When Central Banking Went Missing
Since the financial crisis, central banks have been the only game in town. Now, however, their power is fading since they do not directly control the key factors that matter. Nevertheless, we could witness a return of interest rates and inflation.
Since the Global Financial Crisis, central banks have dominated the economic news. They responded to the crisis with unprecedented interventions, bailing out banks, expanding their balance sheets and pushing interest rates below zero. They became the “only game in town” when other agencies and officials hesitated to act. They were forced into acting as “policy maker of last resort” when fiscal policy shifted toward austerity. They are why asset valuations are so high and interest rates are so low, or so it is argued. Financial market participants are advised “not to fight the Fed” and its counterparts in other countries. Shrewd investors have learned scrutinize their central bank’s every move and to follow in its monetary slipstream.
This may have been true in the past, but it will not be true in 2020. For the first time in many moons, none of the leading central banks will make major monetary moves. With U.S. inflation hovering around 2 per cent and economic growth holding steady, the Fed looks to remain on hold. The European Central Bank already ramped up its program of quantitative easing in the second half of last year. Now, with signs that Euro Area growth is stabilizing, it has no reason to panic; it can simply stay on course. The Bank of Japan will keep doing what it has been doing, namely buying everything that moves. With uncertainty about whether Brexit will happen now behind it, the UK economy is unlikely to tank. But with trade negotiations certain to drag on, neither is the UK about to mount a miraculous phoenix-like recovery. The Bank of England will be happy, therefore, staying right where it is.
A possible exception is the People’s Bank of China, given the uncertainty clouding the outlook for the Chinese economy. The trade war with the U.S. is not over, “Phase 1” trade deal or not, and the “New Cold War” will only intensify whomever wins the November 2020 U.S. presidential election. China’s demographics are turning against it. The PBOC has already reduced reserve requirements once in order to encourage bank lending. It may do so one more time later this year. But it will not go further, given worries about an excessive level of corporate indebtedness.
So the most likely contribution from central banks this year is: nothing. To be sure, a recession in the U.S. could drag down the world economy. Conflict between the U.S. and Iran could roil global oil markets. North Korea could become more provocative and bellicose. Tariff Man could resort again to his favorite policy instrument. Any of these scenarios could startle central banks out of their slumber.
Still, “on hold” remains my baseline forecast for monetary policy in 2020. What, then, does this prospect, that central banks will go missing, imply for financial markets, interest rates, and the world economy?
First, interest rates will remain low because their current low level is the product of very long-term trends in which central banks have, in fact, played little role. That rates in the advanced countries are currently far below levels one would expect at this stage of the business cycle is not simply a legacy of the Global Financial Crisis; rather, this trend decline has been ongoing since the 1980s. Economic models suggest that it is partly a reflection of demographics: of ageing populations and a more slowly growing labor force. It is also a function of high global savings, courtesy of emerging markets like China, in conjunction with lower investment, as the relative price of capital goods declines and activity shifts from capital-intensive heavy industry to capital-light high tech and services. The point is that there is no reason to expect any of these long-term trends to change in 2020. In any case, none of them is much affected by central banks.
Could interest rates be pushed up by a sudden burst of inflation? None of the leading central bank models forecasts this, although that’s not exactly an answer to the question. A proper answer hinges, in my view, on whether changes to the labor market are profound or superficial. Profound means that with the rise of digital job-matching platforms, labor markets are becoming more flexible and efficient. Wage inflation will therefore remain subdued even with unemployment unprecedentedly low.
Superficial, on the other hand, means that the ability of labor markets to flexibly reallocate workers still has its limits, creating the possibility that worker shortages are about to intensify and demands for sharply high wages are about to explode. Cassandras predicting this have been consistently wrong for the better part of a decade. My guess is that they will be wrong again in 2020.
The floor may be reached
Another possibility is sharply higher productivity growth starting this year, which would fuel profitability, push asset valuations even higher, and encourage investment in the new technologies underlying that productivity advance. The additional spending and hiring induced by this productivity surge might be just the thing to get inflation trending higher.
For some years now, the consensus explanation for why productivity growth has been slow despite dramatic advances in computing, robotics and artificial intelligence is that it takes time for firms to reorganize in order to effectively exploit these new technologies. It took them a considerable period to adapt to the electric motor. They had to endure approximately 15 years of costly investment, with scant payoff, before the results of electrification began to show up as higher productivity on the shop floor. Why should robots and AI be different?
This argument may have had merit in 2005, around the time the current slump in productivity commenced, but it is less plausible 15 years later. In 2005 it was unclear how firms might best capitalize on nascent digital technologies. Fifteen years later, many cutting-edge companies have reorganized their operations quite radically to capitalize on the digital revolution. A growing body of evidence suggests that the period of “reorganization drag” is now over, and the impact of radical new technologies should be showing up in the productivity statistics. This is what happened between 1995 and 2005, when, after a 15-year hiatus, firms finally succeeded in implementing new micro-computing technologies developed in the 1970s and early 1980s, and productivity surged.
My own view is that successful adaptation to radical new technologies is now in fact boosting productivity, but this is hidden from the statistics by other factors. Prominent among those other factors are the disruptive effects of restrictive trade policies, first and foremost in the United States but also in other countries. Barriers to imports insulate inefficient domestic firms from foreign competition, delay their exit from the market, and slow the efficiency-enhancing reallocation of resources. Supply chain disruptions that raise costs show up as lower productivity. Research at the International Monetary Fund and elsewhere show that the negative impact on productivity can be quite significant. Thus, technological advance is boosting productivity growth, but the trade war is pushing it back down.
All this suggests that the developments to watch in 2020 center on labor markets, product markets, trade and tariffs. The number to monitor is productivity growth. These are not markets, policies and statistics for which central bank decisions matter directly.
Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley