A harsh reality is dawning on central banks

Inadequate demand and low cash rates are weakening the potency of conventional monetary policy, leading some to suggest that central banks can no longer bear the burden of managing the economy on their own.

Structural shifts across the developed world, including Australia, have created a range of fresh challenges for conventional monetary policy. ‘Secular stagnation’ might sound like economic jargon, but inadequate demand and a shift towards a lower neutral real cash rate has important implications for economic growth and public policy.

Leading economists believe that conventional monetary policy faces an uphill battle to manage the business cycle, following six years of modest results, as developed countries shift towards a period of softer income growth and a lower neutral cash rate.

Last week, the always excellent VoxEU released a report on secular stagnation. The research, which features articles from economists such as Paul Krugman and Lawrence Summers a range of other academic and institutional economists, provides a comprehensive analysis of the economic community’s new buzzword. 

What is secular stagnation?

At its core, secular stagnation is the theory that negative real interest rates may be necessary to equate savings and investment and maintain full-employment. According to Summers, it raises “the possibility that it may be impossible for an economy to achieve full employment, satisfactory growth, and financial stability simultaneously simply through the operation of conventional monetary policy”.

With most central banks pursuing a low inflation target (often about 2 per cent annually) there is a practical floor on real interest rates of about -2 per cent (zero nominal cash rate less annual inflation).

But with inflation typically easing during a downturn, the floor on real interest rates is often much higher, increasing the likelihood “that no attainable interest rate will permit the balancing of savings and investment and full employment”.

According to Summers, the past six years provides ample evidence of this phenomenon. The Federal Reserve lowered rates to zero per cent (or near enough) in late 2008, and the Bank of England did so in early 2009. Meanwhile, the inflation hawks at the European Central Bank paid a heavy price by taking too long to follow suit.

Yet despite low rates and a range of unconventional policy responses, the recovery has been tentative in the US and the UK and largely non-existent in the eurozone. It is also particularly concerning that this recovery has been plagued with hints of fresh new asset bubbles.

Why is it happening?

Certainly financial market distortions have reduced the efficiency of the monetary policy transmission mechanism, particularly in Europe, and households and businesses continue to repair their balance sheets. A more cautious approach by investors, combined with an inability by banks to allocate capital efficiently, has naturally required a lower interest rate to encourage spending and investment.

But some economists argue that the root cause reflects a number of structural changes, including an ageing population, poor productivity growth and the end of the education revolution, which has resulted in insufficient demand and a shift towards persistently lower income growth.

In Japan, the working-age population is declining, while parts of Europe will soon follow in its footsteps. The US and Australia are somewhat younger than both Japan and Europe but we will also head down that path over the next couple of decades.

Developed countries are approaching a period in which the business cycle will fluctuate around a much lower average growth rate. At the same time, the neutral cash rate (the rate consistent with full-employment) has eased.

Lower average growth increases the probability of more frequent recessions and a lower neutral rate reduces the ammunition available to central banks, resulting in longer-lasting recessions.

Conventional monetary policy has proved that it works effectively during the ‘good’ times, characterised by growth in the working-age population and the absence of credit constraints. But how will policy cope when faced with the opposite?

Will the Phillips Curve -- the trade-off between inflation and employment -- hold when our working-age population begins to decline? The last two decades in Japan suggest that conventional measures may struggle to manage a more complicated business cycle.

Are there any solutions?

One approach is simply for central banks to raise their inflation target. But could the Federal Reserve or ECB credibly deliver inflation of, say, 4 per cent when they have struggled to achieve 2 per cent over the past six years? It seems unlikely.

The reality is that central banks can no longer bear the entire burden of managing the economy. If ‘secular stagnation’ exists, then policymakers need to rethink their approach. Fiscal policy may need to assume a greater role in smoothing the business cycle and enhancing productivity. Investment in quality infrastructure and improved education are two such measures, while boosting labour force participation, reducing red tape and pursuing a fresh round of competition reform would also prove beneficial.

Central banks have been extremely creative over the past six years but rapidly expanding central bank balance sheets is a temporary solution rather than a recipe for sustainable growth. The US and Europe (as well as Australia) will need forward-looking policymakers to navigate these new challenges.

For Australia, a greater burden will fall on the shoulders of our state and federal governments, who will have to overcome their petty squabbles to usher through reforms to boost labour and multi-factor productivity growth. A failure to do so could set Australia up for a decade of disappointment.