Central banks have been the only game in town for years now, driving asset prices higher with the help of interest rate cuts and quantitative easing (QE) programs. But all these policies were meant to do is to buy time - and time is running out. Central banks are not entirely out of bullets, but their ability to respond to the next downturn appears limited.
We don't see much scope for rates to go more negative, as evident in the chart above. But this isn't the only limit of monetary policy. We see current policies losing effectiveness over five key dimensions:
Negative interest rate policies are just basis points away from a hard limit: It will soon make sense to hoard cash. Also, negative rates targeted at depreciating currencies are a zero-sum game for the world.
Interest rate cuts lose their effectiveness if households and businesses see rates staying low for too long. There is no rush to borrow and invest today. And low rates make savers poorer, reducing demand.
Negative and "low for long" rates pressure bank profitability, potentially curbing credit creation. They also threaten the viability of money market funds and make life tough for investors with nominal liabilities, such as insurers and pension funds.
Financial stability is an underappreciated limit on monetary policy. These risks can be high even with low growth and inflation, the traditional focus of central banks. We see financial stability risks rising, the longer growth stays tepid and monetary policy easy.
Expectations do a lot of the heavy lifting for monetary policy. The absence of clarity on the response to a significant downside surprise undermines the effectiveness of the policy framework. Japan is a cautionary tale. Credibility is difficult to regain once it is lost.
To overcome these limits, the policy mix needs to shift toward fiscal policy. We see potential for quasi-fiscal operations, such as broader credit easing by central banks or sovereign guarantees on infrastructure projects, as part of the solution.
Easy monetary conditions should keep yields compressed in the near term and support risk assets, including European credit and equities. A greater shift towards quasi-fiscal policy could create investment opportunities in credit and infrastructure. We also see a broader reflationary theme playing out, particularly in inflation break-evens.
Until we get a Plan B, markets will likely doubt the ability of policymakers to deal with the next downturn. A credible plan must be explicitly fiscal and have political support. Otherwise, more drastic responses may be required, including ill-conceived helicopter drops of money. This could be a drag on current growth and cause risk-on/risk-off gyrations, making long-duration bonds useful portfolio diversifiers.
Jean Boivin, PhD, is head of economic and markets research at the Blackrock Investment Institute. He is a regular contributor to The Blog.
This post originally appeared on the BlackRock Blog.