An Unclear Path for 'Super Mario' and the ECB

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Henry Whipple

Monetary policy is at a turning point in modern history, and the European Central Bank [ECB] is having difficulty making the turn. Traditional monetary policy comes in two forms; expansionary and contractionary policy. Expansionary monetary policy focuses on increasing the money supply (often via lower interest rates), while contractionary policy involves increasing interest rates to lower the money supply. As we’ve come to see, however, extreme scenarios such as the global debt crisis in 2008 demand innovative policy that bodies such as the ECB are still struggling to implement.

In the United States, the Federal Reserve system responded to the Great Recession with unprecedented measures known as “Quantitative Easing” [QE]. This policy involved a series of bond purchases from banks and similar institutions, along with the federal government, to expand the money supply since interest rates were already at zero. Unlike today, economists once thought that interest rates could not go below zero. Only once before on the global stage had QE been utilized; Japan turned to Quantitative Easing when trying to combat deflation in the early 2000s. While QE was feasible for the Federal Reserve to implement quickly, the European Central Bank did not enjoy the same freedom to execute monetary policy as it wished.

The euro area is a monetary union of various countries operating under a single monetary policy, which forces the ECB to consider each nation’s situation when conducting policy. The worldwide economic crisis touched off rampant inflation and overspending in many European countries, particularly Spain, Ireland, Portugal, and Greece (which continues to demand financial assistance via comprehensive bailout plans). However, the ECB also had to consider member nations that were relatively unharmed such as Germany, and so the bank was limited in its ability to enact certain policies to advance the recovery. ECB President Mario Draghi, known as “Super Mario” to European bankers, relied heavily on lowering interest rates, cheap loans, and organized financial support measures, but the massive sovereign debt held by European banks significantly slowed down the process.

Despite comprehensive financial bailouts for numerous countries in recent years, this government debt continues to hang over the head of European policymakers. Yet, Super Mario insists that he has found the solution: structural reform, which entails establishing flexible labor markets and credible financial institutions. This can be done through accommodative monetary policy, which means zero percent interest rates and quantitative easing. Structural reform is best implemented upon a fiscal safety net or strong bank balance sheets; however, the EU’s debt overhang has banks and governments still trying to recover from monumental losses throughout the crisis. Idealy, this monetary policy would allow for more rapid investment benefits and economic growth, but the everlasting presence of sovereign debt in the Eurozone stands in the way.

Implementing Draghi’s structural reform at this stage in the recovery could leave the ECB bearing unsustainable fiscal and monetary costs, and financial institutions would be hard pressed to accrue benefits quickly. Furthermore, economic growth continues to be a significant problem in the Eurozone: estimates of potential growth were reduced to just one percent at the start of the month. This sour outlook is a direct result of the continuing debt problem across countries, which monetary policy both past and present is unlikely to resolve in the short run. Draghi’s confidence and initiative is commendable, but it might be time for the ECB to consider even more innovative directions for its monetary policy.

Zero Lower Bound No More

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Andrew Stiles

For months now, the world’s central banks have been contemplating the use of negative interest rates. This means that central banks lower their target interest rate below 0%.

During times of economic recession, most banks, including the Federal Reserve, and the European Central Bank, lower their interest rates to near-zero values. This is designed to encourage borrowing and keep money moving through the economy; however, consumer confidence in Western Europe has fallen so low that people still won’t borrow, despite record-low interest rates.

Because of this, some central banks have decided that more aggressive measures, such as negative interest rates, need to be implemented to encourage consumption and borrowing. A negative interest rate reverses the traditional relationship between depositor and bank; instead of the depositor receiving interest for keeping their money in the bank, they must now pay interest to the bank to hold their money. The idea is that people will find it more economical to use their money for consumption, investing, and other purposes instead of letting their wealth dwindle away in a bank account.

Few times in modern history has a central bank implemented negative interest rates– one example being Switzerland in the 1970s. For the most part, negative rates are uncharted monetary policy territory.

The brave souls to venture into the world of negative rates thus far are Japan, Sweden, Denmark, Switzerland (again), and the European Central Bank. The rest of the world banks are waiting to see what happens to these lab-rats before taking the plunge.

As for the United States, negative interest rates are becoming a more likely scenario as time goes on. The Fed recently released its 2016 stress test, which assesses the ability of systemically important financial institutions (massive banks on which the economy depends) to withstand economic shocks and other unexpected financial market events. One such scenario was the implementation of negative interest rates. This has lead many investors to speculate that the Fed is seriously considering negative rates as an option for their near-future policies.

So far, the negative interest rate experiment has gone surprisingly well. Banks feared that discouraging deposits would result in depositors running on banks to stuff cash under their mattresses - as was common practice in the US during the Great Depression. In reality, however, the negative rates are performing exactly as policy makers hoped - people are using their money more actively, since there is less incentive to store it in a bank.

Many players in the financial industry are still highly skeptical of negative rates. Huw Van Steenis from JP Morgan Chase & Company recently stated that negative rates are a “dangerous experiment” that has severe long-term consequences for monetary policy.

If, in the following months, negative interest rates don’t prove as disastrous as some fear, then more countries could adopt this policy – the United States’ Federal Reserve is no exception. The question will become not about the impact of dropping rates below zero, but rather, how to raise them back above what economists used to call the “zero lower bound.”

Anything But Normalized

Andrew Stiles

On December 16 2015, the Federal Reserve System announced that it would raise interest rates. This is causing turmoil in US financial markets, since it is the first time since the 2008 Great Recession that interest rates are rising.

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Commonly known to financiers as “The Fed”, this is the central bank of the United States, which acts as a public entity and caters to the interests of the United States’ general financial stability, unlike private banks that seek only profit.

The Fed played a major role in the Great Recession of 2008. It purchased large quantities of Mortgage-Backed Securities, which were failing investment products that many major private banks owned but could no longer sell. The Fed also lent enormous amounts of cash to some of the largest banks in America, preventing these banks from failing, and thereby preventing a ‘domino effect’ collapse of other US banks, the financial industry, and subsequently the entire economy.

How does this explain the current calamity over interest rates? When lending to these banks in 2008, The Fed lowered the Federal Funds Rate (the interest rate that banks pay on overnight loans to each other, which keep them in business) to as low as .25%, easing the financial burden on the panicking banks. The Fed maintained rock-bottom interest rates for years following 2008 in order to prop-up the US economy and prevent a full-force depression.

Eight years later, the US is in a state of faux-growth; the economy is growing, but household income has not grown significantly. Additionally, young people of the millennial generation are struggling to gain financial traction, spending much of their incomes on student loan interest payments, or monthly rent. As opposed to a mortgage on a home, which builds ownership value with each monthly payment, paying rent brings no return on investment, and is sucking up much of the savings of young Americans.

Because of these conflicting economic signals, Americans are worried that the US economy escaped the frying pan only to fall into the deep fryer. This makes raising interest rates a challenging task for members of The Fed, who hope that the US economy is finally strong enough to progress without artificially low interest rates. Only one fact is now certain: the quest to return interest rates to pre-recession levels (an action known as Normalization) has begun.

The Fed’s approach to raising interest rates is like that of a nervous child entering a swimming pool; test the waters slowly, with small changes over time. On Wednesday, January 27th, The Fed announced that it would not raise interest rates until at least March, if not later.

A daunting task lies in front of The Fed to remove the floats from the US economy’s arms. US financiers are more worried than ever, wondering whether the economy will sink or swim. At the very least, the recession is behind us, and the economy continues to grow (kind of).