October 2016: From monetary to fiscal

Central bankers responded to the global financial crisis with a mix of unconventional policies, including negative rates and asset purchases. Addressing September’s OMFIF main meeting in Rome, Banca d’Italia Governor Ignazio Visco noted that such policies helped cushion the initial shock, and that both subsequent GDP growth and inflation would have been lower without them. But they have hardly provided a panacea. As Visco also noted, such policies have distorted markets and created risks for financial stability. Extraordinarily loose policies have not only failed to boost growth substantially, but have also created dangerous debt overhangs in many economies. There have been some collateral effects too, examined in this month’s Bulletin. Charles Goodhart and Geoffrey Wood argue that these measures have hurt bank profitability, while Stijn Claessens and Nicholas Coleman of the Federal Reserve Board of Governors, and Michael Donnelly of MIT, consider evidence on the effect on banks’ net interest margins. Ben Robinson presents the findings of an OMFIF report, produced with BNY Mellon, showing that unconventional policies have reduced the supply of liquid assets for collateral. Panicos Demetriades, former governor of the Central Bank of Cyprus, highlights the negative consequences for central banks’ credibility and the notion of their independence. The good news is there are signs that monetary policy is reaching an important inflection point. This might not be apparent at first sight. The US Federal Reserve defied expectations that it would raise rates at its September meeting. But as Darrell Delamaide argues, this was driven more by politics than economics – a December rate rise is now a virtual certainty. Meanwhile, the Bank of Japan’s decision to refrain from a rate cut and introduce yield curve controls in asset purchases confirms a shift to a more flexible approach. Some monetary alchemy will still be needed to help Japan exit its debt trap without pain – the subject of OMFIF’s latest report, published in September, by John Plender. The case of the Bank of England is more worrying, maintains Peter Warburton, who argues that even a shock as big as Brexit did not warrant the Bank’s August rate cut.

Yet escaping from this unconventional quicksand dragging down central bankers will not be easy. As Luiz Pereira da Silva of the Bank for International Settlements told an OMFIF City Lecture in September, central bankers face a ‘singular dilemma’: continuing with such policies carries dangers in the long run, but exiting also risks market panic. One way to exit is to use more fiscal policy to ease the pain of tightening the monetary screws. With borrowing rates at historical lows, it is now time for governments to invest and they are not doing enough of it. This is not just a feature of developed markets: Donald Mbaka of the Central Bank of Nigeria echoes Visco’s warnings of a ‘suboptimal policy mix’. Despite these risks, the central bank that was the slowest to join the QE party may still find it hard to leave. Around half of respondents in our Advisory Board Poll expect the ECB to expand its QE programme into new asset classes instead of letting it expire in March 2017. This could bring the economics back into the spotlight, but for now Europe’s biggest headache remains its politics. As Vicky Pryce highlights, divisions across the euro area have risen and anti-euro movements are gaining ground in many countries. Steve Hanke alerts us to a doomsday scenario for Italian banks – even though the well-publicised problems of Deutsche Bank may provide Italy with a welcome distraction. There may be some silver linings for the European economy however, as Brexit creates an opportunity for financial centres on the continent. This month’s edition includes the second in OMFIF’s series of Focus reports, examining the case for Frankfurt. We round off with William Keegan’s review of an account of his time in politics by Ed Balls, the UK Labour party’s shadow chancellor who lost his parliamentary seat in the 2015 election.

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