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  1. Post Financial Crisis Failure of Monetary Stimulus

Central banks and sluggish growth

The failure of monetary stimulus

Key points

  • During the financial crisis, central banks implemented unprecedented conventional and unconventional monetary stimulus in an effort to boost aggregate demand. But the net impact of further monetary easing may well be negative.

  • We consider six broad transmission mechanisms by which lower interest rates impact demand in the economy. The price, wealth and currency effects of monetary stimulus are mostly positive and the income, confidence and expectations effects are mostly negative.

  • Further central bank is easing is likely. We believe it will contribute to an era of continued slow growth, low inflation and low interest rates in the decade ahead.
Failure-of-Stimulus

Doctors know that any medicine can be a poison if administered to the wrong patient, at the wrong time or in the wrong dose. Its efficacy depends on a fine balance of positive over negative effects.

Similarly, economists recognize that there are serious negative side effects from monetary stimulus, but few properly assess the relative strength of the positive and negative effects. During the financial crisis, central banks implemented unprecedented conventional and unconventional monetary stimulus in an effort to boost aggregate demand. However, with the evolution of economies over time, it may be the case now that, for major developed nations, cutting interest rates from already very low levels could actually suppress rather than stimulate demand. This could possibly render the global economy weaker rather than stronger after the latest round of monetary easing.

To see this, consider the six broad transmission mechanisms by which lower interest rates impact demand in the economy:

On the positive side, there is a price effect, by which lower rates make it cheaper to borrow and less rewarding to save, thus encouraging investment and discouraging savings. In addition, there is a wealth effect, by which lower interest rates boost asset prices and thus wealth, promoting consumption, and a currency effect, by which lower interest rates can cause a currency to fall, boosting exports and reducing imports.  

However, we believe these effects are less positive today. For example, in the U.S. the declining importance of the manufacturing sector, which has fallen from over 30% of employment in the 1950s to less than 9% today, has reduced the benefit of lower interest rates in spurring capital spending. Further, a very low starting level of interest rates makes other factors, such as down payments and credit scores, more important in qualifying for a mortgage, diminishing the ability of lower rates to stimulate housing. The wealth effect has also become less potent over time because of an increasing concentration of wealth among upper-income households, which are less likely to spend stock market windfalls. Federal Reserve (Fed) easing can still help boost exports by pushing the U.S. dollar down, but this doesn’t work if other central banks are trying to do the same thing. 

On the negative side, there is an income effect, by which lower rates reduce income for savers, potentially more than they cut expenses for borrowers. There are also psychological impacts.  These include a confidence effect, by which consumers and businesses worry when they see a central bank being forced to cut rates to support the economy, and an expectations effect, by which borrowers assume that rate cuts today mean further rate cuts down the road and thus wait for lower rates before borrowing.

To illustrate, rising levels of household interest-bearing assets (which are 50% larger than interest-bearing liabilities) increase the negative impact of lower rates on savers. Moreover, because so much U.S. consumer debt is in the form of fixed rate mortgages, many of which have already been refinanced to very low payments, rate cuts have a limited ability to reduce interest expense. Finally, the psychological effects from monetary easing are also largely negative, as consumers take signs of Fed easing as a reason to worry about recession and to delay borrowing until rates fall further.

In summary, we believe the net impact of further monetary easing may well be negative. However, we recognize that central banks do not subscribe to this view. Thus, we believe that further central bank easing, which will be either ineffective or even counterproductive, will contribute to an era of continued slow growth, low inflation and low interest rates in the decade ahead and beyond.

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JPMAM Long-Term Capital Market Assumptions: Given the complex risk-reward trade-offs involved, we advise clients to rely on judgment as well as quantitative optimization approaches in setting strategic allocations. Please note that all information shown is based on qualitative analysis. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. Note that these asset class and strategy assumptions are passive only – they do not consider the impact of active management. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell securities. Forecasts of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. The outputs of the assumptions are provided for illustration/discussion purposes only and are subject to significant limitations. “Expected” or “alpha” return estimates are subject to uncertainty and error. For example, changes in the historical data from which it is estimated will result in different implications for asset class returns. Expected returns for each asset class are conditional on an economic scenario; actual returns in the event the scenario comes to pass could be higher or lower, as they have been in the past, so an investor should not expect to achieve returns similar to the outputs shown herein. References to future returns for either asset allocation strategies or asset classes are not promises of actual returns a client portfolio may achieve. Because of the inherent limitations of all models, potential investors should not rely exclusively on the model when making a decision. The model cannot account for the impact that economic, market, and other factors may have on the implementation and ongoing management of an actual investment portfolio. Unlike actual portfolio outcomes, the model outcomes do not reflect actual trading, liquidity constraints, fees, expenses, taxes and other factors that could impact the future returns. The model assumptions are passive only – they do not consider the impact of active management. A manager’s ability to achieve similar outcomes is subject to risk factors over which the manager may have no or limited control. The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield are not a reliable indicator of current and future results.

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