve’s funds rate at 1.75 per cent. This is enough ammunition to deal with a single, moderate economic slowdown. Financial markets imply the probability of a return to the zero lower bound by the end of 2021 is around 24 per cent. And half of the Asian economies have cash rates below financial crisis levels.

The well may never run truly dry. But when the effectiveness of monetary policy diminishes to such a point it can no longer be relied on to deliver its inflation objective or protect from even a modest downturn, a much broader range of actions needs to be considered. This task is becoming more pressing.


The demand and supply of credit is the primary monetary policy transmission mechanism. Other mechanisms are usually much less important. Generally, participants in the economy have a natural bias to borrow – and monetary policy loses much of its potency when they don’t.

This propensity to borrow can diminish for a range of reasons. Businesses can cut expected investment returns faster than central bank cuts can reduce the hurdle rate.

Consumers can voluntarily reduce their demand for credit as debt levels escalate. And banks can reduce the supply of credit to either rebuild capital after a non-performing loan cycle or for regulatory reasons.

One option in confronting this situation is forbearance. Just live with it. If this option doesn’t sound appealing, that’s because it’s not.

Even if calibrated properly, an environment of deleveraging is one of very low economic growth, restricted supply of credit and a stagnant labour market. The alternative is to genuinely challenge our approach to economic policy.

Many countries run the same basic policy recipe. Monetary policy deals primarily with cyclical issues. Fiscal policy generally focuses on medium-term sustainability, although it might lend a hand during deep slowdown or recessions. And regulatory policy focuses on industry-specific challenges.

Why this separation of powers? The recipe only works when each policy element is fully effective; not when one is impaired. Improved policy co-operation is required.

Moreover, in a deleveraging environment a conventional numerical inflation target is less relevant.

With deleveraging the main factor reducing the effectiveness of monetary policy, the overall policy objective shifts to offsetting the deleveraging in the private sector: lost private demand needs to be replaced with something else.

In this environment, higher inflation is better than lower but the exact numeracy is a less pressing issue.


“When the effectiveness of monetary policy diminishes to such a point it can no longer be relied on to deliver its inflation objective or protect from even a modest downturn, a much broader range of actions needs to be considered.”

Not immutable

Yuval Noah Harari in his book Homo Deus argues when we understand history we free ourselves from it. In that vein numerical central bank inflation targets are only 25 years old. They are not immutable.

Monetary history is littered with examples when acting responsibly relative to orthodoxy failed to generate outcomes consistent with historical experience.

For deleveraging to be benign, the decline in demand from the private sector needs to be replaced to keep overall demand rising over time. If that demand is not replaced, then we are back at forbearance.

One option is a much weaker exchange rate; some countries are likely to try it. But it is a zero sum game in the truest sense of the word and will ultimately lead to unstable, politically-influenced outcomes.

It also involves tradeoffs. While a weaker currency might help growth for a period, it is not a sustainable way to build national wealth. A lower currency reduces a country’s ability to benefit from global technology and expertise, and increases its sensitivity to global demand.

In much the same way, lower interest rates help the economy in the short term but generate longer-term problems around issues like retirement incomes.

The only real macro policy option is fiscal. But clarification on this is important.

This is not just fiscal ‘stimulus’ designed to generate a bit more growth for a year or so. Traditional fiscal stimulus is based on the premise what ails the economy is temporary. Current circumstances appear to be much more secular. While things could return to ‘normal’ we should welcome that if it happens, rather than relying on it as the solution.

We need a fiscal program deliberately calibrated to counter private sector deleveraging with public leveraging. In this context the quality of the fiscal expenditure matters as much as it’s quantum.

More broadly this implies activist micro policy needs to take leadership from macro policy as the policy focus. The allocation of spending and the quality of regulation are better points of focus than the quantity of policy effort.

Secular stagnation is, at its heart, a loss of economic momentum coupled with a loss of monetary policy effectiveness.

Many countries are approaching the point where they cannot rely on monetary policy to achieve short-term economic objectives. Rather than relying on the environment returning to ‘normal’, we should review our policy frameworks on the basis it doesn’t.

Richard Yetsenga is Chief Economist at ANZ

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