The Federal Reserve and other major central banks have a relatively straightforward, albeit difficult, mandate to maximize employment and keep inflation stable. But many politicians and investors see the Fed and other central banks as something else: the all-powerful solution to bad investments and bad policies.
This false worship is misguided. If central banks fail to turn toward pro-growth government policies and do not coordinate investment in research and development, their ability to restart growth will reach its limit.
Retailers, manufacturers, and brands need to consider strategies not only during a recession, but also after a recession when central banks play a minor role in the recovery. Instead, fiscal policy that is largely set by politicians will have to steer the economy toward sustainable growth. Starkly different political visions for the government’s role in the economy could create outsized benefits for some retailers and manufacturers.
As we reconsider the 10 commandments for doing right in a recession, here’s a closer look at our second commandment, about why we need to stop idolizing central banks during a downturn.
Central Banks Have Immense Powers
Lowering interest rates quickly is a strong tool that central banks have for softening the initial blow in a deteriorating economy. Quickly lowering short-term interest rates or using quantitative easing (i.e., printing money) allows central banks to stimulate the economy and reduce risks to the financial system.
Lower interest rates can prompt consumers and businesses to refinance loans, which may free up cash or boost borrowers’ financial security. This can often occur without any improvement in confidence since the risk to borrowers is often the same or less. That’s important because a lack of confidence is prevalent when a recession first hits and often amplifies the downturn’s length and severity.
For those who do feel confident enough to borrow more, lower rates can encourage big-ticket business and consumer spending that likely wouldn’t occur until after a recession, if at all.
Asset prices, such as real estate and equity, may also get a boost from lower rates and an increase in the money supply as investors chase assets with a relatively higher return than safer government bonds. Of course, this assumes that investors don’t consider these widely held assets to be at a high risk of default or to have a too-low return on investment in a persistently weak economy.
Central Banks Have Increased Their Powers
In recent credit crises, central banks have expanded their powers beyond just their broad influence on long-term rates. Instead, they’ve purchased specific loans perceived to be of especially high risk to the financial system.
The Federal Reserve’s purchase of mortgage-backed securities during the Great Recession and the European Central Bank’s purchase of debt of heavily indebted governments during the euro debt crisis are notable examples of these expanded powers.
While printing money and buying government bonds to decrease long-term rates have been common in the past (often referred to as quantitative easing), large-scale buys of risky debt to safeguard the financial system are less common and more controversial.
These bond purchases shift the risk of default from the private sector to government budget sheets, potentially encouraging high-risk borrowing from private investors and distribution of low-quality loans from private banks. Offloading these bonds once the economy improves is also likely to distort financial markets (more on that later).
Most recently, the Bank of Japan has gone a step further by buying equities. According to The Wall Street Journal, the bank owns 75% of the country’s exchange-traded funds with the goal of raising stock market prices of Japanese corporations and attract foreign investors. This hasn’t happened, leaving the central bank with a significant ownership of corporate shares with very few future buyers.
Central Banks Are Mortal
But central banks’ ability to save economies has limits. Its healing powers depend on the degree to which it can push down rates without creating counterproductive effects on savers and lenders.
For the longest time, that limit for rate decreases was thought to be zero. Before the COVID-19 outbreak, the Fed’s target rate was only 1.75%, leaving not much room above zero. In recent downturns, the Fed has cut rates an average of 4-5 percentage points (Figure 1).
As recession concerns increase, such as the drop in the stock market related to COVID-19, reducing rates to near zero may not provide much stimulus unless the Fed targets negative short-term rates.
Pursuing negative short-term rates is exactly what the European Central Bank and Bank of Japan have done in an attempt to stimulate their economies. This means banks and potentially savers pay to hold money with the central bank or private banks, respectively. This encourages banks to lend to avoid paying the penalty and borrowers to take advantage of historically low rates. The concern is that savers will then hoard cash, leaving banks with less money to lend. Banks may also struggle to remain profitable if they don’t pass on the full penalty to savers (as they are doing right now). Research from the European Central Bank suggests negative short-term rates so far haven’t hurt banks enough to offset the potential benefit, but the Fed joining the European Central Bank and other central banks may be a tipping point. Global investors and savers will then run out of relatively safe interest-generating investments, creating cracks in the foundation of the global banking system.
Investors Lose Faith in Central Banks
Even if these powers provide some stimulus in the next slowdown, the inability to reverse these policies will pull back the curtain on central banks and cause investors to lose faith.
In the decade since the Great Recession, the US hasn’t been able to get rates back to relatively normal levels or offload the debt it has on its books despite the lowest unemployment rate in decades. The European Central Bank and Bank of Japan have taken more extreme measures, but still face a very weak growth outlook.
Even if the increasingly risky lending brought on by these policies doesn’t catch up to the financial system, the realization from investors and savers that these conditions aren’t temporary will eventually trigger a rush on banks.
Restoring Faith in Markets
Politicians will need to create fiscal policy that restores confidence to the market. It’s unclear if they are up to the task.
Politicians within and, more importantly, among countries will need to coordinate spending increases and/or tax cuts in appropriate areas. The ideological differences between political parties may get in the way, delaying stimulus or producing ineffective policies.
The size and direction of these policies could have big implications for the consumer economy. Spending more on social programs, likely the preference of politicians on the left, would immediately benefit cash flow consumers. But just how and to whom social spending is distributed also matters. The American Recovery and Reinvestment Act of 2009 is an example of the wide mix of initial benefits for households and businesses from a large fiscal stimulus bill.
Tax cuts, which are likely the preference of politicians on the right, would most immediately benefit income statement and balance sheet consumers who pay the majority of taxes. Tax cuts for all businesses would likely be supported over targeted subsidies and tax cuts for specific industries, which was part of the approach in the 2009 stimulus. Broad tax cuts may increase big-ticket spending relatively more than cash payouts that include Cash Flow shoppers, at least in the short term, given that these two consumer segments and businesses spend more of their budget on home goods and luxury items.
Already high government debt may also complicate the political positioning of fiscal stimulus in the next downturn. Governments will have to balance short-term stimulus measures with reforms that will sustain economic growth beyond the recovery. Among the many policies that the Organization for Economic Cooperation and Development and the International Monetary Fund are recommending are lower trade barriers, lower government spending in areas that don’t have long-term economic benefits, and incentives for research and development.
For more information, please contact:
Doug Hermanson, Principal Economist