Central banks have long exercised influence over booms and busts, but their ability is shrinking.
The Federal Reserve and other central banks have long been the unchallenged drivers of financial markets and the business cycle. “Don’t fight the Fed,” goes one Wall Street adage.
That era is drawing to a close. In many countries, interest rates are so low, even negative, that central banks can’t lower them further. Tepid economic growth and low inflation mean they can’t raise rates, either.
Since World War II, every recovery was ushered in with lower rates as the Fed moved to stimulate growth. Every recession was preceded by higher interest rates as the Fed sought to contain inflation.
But with interest rates now stuck around zero, central banks are left without their principal lever over the business cycle. The Eurozone economy is stalling, but the European Central Bank, having cut rates below zero, can’t or won’t do more. Since 2008, Japan has had three recessions with the Bank of Japan, having set rates around zero, largely confined to the sidelines.
The U.S. may not be far behind. “We are one recession away from joining Europe and Japan in the monetary black hole of zero rates and no prospect of escape,” said Harvard University economist Larry Summers. The Fed typically cuts short-term interest rates by 5 percentage points in a recession, he said, yet that is impossible now with rates below 2%.
Workers, companies, investors and politicians may need to prepare for a world where the business cycle rises and falls largely without the influence of central banks.
“The business cycle we’re used to is a bad guide to business cycles going forward,” said Ray Dalio, founder of Bridgewater Associates LP, the world’s biggest hedge fund.
In November, Fed chairman Jerome Powell warned Congress that “the new normal now is lower interest rates, lower inflation, probably lower growth…all over the world.” As a result, he said, the Fed is studying ways to alter its strategy and develop tools that can work when interest rates approach zero.
Central banks are calling on elected officials to employ taxes, spending and deficits to combat recessions. “It’s high time I think for fiscal policy to take charge,” Mario Draghi said in September, shortly before stepping down as ECB president.
There are considerable doubts that any new tools can restore the influence of central banks, or that countries can overcome obstacles to more robust fiscal policy, particularly political opposition and steep debt.
Business cycles in the future may resemble those of the 19th century, when monetary policy didn’t exist. From 1854 to 1913, the U.S. had 15 recessions, according to the National Bureau of Economic Research, the academic research group that dates business cycles. Many were severe. One slump lasted from 1873 to 1879, and some historians argue it lingered until 1896.
Fed’s Fading Influence
U.S. recessions were more frequent before the Federal Reserve took control over interest rates, using them as a lever to slow inflation or boost the economy. Low rates have weakened the central bank by giving it little room to reduce rates further.
The Fed’s sway over the economy has also been weakened by a decline in durable manufacturing and construction, which are sensitive to rates, and the growth in services, which aren’t.
Sources: National Bureau of Economic Research (recessions); Sidney Homer and Richard Sylla (interest rates 1854-1933); Federal Reserve (interest rates 1934-present); U.S. Commerce Department (value-added shares of GDP)
Kathryn Tam/THE WALL STREET JOURNAL
The causes of business cycles were diverse, Wesley Claire Mitchell, an NBER founder, wrote in 1927. They included “the weather, the uncertainty which beclouds all plans that stretch into the future, the emotional aberrations to which business decisions are subject, the innovations characteristic of modern society, the ‘progressive’ character of our age, the magnitude of savings, the construction of industrial equipment, ‘generalized overproduction,’ the operations of banks, the flow of money incomes, and the conduct of business for profits.”
He didn’t mention monetary or fiscal policy because, for all practical purposes, they didn’t exist. Until 1913, the U.S. hadn’t had a central bank, except for two brief periods. As for fiscal policy, U.S. federal spending and taxation were too small to matter.
When central banks were established, they didn’t engage in monetary policy, which means adjusting interest rates to counter recession or rein in inflation. Many countries were on the gold standard which, by tying the supply of currency to the stock of gold, prevented sustained inflation.
The Fed was established in 1913 to act as lender of last resort, supplying funds to commercial banks that were short of cash, not to manage inflation or unemployment. Not until the Great Depression did that change.
In 1933, Franklin D. Roosevelt took the U.S. off the gold standard, giving the Fed much more discretion over interest rates and the money supply. Two years later, Congress centralized Fed decision-making in Washington, better equipping it to manage the broader economy.
Macroeconomics, the study of the economy as a whole instead of individuals and firms, was born from the work of British economist John Maynard Keynes. He showed how individuals and firms, acting rationally, could together spend too little to keep everyone employed.
In those circumstances, monetary or fiscal policy could generate more demand for a nation’s goods and services, Mr. Keynes argued. Just as a dam regulates the flow of a river to counter flooding and drought, monetary and fiscal-policy makers must try to regulate the flow of aggregate demand to counter inflation and recession.
The Employment Act of 1946 committed the U.S. to the idea of using fiscal and monetary policy to maintain full employment and low rates of inflation.
The next quarter-century followed a textbook script. In postwar America, rapid economic growth and falling unemployment yielded rising inflation. The Fed responded by raising interest rates, reducing investment in buildings, equipment and houses.
- The economy would slide into recession, and inflation would fall.
- The Fed then lowered interest rates, investment would recover, and growth would resume.
The textbook model began to fray at the end of the 1960s. Economists thought low interest rates and budget deficits could permanently reduce unemployment in exchange for only a modest uptick in inflation. Instead, inflation accelerated, and the Fed induced several deep and painful recessions to get it back down.
By the late 1990s, new challenges emerged. One was at first a good thing. Inflation became both low and unusually stable, barely fluctuating in response to economic growth and unemployment.
The second change was less beneficial. Regular prices were more stable, but asset prices became less so. The recessions of 2001 and 2008 weren’t caused by the Fed raising rates. They resulted from a boom and bust in asset prices, first in technology stocks, then in house prices and mortgage debt.
After the last bust, the Fed kept interest rates near zero from 2008 until 2015. The central bank also purchased government bonds with newly created money—a new monetary tool dubbed quantitative easing—to push down long-term interest rates.
Despite such aggressive stimulus, economic growth has been slow. Unemployment has fallen to a 50-year low, but inflation has persistently run below the 2% target the Fed set. A similar situation prevails abroad.
In Japan, Britain and Germany, unemployment is down to historic lows. But despite short-and long-term interest rates near and sometimes below zero, growth has been muted. Since 2009, inflation has averaged 0.3% in Japan and 1.3% in the Eurozone.
The textbook model of monetary policy is barely operating, and economists have spent the last decade puzzling why.
One explanation focuses on investment, the main driver of long-term economic growth. Investment is financed out of saving. When investment is high relative to saving, that pushes interest rates up because more people and businesses want to borrow. If saving is high relative to investment, that pushes rates down. That means structurally low investment coupled with high saving by businesses and aging households can explain both slow growth and low interest rates.
Richard Clarida, the Fed’s vice chairman, cited another reason during a speech in November. Investors in the past, he said, demanded an interest rate premium for the risk that inflation would turn out higher than they expected. Investors are now so confident central banks will keep inflation low that they don’t need that premium. Thus, central banks’ success at eradicating fear of inflation is partly responsible for the low rates that currently limit their power.
While the Fed’s grip on growth and inflation may be slipping, it can still sway markets. Indeed, Mr. Dalio said, the central bank’s principal lever for sustaining demand has been its ability to drive up asset prices as well as the debt to finance assets, called leverage. Since the 2008 crisis, low rates and quantitative easing have elevated prices of stocks, private equity, corporate debt and real estate in many cities. As prices rise, their returns, such a bond or dividend yield, decline.
That dynamic, he said, has reached its limit. Once returns have fallen close to the return on cash or its equivalent, such as Treasury bills, “there is no incentive to lend, or invest in these assets.” At that point, the Fed is no longer able to stimulate spending.
Less than zero
A central bank can always raise rates enough to slow growth in pursuit of lower inflation; but it can’t always lower them enough to ensure faster growth and higher inflation.
The European Central Bank has tried—cutting interest rates to below zero, in effect charging savers. Its key rate went to minus 0.5% from minus 0.4% in September. At that meeting and since, resistance has grown inside the ECB to even more negative rates for fear that would reduce bank lending or have other side effects.
In December, Sweden’s central bank, which implemented negative rates in 2015, ended the experiment and returned its key policy rate to zero. Fed officials have all but ruled out ever implementing negative rates.
In a new research paper, Mr. Summers, who served as President Clinton’s Treasury secretary and President Obama’s top economic adviser, and Anna Stansbury, a Ph.D. student in economics at Harvard, say very low or negative rates are “at best only weakly effective…and at worst counterproductive.”
They cited several reasons why. Some households earn interest from bonds, money-market funds and bank deposits. If rates go negative, that source of purchasing power shrinks. Some people nearing retirement may save more to make up for the erosion of their principal by very low or negative rates.
Moreover, the economy has changed in ways that weaken its response to interest-rate cuts, they wrote. The economy’s two most interest-sensitive sectors, durable goods manufacturing, such as autos, and construction, fell to 10% of national output in 2018 from 20% in 1967, in part because America’s aging population spends less on houses and cars. Over the same period, financial and professional services, education and health care, all far less interest sensitive, grew to 47% from 26%.
They concluded the response of employment to interest rates has fallen by a third, meaning it is harder for the Fed to generate a boom.
The U.S. isn’t likely to plunge into another financial crisis like 2008, Mr. Dalio said, as long as interest rates remain near zero. Such low rates allow households and companies to easily refinance their debts.
More likely, he said, are shallow recessions and sluggish growth, similar to what Japan has experienced—what he called a “big sag.”
Former Fed chairman Ben Bernanke this month estimated that through quantitative easing and “forward guidance,” committing to keep interest rates low until certain conditions are met, the Fed could deliver the equivalent of 3 percentage points of rate cuts, enough, in addition to two to three points of regular rate cuts, to counteract most recessions.
Mr. Clarida warned, however, that quantitative easing may suffer from diminishing returns in the next recession. Moreover, the next recession is likely to be global, he said this month, and if all major countries weaken at the same time, it will push rates everywhere toward zero. That would make it harder for the Fed or any other central bank to support its own economy than if only one country were in trouble.
With central banks so constrained, economists say fiscal policy must become the primary remedy to recessions.
History shows that aggressive fiscal policy can raise growth, inflation and interest rates. The U.S. borrowed heavily in World War II. With help from the Fed, which bought some of the debt and kept rates low, the economy vaulted out of the Great Depression. Once wartime controls on prices and interest rates were lifted, both rose.
Today, mainstream academic economists are again recommending higher inflation and deficits to escape the low-growth, low-rate trap.
Advocates of what is called modern monetary theory say the Fed should create unlimited money to finance government deficits until full employment is reached. Some economists call for dialing up “automatic stabilizers,” the boost that federal spending gets during downturns, via payments to individuals and state governments as well as infrastructure investment.
Yet fiscal policy is decided not by economists but by elected officials who are more likely to be motivated by political priorities that conflict with the economy’s needs. In 2011, when unemployment was 9%, a Republican-controlled Congress forced Mr. Obama to agree to deficit cuts. In 2018, when unemployment had fallen to 4%, President Trump and the GOP-controlled Congress slashed taxes and boosted spending, sharply raising the budget deficit. Mr. Trump has pressured Mr. Powell to cut rates more and resume quantitative easing, which the Fed chairman has resisted.
Fiscal policy in the Eurozone is hampered by rules that limit the debt and deficits of its member countries. It is also hamstrung by divergent interests: Germany, the country that can most easily borrow, needs it least. In recent years it has refused to open the taps to help out its neighbors.
Still, Mr. Dalio predicted that a weakened Fed will eventually join hands with the federal government to stimulate demand by directly financing deficits.
Once central banks have agreed to finance whatever deficits politicians wish to run, however, they may have trouble saying no when the need has passed.
The experience abroad and in the U.S.’s past suggests that once politicians are in charge of monetary policy, inflation often follows. In the 1960s and 1970s, presidents Johnson and Nixon pressured the Fed against raising rates, setting the stage for the surge in inflation in the 1970s. Such a scenario seems remote today, but it may not always be.