"The idea that a zero interest policy has no impact is absurd. A zero rate isn't like putting the motor into neutral: it's more like having the accelerator flat to the floor ...This is 'cheap money' and, considered in isolation, should provide a strong incentive to borrow and to spend."
Stephen Grenville,
Does monetary policy still work? Financial Times, Jan. 13, 2009
The year 2008 will be remembered as the year economies throughout the world began to feel the crippling effects of the financial crisis that began in the United States in the summer of 2007. Despite unusually aggressive actions by governments and central banks to support financial markets, financial institutions and their economies, the outlook for global economic growth is the worst since the 1930s.
The U.S. economy is at the epicentre of global woes. The meltdown of the American housing market, the contraction of credit, and the collapse of the "shadow banking sector," as reflected in derivatives trading, hedge funds and equity markets, have already triggered a year-long American recession and a loss of 2.6 million payroll jobs in that country.
A number of central banks, including the U.S. Federal Reserve, the Bank of Canada, the European Central Bank and the Bank of England have sharply reduced interest rates to support their economies in recessionary times.
The U.S. Federal Reserve cut its target for overnight interest rates to a range of zero per cent to 0.25 per cent on Dec. 15. Japan's central bank interest rate is also effectively zero. The European Central Bank and the Bank of England have 1.5-per-cent policy rates, and the Bank of Canada lowered its overnight policy rate to 1 per cent on Tuesday. At 1 per cent, Canada's central bank rate is still a bit higher than the effective zero rates in the United States and Japan.
But despite low central bank interest rates virtually everywhere, private interest rates are still quite high and credit availability is still too tight.
The evidence that very low interest rates are not working to expand economic activity seems obvious. In the recessionary environment, banks are worried about lending to each other, and of course, are worried about lending to consumers and firms. Banks also worry that recessions are a bad time to be pushing loans. Private interest rates, inter-bank lending rates, mortgage lending rates, bank commercial lending rates, all are unusually high considering that inflation is also very close to zero.
But can monetary policy still work when central bank interest rates are so close to zero that they simply cannot fall any further? Can zero interest rates do the job when virtually everything on the real economy side is so sour? Does an easy monetary policy become ineffective at such low interest rates?
The U.S. Federal Reserve has introduced a program of so-called "quantitative easing" on a fairly large scale and, as a result, believes that ordinary monetary policy has not been effective.
While central banks usually lower interest rates and reduce the cost of capital in order to promote bank lending, quantitative easing goes much further and floods the banking system with funds in order to encourage lending.
Japanese policy makers used this approach earlier this decade to combat deflation and stimulate the Japanese economy. Federal Reserve officials have also confirmed that they stand ready to buy long-term Treasuries to help drive down long-term interest rates.
The Fed's new program of quantitative easing is clearly visible in the accompanying chart above.
No, your eyes are not deceiving you. The American central bank, the Federal Reserve, has pumped an unbelievable amount of money into the monetary base in a very short time. The "monetary base" is often called "high-powered money," and the ordinary "money supply" that affects economic activity is a simple multiple of the monetary base.
The size of the U.S. monetary base has more than doubled over the past 12 months.
In effect, the Fed has been monetizing the paper assets held by commercial banks. This action has rapidly increased the U.S. money supply, though conventional definitions of the money supply have little meaning at this time.
But will this new monetary policy approach work? It certainly was tried in Japan. The Bank of Japan lowered its policy rate to zero in February, 2001, and introduced quantitative easing in the following month. Quantitative easing and the zero interest rate policy both ended in Japan in 2006.
While we are working with an almost new economic paradigm, here are some of our concluding expectations.
- Despite all of the goodwill around, the new U.S. administration has inherited a wrenching economic problem that could haunt President Barack Obama's entire first term of office.
- Quantitative easing, together with the substantial fiscal policy stimulants, and in combination with other financial supports will likely work for the major economies, although it will take time.
- There is considerable financial stimulus associated with zero interest rates, and of course, financial markets should ultimately reflect some positive gains. Already there are some signs that the financial markets are unclogging a bit.
- The overall solution requires much more than monetary stimulus, including major fiscal stimulants, some financial bailouts, as well as some new structural initiatives to unclog the banking and credit markets.
- In the meantime, zero or close to zero central bank interest rates imply considerable currency volatility. The U.S. dollar has recently been sliding against the yen and the euro, and the Canadian dollar has been trading very close to 80 cents, but also with considerable volatility.
- The recent sharp slide in the U.S. dollar together with the huge increase in the U.S. monetary base foreshadow the longer-term inflationary risks that the Federal Reserve is taking through jump-starting the U.S. economy using aggressive monetary stimulation.
The expectations of the new Obama team, in terms of economic policy, are exceedingly high. To paraphrase Winston Churchill: "Never was so much expected by so many of so few." Will the combination of a zero interest rate policy, quantitative monetary easing, and a huge package of fiscal stimulus be enough? Only time will tell; but the global economy needs this recovery package to be a success.
Arthur Donner is a Toronto-based economic consultant. Doug Peters is the former chief economist of the Toronto-Dominion Bank.
