Central Banks' last stand?

Sunday Times Economics Editor David Smith considers what central banks could do in the event of a downturn, considering record low interest rates have left them with little room for manoeuvre.

Cast your mind back, if you can, to what we used to think of as normal times, say around about 2005.

Then, an official interest rate, Bank Rate in the UK, of 4.5% or 5% would have been regarded as the norm, even low by past standards. If you had said then that, instead of that level of rates Bank Rate would be below 1 per cent for a sustained period, more than a decade, people would have predicted runaway inflation and the biggest housing boom in history. 

Instead, we have had the ultra-low interest rates, the lowest in history, but not the rest. Inflation is benign and expected to remain so. Neither growth nor the housing market have boomed.

Every time central banks have tried to “normalise” interest rates in the wake of the crisis, they have failed. The most significant market event of the past 12-18 months was the U-turn forced on the Federal Reserve, the Fed. At the end of 2018 it was still apparently in the process of a gradual hiking of rates. Instead, fears about the fragility of the US economy in the wake of Donald Trump’s trade wars forced it to cut. 

The upshot is that in virtually every respect a decade on from the crisis, central banks are still operating with the emergency settings that they adopted then, and which at the time were expected to be very short-lived.

It is not just interest rates that are at emergency levels. The other recent story is that, after a tentative but now abandoned attempt to wind down quantitative easing (QE) by the Fed, central bank balance sheets now stand on the cusp of $20 trillion, a huge number. It is perhaps no coincidence that another big number, the amount of negative-yielding government debt, recently topped $15 trillion. 

Central banks get edgy about the fact that, as well as pushing bond yields down, in some cases into negative territory, QE has raised asset prices. They say that this effect, which has boosted the wealth of the already wealthy, is offset in its impact on inequality by the fact that the policy has supported growth and employment, including among the asset-poor young. The jury is still out on that. 

Where most people can agree is that central banks, by their tentative and ultimately unsuccessful attempts to normalise policy, have left themselves almost powerless in the event of a renewed downturn. Had they made a concerted attempt to underline the fact that emergency levels of interest rates were for emergencies only, and that at the very least real interest rates should be positive – above inflation – things would be different. Some growth might have been sacrificed but probably not much. 

As it is, central banks have very few shots in the locker, at a time when a monetary policy response might be needed. Even before coronavirus, COVID-19, spooked markets and hit the Chinese economy, there were fears over whether a US recovery that broken previous record for longevity, could last much longer.

It is fair to say that their actions during the crisis helped stabilise the situation and prevent a much worse outcome. It is also fair to say that if that was their finest hour, they would struggle to repeat it, but the COVID-19 outbreak puts them firmly back in the spotlight.

entral bankers are fond of saying that they have plenty of ammunition left. But, short of cutting official interest rates below zero, which most are averse to, or unleashing new rounds of QE – which is almost certainly subject to diminishing returns – their tools are quite limited. Ben Bernanke, the former Fed chairman, talked of “helicopter” money, essentially creating money as under QE but distributing it to the public as a cash handout or addition to their bank accounts, rather than using it to buy government bonds.

That would take central banks into new territory and into an overlap with governments, for this would be the same as a tax cut but in the case of the UK provided by the Bank rather than the Treasury. It is probably something we should avoid. In the next downturn it is governments, not central banks, which will have to do the heavy lifting, and we should be realistic about that.