There is a common misconception that central banks are responsible for increasing potential growth. Whilst easy monetary policy can certainly create conditions that incentivise productive investment, the role of a central bank is primarily to manage the demand side of the economy in order to smooth the business cycle. Their role focuses on estimating rather than improving potential growth and productive capacity.
The world fears a slowdown in emerging markets and its spillovers to developed economies. As China slows and world trade decelerates, markets understand that a “new normal” of slower trend growth exists, at least in the near term.
Despite the gloomy outlook I am presenting, I am a big believer in the process of creative destruction and productivity revolutions only seem obvious in hindsight. Hence, to speak about potential growth decades into the future is a fool’s errand. That said, the market is finally adjusting to the idea of potential growth being lower than the pre-recession levels we are used to.
Implications for Monetary Policy
Lower trend growth, at least over an individual business cycle, actually speaks to an economy reaching capacity sooner rather than later. The point, which has been emphasised by the Fed continually, is that the pace matters. Low trend growth speaks to a very slow pace of hikes with a terminal rate much lower than what markets are used to. The implication, however, that the Fed should not start hiking due to lower global growth is actually counterintuitive, if this lower growth is structural rather than cyclical. Inflationary pressures, at least by conventional economic theory, will build earlier in this scenario.
The Fed has highlighted decreasing slack and an improving domestic economy. Despite the weak payrolls print last week, it is estimated that only 75K-100K jobs are required to keep the unemployment rate constant. The Fed decides policy on the assumption that a tight labour market will eventually feed into inflationary pressures and hence what holds the Fed back, other than global growth concerns, is the currency and this is based on divergent monetary policy. The ECB and BOJ are expected to extend/expand QE whilst the Fed is attempting to start a hiking cycle. Whoever goes first in this scenario reduces the pressure on the other central bank to act. A Fed that is hiking takes pressure off further European QE and further European QE puts pressure on the U.S. to stay put.
I argue that a Fed on a hiking path and the ECB less pressured to extend QE is a much healthier environment for the global economy in a world where trend growth is lower. After all, QE does have its unintended consequences and I argue the costs of further global easing outweigh the marginal benefits.
Dangers of more QE
In a world built on confidence, monetary policy can be a signal to consumers and investors on the state of the economy. A Fed that cannot get off the mark and an ECB pumping more liquidity (despite signs of improving fundamentals) sends a negative signal to the real economy and will hold back confidence and the propensity to consume/invest. Furthermore, excess liquidity may ultimately lead to asset bubbles and inefficient investment. Perhaps hiking rates may indirectly improve allocative efficiency and thus potential growth as investors are forced to choose projects and direct hot money more carefully. Lastly, despite initial improvements to risk sentiment and expectations after QE announcements, it would be fair to say that QE has not been effective in truly improving inflation expectations.
I am not suggesting the Fed needs to hike to improve the global economy. After nine years on hold, a delayed hike in the grand scheme of things is not a big issue. My point is that the world economy would be healthier if the Fed leads the way allowing policy differentials to be maintained via slightly higher rates rather than more ECB QE. The global economy is certainly fragile but if this is structural rather than cyclical, the economy will reach capacity constraints quicker than you may expect.