AMP Capital – 23 August 2016
Chief Economist and Head of the Investment Strategy team
For the last two decades, advanced country central banks have been focussed on price stability and have played the first line of defence in stabilising the economic cycle whereas fiscal policy has played back up, focussing more on fairness and efficiency. This same approach has been applied since the global financial crisis with fiscal policy relegated to the back seat since 2010 because growth hadn’t collapsed and there has been a desire to stabilise public debt. But we are starting to see debate about whether a new approach is needed. The issue has been highlighted by San Francisco Fed President John Williams.1
Why the debate?
Several factors are driving this debate including:
- Concerns that too much is being asked of monetary policy in the face of structural factors that may be depressing growth. These include aging populations, high private sector debt levels, rising levels of inequality (as high income earners save more of their income than low income earners – so a greater share of income going to high income earners means slower economic growth) and low levels of investment in an increasingly “capital lite” economy.
Data is after taxes and welfare transfers. Source: OECD, AMP Capital
- A fall in the natural (or equilibrium) rate of interest as slower population and productivity growth drive slower potential economic growth.
- Concerns that relying too much on easy monetary policy may contribute to rising inequality as low interest rates disproportionally harm lower income earners but higher share markets help high income earners.
Monetary policy has worked
For what it’s worth, my view is that ultra easy monetary policy has worked during the last few years.
- In the absence of aggressive monetary easing, advanced countries would likely have faced depression, deep deflation and a complete financial meltdown after the GFC.
- On virtually all metrics – confidence, employment, unemployment, underemployment, consumer spending, business investment, bank lending, core inflation – the US economy has improved significantly in recent years. And the household savings rate has fallen from its post-GFC high.
- Similarly in Australia, the fall in interest rates since 2011 has helped the economy rebalance in the face of collapsing mining investment: via a pick-up in housing construction and growth in consumer spending. While those close to retirement may be saving more because of lower investment returns, the household saving rate overall has drifted down from 11% to around 8% since the first RBA rate cut in 2011. And the RBA rate cuts have helped push the $A lower, which has helped sectors like tourism and higher education.
- Japan and Europe have been less successful – perhaps because they were slower and less aggressive in easing initially. But even so, core inflation in both regions is up from its lows and unemployment has been falling.
- And much of the threat of deflation in recent years has been due to the plunge in commodity prices – which is mainly due to a surge in their supply – rather than any failure of easy monetary policy. This looks to have largely run its course.
However, it is right to ask whether too much is being asked of monetary policy.
Monetary versus fiscal policy
There are several aspects to this debate. First, some have suggested – mostly in Australia – that inflation targets should just be lowered but this “changing the goal post” approach will just lock in very low inflation and leave us vulnerable to deflation in the next downturn. Falling prices can be good if it reflects high productivity and where wages growth is strong. But in the current environment of high debt levels, it would most likely be bad because it would make it harder to service debt and further threaten economic growth. So lowering inflation targets makes no sense.
Second, it’s been suggested that the approach to inflation targeting should be changed to either a higher inflation rate target (as this might make achieving a lower real official rate of interest easier – eg getting a real interest rate of -3% if that is needed to boost the economy is much easier if inflation is 3% than if it is 2%) or switch to targeting either price levels or nominal GDP levels (which would mean that if there is underachievement in one period it would have to be made up in the next). While these sound nice in theory, they remind me of the joke about an economist on a deserted island with a can of baked beans who assumes he has a can opener. Neither approach actually gets inflation up.
Third, another approach is to adopt a larger role for government spending and taxation policy in areas that enhance economic growth, like infrastructure, in measures to reduce inequality and in terms of more countercyclical spending (such as public spending that automatically ramps up with rising unemployment and falls with falling unemployment).
Finally, there are policies that combine both monetary and fiscal policy using some form of monetary financing of public spending, often called “helicopter money”. It would have the benefit of a much bigger spending payoff than quantitative easing (much of which just sat in bank reserves), the spending could be targeted to reach fairness objectives and it could be wound back when inflation objectives are met.
Issues and constraints
Of these, the measures involving a greater role for fiscal policy make more sense. As noted, lower inflation targets would make no sense. Higher inflation targets have merit and it’s worth noting that when Australia introduced its relatively high (by New Zealand standards!) inflation target of 2-3% over 20 years ago, it was partly motivated by a desire for flexibility on the downside. So there is a case for the 2% targets in the US, Japan and Europe to be revised to 2-3% just like Australia!
Similarly price level or nominal GDP level targeting has merit. But a central bank targeting nominal GDP does leave it with too much responsibility for real GDP growth and could lead to years where, say, a nominal growth target of 5% is met but it’s made up of too much inflation. More broadly, as noted earlier, all these ideas do little to actually push inflation up.
Which brings us to a greater role for fiscal policy. An obvious constraint here is that public debt to GDP ratios remain way up from pre GFC levels – and in fact in most countries have increased over the last few years – despite several years of austerity. This can be seen in the next chart.