Central banks aren’t out of antidotes, but beware the dangerous tonic of helicopter money
After years of unconventional monetary policy but stubbornly low inflation, investors are asking whether central banks are out of ammunition.
But central banks are not soldiers fighting a war; they are doctors trying to cure a disease. As traditional medicines fail, they try ever more experimental cures.
After the standard dose of rate cuts proved insufficient, quantitative easing (QE) was the first out of the cupboard of alternative remedies. But QE is really just switching focus from the price of money to the quantity of money.
Negative rates are a truly experimental medication, but the side effects could outweigh the benefits. If savers are targeting a level of retirement income, negative rates mean that they will have to save more, not less. And if banks cannot or will not pass on the negative rates to depositors, they may actually increase loan interest rates so as to preserve their profit margins.
If QE did not fix the problem, and negative rates are approaching their limit, what is left?
The obvious answer is helicopter money, more formally known as monetisation. This is printing money to permanently increase the money supply (unlike QE which is a temporary increase).
If monetisation is to work, it must trigger additional spending. It could finance a new fiscal stimulus, or be given directly to households. Monetisation would be more equitable than QE, which inflates asset prices, and by definition more assets are owned by the wealthy, who are least likely to spend their windfall.
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Monetisation is not a revolutionary concept. In the past it has led to hyperinflation, but most people do not realise that every year central banks print some money to keep the money supply in line with growing economic activity.
The government benefits from this monetisation, but the size is small so the impact on the economy is limited. It is all a matter of dosage.
Monetisation is not free; it leaves a hole in the central bank balance sheet. It creates a liability (cash and bank reserves are a promise by the central bank to pay) but no asset on the other side of the balance sheet. When interest rates rise, the central bank may end up paying out more interest than it receives. This is not insurmountable, but demonstrates the limits of monetisation.
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Critics of monetisation argue that it will push up inflation expectations. They are right, but that is the whole point.
Monetisation makes sense when the central bank has lost credibility and inflation expectations have fallen too low. It does not make sense when inflation expectations are on target or too high, or when the government simply wants to avoid difficult decisions on taxation.
The real danger with monetisation is that it can be like a drug; it seems to answer all the difficult questions at little cost.
It is like a drug that makes your heart beat faster: life-saving if your heart rate is slow, life-threatening if your heart rate is high. Thus it is best left under the control of the doctors, not the patient.