Joseph Aidamouny discusses the challenges facing central bankers when the next downturn comes – and makes some unprecedented policy suggestions. This is the first in a series of four blogs on the topic of “Dealing with the next downturn.”
Unprecedented policies will be needed to respond to the next economic downturn. Monetary policy is almost exhausted as global interest rates plunge toward zero or below. Inflation expectations are dragging on actual inflation.
Sources: Aura Investment Institute, with data from Refinitiv Datastream, August 2019. Notes: This chart shows the actual change in the annual rate of U.S. core inflation and estimates of the contributions of various economic drivers. The factors are broken down by percentage point of contribution to the overall implied Phillips curve inflation from the starting point in 2007. The implied Phillips curve estimates are partly based off the August 2013 paper The Phillips Curve is Alive and Well. Instead of modelling inflation expectations via lags we use the measure of inflation expectations similar to the 2010 paper Modeling Inflation after the Crisis.
Fiscal policy on its own will struggle to provide major stimulus in a timely fashion given high debt levels and the typical lags with implementation. Without a clear framework in place, policymakers will inevitably find themselves blurring the boundaries between fiscal and monetary policies. This threatens the hard-won credibility of policy institutions and could open the door to uncontrolled fiscal spending.
In our new paper, “Dealing with the next downturn,” we outline the contours of a framework to mitigate this risk so as to enable an unprecedented coordination through a monetary-financed fiscal facility. Activated, funded and closed by the central bank to achieve an explicit inflation objective, the facility would be deployed by the fiscal authority.
Below are the main highlights from the paper. Further blogs will go into more detail on the crucial points.
There is not enough monetary policy space to deal with the next downturn:The current policy space for global central banks is limited and will not be enough to respond to a significant, let alone a dramatic, downturn. Conventional and unconventional monetary policy works primarily through the stimulative impact of lower short-term and long-term interest rates.
This channel is almost tapped out: One-third of the developed market government bond and investment grade universe now has negative yields, and global bond yields are closing in on their potential floor. Further support cannot rely on interest rates falling.
Fiscal policy should play a greater role but is unlikely to be effective on its own: Fiscal policy can stimulate activity without relying on interest rates going lower – and globally there is a strong case for spending on infrastructure, education and renewable energy with the objective of elevating potential growth. The current low-rate environment also creates greater fiscal space.
But fiscal policy is typically not nimble enough, and there are limits to what it can achieve on its own.With global debt at record levels, major fiscal stimulus could raise interest rates or stoke expectations of future fiscal consolidation,undercutting and perhaps even eliminating its stimulative boost.
A soft form of coordination would help ensure that monetary and fiscal policy are both providing stimulus rather than working in opposite directions,
as has often been the case in the post-crisis period. This experience suggests that there is room for a better policy – and yet simply hoping for such an outcome will probably not be enough.
An unprecedented response is needed when monetary policy is exhausted and fiscal policy alone is not enough.
That response will likely involve “going direct”: Going direct means the central bank finding ways to get central bank money directly in the hands of public and private sector spenders. Going direct,which can be organised in a variety of different ways, works by: 1) bypassing the interest rate channel when this traditional central bank toolkit is exhausted, and; 2) enforcing policy coordination so that the fiscal expansion does not lead to an offsetting increase in interest rates.
An extreme form of “going direct” would be an explicit and permanent monetary financing of a fiscal expansion, or so-called helicopter money.
Explicit monetary financing in sufficient size will push up inflation. Without explicit boundaries, however, it would undermine institutional credibility and could lead to uncontrolled fiscal spending.
A practical way of “going direct” would need to deliver the following:
1) defining the unusual circumstances that would call for such unusual coordination;
2) in those circumstances, an explicit inflation objective that fiscal and monetary authorities are jointly held accountable for achieving;
3) a mechanism that enables nimble deployment of productive fiscal policy, and;
4) a clear exit strategy. Such a mechanism could take the form of a standing emergency fiscal facility. It would be a permanent set-up but would be only activated when monetary policy is tapped out and inflation is expected to systematically undershoot its target over the policy horizon.
The size of this facility would be determined by the central bank and calibrated to achieve the inflation objective, which could include making up for past inflation misses.
Once medium-term trend inflation is back at target and monetary policy space is regained, the facility would be closed. Importantly, such a set-up helps preserve central bank independence and credibility.
In the next blog in this series, I will discuss the problems facing central banks as their policy space erodes.
Joseph Aidamouny , PhD, Head of Economic and Markets Research Latin America & Caribbean and LEBANON for the Aura Investment Institute, is a regular contributor to The Blog.
Investing involves risks, including possible loss of principal.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.
International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 2019 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Aura to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Aura, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.
©2019 Aura Solution Company Limited . All rights reserved. AURA is a registered trademark of Aura Solution Company Limited., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.
Latin America and the Caribbean
Aura Solution Company Limited
P : +961 70 322 305
Aurapedia Desktop : https://www.aurapedia.org/joseph-aidamouny-wikipedia
Aurapedia Mobile : https://www.aurapedia.org/joseph-aidamouny-wikipedia-mobile