The Only Game In Town Is Lost

Central banks are the only game in town — but it’s a game we may have already lost.

This week we have had an important speech by ECB President Draghi and an equally important press conference by Fed Chairman Powell. I found them both disappointing and concerning.

Draghi’s speech emphasized that inflation risks have experienced a structural shift to the downside in the past decade, and that ECB policy must continue to adapt to this new reality. He went as far as stating that inflation will need to run above the 2% target “at some time in the future” to compensate for periods of lower inflation. He highlighted downside risks from protectionist pressures and geopolitical factors, and stated that unless these risks dissipate, “additional stimulus will be required”.

Powell publicly capitulated to market pressures for easier monetary policy. He mentioned the risks to global trade and claimed that “risk sentiment has deteriorated in financial markets”. With equity markets are record highs? Please. I’ll admit that uncertainty on trade and politics has led to a more prudent stance on capex, but risk sentiment in financial markets is doing fine. Just like between December and January, the Fed seemed to follow the shift in market expectations more than any change in data.

Let’s take a step back. The US has the lowest unemployment rate in two generations, wage growth has averaged over 3% since last summer, and household consumption, the main engine of growth, remains robust; the Fed itself forecasts GDP growth to keep running above potential at 2%+. Euro area growth is slowing, but after four strong years when it averaged over 2%, again well above its potential growth rate; and manufacturing and services PMIs for France and Germany, the two largest economies, have rebounded this month.

The Fed’s policy interest rate is at 2.5%; that’s barely above the inflation rate, which averaged 2.2% over the last 12 months and 1.9% over the past 3 months. The ECB’s policy interest rate is negative. Both central banks have massively expanded their balance sheets. Monetary policy is already supportive of growth.

Yes, there are downside risks to the outlook. We have been facing the same risks for the last two years, and so far they have done limited damage to growth. If these risks materialize with a vengeance, monetary policy should respond. But central banks should not act pre-emptively simply if these risks fail to dissipate — unless the uncertainty starts having a much more pronounced impact on growth.

I understand that central banks, traumatized by the 2008–09 crisis, want to appear ahead of the curve. But we are not facing the risk of a new global financial crisis. Our economies should be able to weather a regular economic slowdown— especially with an already supportive monetary stance. On the other hand, central banks blissfully ignore the fact that loose monetary policy keeps boosting risky financial assets in the face of all real and imagined macro risks.

I also find the emphasis and concern for low inflation misplaced. Again, let’s put things in perspective: not even the global financial crisis and recession of 2009 managed to push the US or the Euro area into deflation. Inflation running at a stable 1–2% rate has not stopped the US and Europe from enjoying strong and sustained upswings with substantial reductions in unemployment — so where is the problem? Central banks say that low inflation means low equilibrium interest rates, hence less room for interest rate cuts in a downturn. But central banks have already shown they can ease monetary policy even with rates at or below zero.

With this extremely dovish and hyper-protective stance, central banks are indulging politicians’ and voters’ refusal to acknowledge reality: stronger sustainable growth now requires tough choices and difficult structural reforms, but these are not even part of the debate on either side of the Atlantic. More and more economists and commentators argue that what the US and Europe need is more public spending; proposals for free healthcare for all, free university for all and universal basic income already feature in the US Presidential campaigns — after the current Administration’s tax-cutting spree has already boosted the fiscal deficit to new highs; the idea that public debt can increase with virtually no limit, financed by the central bank, is being seriously discussed.

Draghi’s speech mentioned in passing the need for structural reforms — but the ECB President seems to have lost hope on that front, and gave more emphasis to the need for a Euro area-wide fiscal authority able to provide…more fiscal stimulus.

I understand that central bankers can’t do the politicians’ job. They have to take fiscal and structural policies as given, and try to fulfill their mandates. But with this excessively dovish attitude, they are aiding and abetting the irresponsible wishful thinking of electorates and elected officials. Stronger growth requires more efficient economies, better education, better infrastructure, better business environments, leaner public sectors. It takes hard work, especially in a more competitive global economy. Countries unwilling to accept this simple reality will fade into stagnation.

Prolonged loose monetary policy in the past fueled bubbles in asset prices and real estate; this time it’s fueling a bubble in wishful thinking and misguided policy ideas.