THE FAILURE OF MONETARY 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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2020 Long-Term Capital Market Assumptions