Monetary policy is a cyclical tool used to bring forward future demand. The idea is that you can smooth the business cycle and raise inflation by lowering interest rates and encouraging people to spend and invest. The BIS recently published a strong critique of unconventional monetary policy which has gone from “exceptional and temporary” to “standard and permanent” 1. In an attempt to raise subdued inflation globally, central banks have continued to explore the monetary policy toolbox. The BIS argue that unconventional monetary policy can have serious unintended consequences that can be entirely counterproductive and hence should only be reserved for crises.
I am not as big a critique of easy monetary policy since low inflation indicates slack. However, the BIS argument does have its merits. Most economic models make a key assumption of rationality but more often than not, people are predictably irrational. Central banks have pushed nominal interest rates negative in an attempt to further reduce real rates. Whilst rational individuals should only care about real economic variables and their ability to purchases real goods and services, this is not the case in reality. It is this intersection between economics and psychology that economists often underappreciate. Theoretically, you should not care about nominal variables if you are better off in real terms, but in reality, people view negative interest rates as a tax. Ironically, it can be viewed as double taxation if it succeeds in raising inflation.
Counterintuitively, consumers may spend less when interest rates are reduced in order to maintain the same level of savings. Whilst this can occur at positive nominal interest rates as well, psychologically, the effect is probably larger as interest rates approach zero or negative.
Furthermore, it is very hard to pass on negative interest rates to the depositor and therefore they can act as a tax on banks. In Switzerland, mortgage rates actually increased to protect bank profit margins as the central bank pushed rates further into negative territory.
What does all this mean for interest rates?
Central banks will continue to fight low inflation. Whilst they recognise the unintended consequences and the limits of monetary policy, they will not give up in their attempt to achieve their (growth and) inflation mandate. They would never admit defeat explicitly. However, as their options diminish and markets become more distorted, the rhetoric for fiscal policy has stepped up. Central banks will maintain low or negative rates to facilitate larger government deficits and help sustain higher levels of debt.
Would fiscal policy work?
It depends. If the action is co-ordinated such that the market views the move as monetary financing, then inflation expectations would almost certainly rise at the expense of ending decades of central bank independence. This would cause curves to steepen globally. It is more likely such an aggressive step will be reserved for the next crisis. However, debt-financed fiscal policy is the most logical next step in raising nominal growth. Demand targeted fiscal policy would probably raise inflation, if consumers do not expect higher tax rates in the future. That said, there are many issues in the global economy that bringing forward future consumption simply cannot solve. I would prefer to see fiscal policy targeted at raising potential growth which could increase slack and be detrimental to the inflation mandate in the short term.
Ultimately, I believe yields will remain lower for longer as central banks remain extremely accommodative and fiscal policy will most likely remain debt financed and small in scale. However a political shift, either in the form of large scale fiscal policy or monetary financing, is the biggest risk to this view. For now, this remains unlikely.
1 Unconventional monetary policies: a re-appraisal, BIS, https://www.bis.org/publ/work570.htm