A return to excessive monetary stimulus will distort markets and increase risks

Globally, major central banks are continuing or returning to their extremely accommodative policies after a temporary normalisation. Nevertheless, inflation remains persistently low and, in many cases, well below target. Thus, with regards to the price stabilization mandate of most central banks, current monetary policy is not very effective. Moreover, the side-effects of the ‘cheap money’ policy of the past decade are gradually outweighing the benefits. Important side-effects are distortions in financial markets with artificially low (or even negative) interest rates, insufficient credit and liquidity risk premia and the increasingly high valuations of risky financial assets.

Back to stimulus

The US Federal Reserve was the first of the major central banks to take steps towards the normalisation of its extremely accommodative monetary policy that had been put in place to deal with the financial crisis a decade ago. The Fed gradually increased its policy rate starting in late-2015 and even began to reduce the bond portfolio it had built up as part of its quantitative easing programmes. However, over the course of 2019, this policy normalisation came to an end. The Fed lowered its policy interest rate again and stopped the reduction of its balance sheet earlier than expected. Considering the Fed’s new liquidity injections into US money markets following the recent spike in repo rates, one can even say the Fed has restarted its quantitative easing. The ECB, meanwhile, didn’t even get the opportunity to attempt normalisation. On the contrary, in September it lowered its negative policy rate to a new low and resumed its quantitative easing programme, which it had previously phased out at the end of 2018. In the meantime, the Bank of Japan continues to pursue its extremely unconventional policy. This policy also explicitly focuses on long-term interest rates and even includes the purchase of equity funds.

Ebbing effectiveness

Some ECB officials seems to think the current policy stance could be made even more accommodative if necessary. However, the ECB’s increasingly explicit call for fiscal policy support suggests that central bankers are also aware of monetary policy’s limits. Indeed, despite extremely accommodative monetary policy, underlying inflation in the eurozone remains stubbornly low, fluctuating around 1% – only half of the ECB’s medium-term inflation target.

The effectiveness of monetary policy in meeting central banks’ inflation targets and stabilising the business cycle is diminishing. More and more stimulus is needed to achieve the same objective (and even then the objective isn’t met). For example, the Fed’s real policy rate has been in a downward channel for a few decades already. To some extent, this is related to structurally slowing economic growth. However, it is striking that during each successive downward economic cycle, real policy interest rates need to be cut deeper than in the previous cycle. At the same time, during the upward phase of each business cycle, the real policy rate does not rise to the same level as in the previous one.

Distortions, risks and a dangerous trend

Monetary stimulus is also having increasingly negative side effects. The ECB itself pointed to financial risks in its latest Financial Stability Review, including distorted asset prices in financial markets (i.e. financial bubbles) and increasing appetite by institutional investors for credit and liquidity risks. The negative German bond yield (both nominal and real) is a remarkable example of such a price exaggeration. Investors holding these bonds until maturity fully expect not to be repaid their initial investment, not even in nominal terms. Put differently, borrowers are being paid to accumulate debt.

The ‘search for yield’ in times of negative benchmark rates has led to a steady decline in both the average credit quality and the average liquidity of debt securities. According to the ECB, around 45% of traded and rated corporate bonds in the euro area now have a BBB-rating. The combination of poorer credit quality, lower liquidity and higher asset valuations is a potentially explosive cocktail that calls for vigilance.

Indeed, excessive asset price increases lead to corrections sooner or later. The sustainability of high financial asset valuations is often heavily dependent on interest rates remaining very low. A stronger than expected rise in these interest rates would therefore probably lead to an abrupt downward price correction. Even a decade after the financial crisis, monetary policy still has to consider debt sustainability and financial market expectations. Therefore, a meaningful policy normalisation is not on the agenda for some time to come. Meanwhile, the side effects are piling up, a trend that is set to continue in 2020.

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