Are central banks out of ammunition? - J.P. Morgan Asset Management

Are central banks out of ammunition?

Contributor Dr. David Kelly

We believe that central banks have been out of effective ammunition for a long time, in the sense that monetary stimulus measures have done very little to actually stimulate economic growth. However, they will likely continue to engage in unconventional measures, which may be able to maintain lower short-term and long-term interest rates.

The good news in the short run is that the global economy should be able to grow without further central bank stimulus. The bad news in the long run is that these unconventional measures are probably leading to a misallocation of economic resources and may contribute to asset bubbles or inflation. For investors, it is also important to recognize the implications of central bank actions in leading to mispricing of risk in financial markets.

The last few months have seen further forays into unconventional monetary policy by central banks, with the Bank of Japan introducing negative interest rates and the European Central Bank extending its negative interest rate policy while widening the scope of its asset purchases to include corporate bonds and introduce a new targeted long-term refinancing operation program.

These programs have been successful in lowering interest rates in the eurozone and Japan, just as the Fed’s asset purchase program succeeded in reducing U.S. interest rates. However, there is very little evidence that the stimulative effects of these programs (making it cheaper to borrow) offset the negative effects (reducing consumer interest income, increasing uncertainty, reducing the incentive to lend and reducing the urgency to borrow ahead of higher rates). Even the assumed effect of reducing exchange rates has not worked out in recent months.

However, while these policies have not been effective at stimulating economic growth, central bankers do have the ability to expand them further by the wider use of negative interest rates or asset purchase programs. Moreover, there is no sign that central banks recognize that they have reached the region of counterproductive monetary easing.

It is likely that, even without further monetary easing, labor markets will tighten in the U.S. and Europe. This, combined with a rebound in commodity prices, could lift inflation and so forestall, for now, further bouts of unconventional policy.

However, long-term damage is being done to the structure of the global economy by setting interest rates at an artificially low level. While many economic agents feel little incentive to engage in physical investment, low interest rates are promoting big gains in asset prices including equities, real estate and bonds. If and when central banks begin to normalize rates, they are likely to cause a collapse in some of these asset prices, potentially raising the threat of recession. However, not raising rates in a tightening labor market with very weak supply runs the risk of an acceleration in wage inflation. Either way, central banks have painted themselves into a corner from which it will be difficult to escape without pain.

Investment Implications

While central banks are not ""out of ammunition,"" investors should take little comfort in that fact, since current unconventional measures are doing nothing to boost economic growth. However, we do expect slow and steady growth with or without further unconventional policies. Moreover, while very low interest rates will distort and undermine economic activity in the long run, in the short run they suggest an overweight to stocks and other risk assets relative to fixed income securities.

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