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27 September 2015

Financial Times: What if the Fed is wrong?

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The FOMC supports a rate hike this year, believing that a firm recovery has now taken hold in the US. But the markets think that the emerging market shock is gathering momentum and that it could bring the developed economies down with it. What would happen if the Fed is making a historic mistake?

[...] That was the question posed, implicitly, by the Bank of England’s Chief Economist Andrew Haldane in one of his challenging speeches on 18 September. As he points out, it is quite likely that the next recession in the developed world will arrive with interest rates still stuck close to the zero lower bound. What then? [...]

The most obvious option would be to go for another large dose of quantitative easing. That option was chosen repeatedly after 2010 mainly because it was politically feasible. The central banks were willing to press the button, the public did not understand the consequences, and the political opposition was wrong footed when QE seemed to work without causing inflation.

But that was then, and the next time could be very different. Government bond yields are already very low, and recent experience with large injections of QE by the ECB and the Bank of Japan have not been all that encouraging. Furthermore, a political backlash is beginning to get off the ground. QE is now widely seen as helping holders of financial assets – the rich – and the banking sector. Central banks might run into severe political opposition if they were to launch yet another open ended programme of asset purchases and liquidity injections into ailing banks.

Nevertheless, this would initially be the path of least resistance if a global recession took hold. QE has now become almost a conventional arm of monetary policy, and the majority of today’s central bankers still firmly believe in it. But in order to work next time, it would need to be extended to purchases of private sector assets, notably equities.

That would be far more controversial than government bond purchases, and would involve taking much more risk onto the central bank balance sheet. It is far from obvious that central bankers will be willing to undertake this on any significant scale. In any event, such action clearly involves transfers of wealth between citizens, which is normally thought to be the preserve of the fiscal authorities.

There are two other, highly unconventional, methods of circumventing the problem of the zero lower bound: “crypto” money and “helicopter” money.

Haldane seems surprisingly sympathetic to the former, which would involve banning physical cash while forcing everyone to use a sort of government-sponsored bitcoin currency. This would work in theory because it would enable the government to levy negative interest rates on citizens holdings of electronic cash, and people would no longer be permitted to avoid these levies by shifting their liquid holdings into banknotes. This would theoretically allow the central bank to drive interest rates deep into negative territory if they needed to do so.

FT Economics Editor Chris Giles argued strongly against the social and political legitimacy of this idea last week. In addition, the notion will be impractical for many years, since a large proportion of the population will not have shifted any of their cash holdings to electronic money. Furthermore the politics of this look daunting. Few would support a party that wants to ban cash in order to force citizens to hold electronic wallets that could subsequently be subjected to levies. It is surely political poison.

The final option is helicopter money, involving the permanent monetisation of higher budget deficits. In effect, it would mean printing money to buy goods and services, instead of financial assets. [...]

A shortage of aggregate demand can, always and everywhere, be eliminated by this strategy. But, until now, it has not been publicly supported by any central bank, because it is (rightly) deemed to be inflationary in the long run. [...]

Could such an extraordinary step ever become conceivable? Clearly, if the newly printed money were piled into extra public expenditure, Corbyn-style, it would be implacably opposed by the political right. But if it were used to finance tax cuts, with lower marginal rates for income and capital gains tax, it might gain some surprising converts.

The problem with helicopter money, of course, is that it would be extremely difficult to apply the correct dose to combat deflation, without risking a sea change in the political climate that eventually leads to much higher inflation. Would democratic politicians really be able to leave such a potent weapon in the hands of “independent” central bankers when under electoral pressure? Andrew Haldane is sceptical about the risk that “fiscal dominance” over the monetary authorities would take hold, and he is right.

It is clear that none of the options to control the next downturn comes without serious collateral problems. If the Fed does raise rates this year, their judgment had better be right.

Full article on Financial Times (subscription required)

© Financial Times

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