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Macro View: Low interest rates and aggressive QE impact has been mediocre

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AFTER sharp falls in the first few weeks of the year, which pushed many equity markets into “bear market territory”, share prices have recovered by mid-March all or most of their 2016 losses. Earlier acute pessimism has eased; but the mood remains apprehensive, largely due to growing doubts over the ability of central banks to control events and provide reliable guidance.

Since the 2008 financial crisis, central banks have been at the centre of policy-making. Huge budget deficits made it very difficult for governments to use fiscal tools to manage demand. As a result, exceptionally low interest rates and aggressive quantitative easing programmes became key weapons in efforts to avoid recession and deflation. These unprecedented monetary measures, pursued over more than seven years, have been necessary tools in the initial efforts to avert calamitous banking collapses; but their effectiveness has diminished over time, and the impact on the wider economies has at best been mediocre only.

Extreme tools
Fears that extreme tools, such as negative interest rates, may prove not only ineffective but outright damaging are now adding to instability. Policy makers are facing difficult dilemmas. The markets are still displaying an unhealthy appetite for huge quantities of cheap central bank money. Given the fragility of the global recovery, and the turmoil in the first two months of 2016, any premature withdrawal of stimulus could risk unleashing a new recession. Even the US Federal Reserve is scaling back earlier plans to tighten policy during 2016, although the US economy is creating jobs at a healthy pace and US core inflation is now above 2 p%.

In the eurozone and Japan, where real economies are weaker and inflation is lower than in the US, it is clearly much too early to raise interest rates. Nevertheless, the drawbacks associated with existing policies are becoming increasingly clear. By distorting investment decisions, ultra-low interest rates and other unconventional policies are making it easier for inefficient comapnies to survive. This impedes the necessary move of resources to more productive firms, damages economic growth and makes the entire policy counter-productive. There is too much emphasis on raising inflation towards its target, and too little focus on supply side policies that would boost growth.

Unfortunately it is difficult to identify effective alternative policies. Traditional Keynesians advocate a shift to fiscal policies, particularly increased spending on public investment, at a time when the cost of borrowing is historically low. Spending more on infrastructure is an attractive option, because it could boost productive potential. However, government finances are still overstretched, and the constraints of excessive deficits and debt ratios cannot be shrugged off. Like negative interest rates, fiscal activism could also prove to be counter-productive, hindering growth rather than supporting it. There are no easy choices. Government and central banks will have to adjust to more adverse circumstances; they may have to accept that weaker growth than before the crisis is inevitable, due to factors beyond their control. Using dangerous tools in repeated attempts to boost growth can do more harm than good.

Additional stimulus
As widely expected, the European Central Bank (ECB) announced additional stimulus at its 10 March meeting: the deposit rate was pushed further into negative territory, to -0.4%; the main refinance rate was cut to zero; and the quantatative easing programme was expanded further, from €60bn (£47.9bn) to €80bn per month. The ECB also announced measures aimed at boosting lending to businesses and consumers, while reducing the adverse impact of negative interest rates on bank profits. The ECB package was more expansionary than expected, but the euro recorded net rises since the new measures were announced. This reaction, which reflected disappointment with ECB president Mario Draghi’s comment that the scope for further interest rate cuts is now limited, was reinforced by the Fed’s shift to a more dovish attitude. Even so, in a longer term perspective, expectations of a strengthening euro vs. the dollar are illogical and somewhat perverse.

Growth will remain weaker in the eurozone than in the US, while inflation will remain lower, having fallen in February to -0.2%. US interest rates will remain higher than in the eurozone for the foreseeable future, since even a more dovish Fed will pursue tighter policies than the ECB. Official rates will not be cut much lower, but the ECB still has tools in its armoury to boost bank lending. But the underlying economic tensions in the eurozone, which will be exacerbated by the unresolved refugee crisis and by terror risks, will dampen further long term euro strength.

US GDP growth the fourth quarter of 2015 was revised up to an annualised 1%, still weaker than the 2% growth in the third quarter but better than the first estimate of 0.7 %. US growth is mediocre compared with previous cyclical recoveries. But our forecasts, at 2.1% in 2016 and 2.3% in 2017, remain considerably higher than in Japan and in the eurozone. At a time when the global economy is facing major headwinds, the US is an oasis of relative strength and stability.

Dovish Fed
The jobs market remains healthy. The US economy created 242,000 new jobs in February, well above expectations, while the gains of the previous two months were revised up by 30,000. The jobless rate held steady at 4.9 %, lowest since February 2008, and close to what many regard as “full employment”. Core US annual inflation, excluding energy & food, and a measure closely watched by the Fed, edged up to 2.3% pace in February, slightly above the Fed’s 2% target. Nevertheless, the Fed’s minutes published on 16 March were more “dovish” than expected, and downgraded predictions of future interest rises this year. While in December 2015 Fed officials signalled four increases in 2016, they are now anticipating two hikes only, much closer to market perceptions. In reaction to the minutes, which were seen as evidence that the Fed will be prepared to tolerate higher inflation before tightening policy, US inflation expectations rose markedly.

In the UK, the debate over Brexit has become increasingly acrimonious, as the divisions within the governing Conservative Party deepened. The post-Budget resignation from the government of Iain Duncan Smith (a strong Brexit supporter) forced the chancellor to abandon key planned welfare cuts, thus making it more difficult to implement ambitious plans to achieve a budgetary surplus by 2020. Though the UK is expected to continue growing more strongly than all major developed economies other than the US, and our flexible and dynamic labour market continues to create jobs at an impressive pace, sterling is set to remain under pressure due to a mixture of political and economic factors: Brexit fears, concerns over disarray in the government, a big external deficit and low productivity. In the face of global uncertainties, and with UK inflation expected to stay below the 2 per cent target until the final months of 2017, we expect the first modest increase in UK official rates in Q4 2016 at the earliest. But there is a realistic chance that UK tightening will only start in 2017.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce

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