Interesting comments from FitchRatings in their Global Perspective series.
There has long been a sense of finality about quantitative easing (QE): when policy interest rates are at or near zero, it seems the last option available to central banks in countering deflation. But this ignores other monetary and exchange rate policies implemented in the past, those recently considered implausible but being deployed at present, and additional creative ideas that may – by necessity and where possible – receive more widespread use in the future.
Ultimately, central banks control the quantity of money (narrowly defined) and exert influence over its price (the interest rate). With this in mind, it is logical to conclude that once the price of money is at its minimum, and further accommodation is desirable, central banks are left with only the quantity of money to consider. However, there are a few other policy options, although they would be likely to prove contentious and subject to questions about their effectiveness.
In the Past: Exchange Rate Interventions
Another way to express the price of money that central banks, including those in advanced economies, have at times tried to influence is the price of foreign currency, the exchange rate.
In September 1985 finance ministers and central bank governors of France, Germany, Japan, the UK and US announced in the Plaza Accord that “exchange rates should play a role in adjusting external imbalances” and that “an orderly appreciation of the main non-dollar currencies against the dollar is desirable”. This was directed primarily at the Japanese yen/US dollar exchange rate, to reduce the US-Japan trade imbalance and the broader US current account deficit. A year later the US dollar had depreciated by 35% against the yen (see chart), and two years later US inflation was more than 4%, where it remained until mid-1991.
There are two common objections to exchange rate intervention. First, it is a zero-sum game: one country’s beneficial depreciation is at the expense of others’ appreciations. Second, intervention is ineffective in the longer term when market forces take hold.
One counter to these objections is that they are inconsistent with each other, at least over time. More importantly, policymakers may eventually conclude that it is not a zero-sum game if countries in deflation represent a broader global risk to growth. And, as with QE, doubts about the effectiveness of currency intervention may be shelved when other policy options appear to have been exhausted and policymakers need to be seen to be taking all necessary steps.
In the Present: Doing the “Unthinkable”
It seems sensible that nominal interest rates have a zero lower bound, as investors would be unlikely to buy assets that, if held to maturity, deliver a nominal loss. It also seems sensible that central banks would want to avoid pushing policy rates below zero. They have long argued that the proper functioning of financial markets would be impaired by negative nominal rates.
Nevertheless, the zero lower bound has been breached by both policymakers and the market. At end-March, the Swedish central bank repo rate, the Swiss central bank three-month LIBOR (Swiss franc) target range, and the Danish central bank certificate of deposit rate were below zero. A number of European government bond yields were also negative.
At least some objections to breaching the zero lower bound on policy interest rates have clearly been set aside, and – assuming deflationary conditions warrant it – the rationale for doing so may become more appealing. From a central bank perspective, two risks associated with negative yields are that they encourage a greater reliance on cash, taking funds outside the financial system, and there could be a run-up in credit, portending asset bubbles and financial instability.
A shift towards large-scale cash holdings in advanced economies appears improbable, if for no reason other than it being impractical. Asset price bubbles and future financial instability may present a bigger problem, but the calculus of central banks could change. If faced with the choice of immediate, intractable deflation and potential financial instability, policymakers may opt to first address the more pressing challenge.
The Future: Policy Creativity
Negative interest rates and a return of more active exchange rate policies might not be the only options to consider. The government and Nationalbank of Denmark have developed another strategy to provide additional monetary accommodation. The government is issuing no bonds until further notice, and will draw on its deposits at the central bank as needed, effectively adding to base money. This may not be an option for many countries (Danish government deposits at the Natioanlbank were large), but it underscores the potential for policy creativity.
