Are you confused by all the central bank talk today? You are not alone. Terms like “quantitative easing” and “negative interest rates” do not come naturally to most investors. Luckily, we have the words of William McChesney Martin Jr. to help us out.
Martin, who was the chairman of the Federal Reserve Board from 1951 to 1970, famously quipped that the job of the Federal Reserve was “to take away the punch bowl just as the party gets going.” This refers to the Fed’s most difficult task: raising interest rates to slow down the economy before it overheats with inflation. Let’s see how far we can take Martin’s punch bowl analogy to explain both the terminology and the recent actions of central banks around the world.
We’ll start by defining the players. First, the punch bowl is monetary policy. Policy accommodation, otherwise known as “easy money,” is the liquid lubrication that keeps an economy humming, the way a punch bowl keeps a party humming. The central bank plays the role of the party host or chaperone, determining whether the party is too slow and needs more alcohol (lower interest rates) or when it is out of control and needs to be shut down (higher interest rates). Simple enough.
So what is quantitative easing? In simple terms, quantitative easing (QE) is the process of expanding the assets of a central bank – creating a bigger punch bowl. The central bank does this by digitally “printing money” and using those funds to buy bonds from banks. Buying these bonds pushes down interest rates and gives banks fresh cash to lend out. As an example, the Fed’s balance sheet doubled in size from just under $500 billion in 1995 to nearly $1 trillion in 2008, prior to the financial crisis. However, after three rounds of QE the Fed’s balance sheet has grown to approximately $4.5 trillion. Imagine that the punch bowl is now the size of a swimming pool.
Earlier this year, following the lead of the Danish and Swiss national banks, both the Bank of Japan (BoJ) and the European Central Bank (ECB) began implementing a policy of negative interest rates. As a result of quantitative easing, many banks are stuffed full of cash they have yet to lend out. To encourage them to extend credit (or to punish them for not making additional loans), central banks can apply a negative interest rate to these excess funds they hold. Generally, the central bank pays the savings bank a nominal rate of interest on these deposits. Under negative rates, the savings bank pays the central bank. This forces interest rates even lower and encourages banks to extend credit, fostering economic growth – the equivalent of pouring more rum into our swimming pool of punch.
So we understand that the Fed and other central banks are trying to keep the party going. But what’s the downside? Clearly a party with a swimming pool of punch is likely to lead to impaired judgment and the party getting out of hand. The economy is no different. All the new money ginned up through QE could eventually lead to much higher inflation – although this hasn’t happened yet. Super-low interest rates could also lead businesses or individuals to take on too much debt, thinking it can be paid back easily at these lower rates. Perhaps most worrisome, artificially low interest rates can lead to sub-optimal capital allocation decisions. They may encourage businesses and investors to take on projects/risks that might not be appropriate if interest rates were higher.
The Limits of Lower Rates
Ultimately the most important question may be, “Will this all work?” Can super-low/negative interest rates and QE bolster economic growth and push the economy out of this era of secular stagnation? Again, consulting the punch bowl, probably not. Spiking the punch at a dry party can certainly liven up the conversation and relax partygoers. Likewise, lowering interest rates from normal levels will both reduce the cost of capital for businesses and foster credit creation – also helpful to a stagnant economy. Easy money, like alcohol, can provide the right environment, the right conditions, but it cannot by itself jumpstart growth. At a certain point, there is a limit to what extraordinary policy accommodation can do. Most businesses and consumers have already reached the upside limits of refinancing. Banks have plenty of cash to lend (excess reserves), but few customers who want to borrow – even at these rates.
Lower and lower (even negative) rates have diminishing returns. At this point, real economic growth has to come from fiscal action and structural reform. Central banks shouldn’t be faulted for trying to develop creative policy responses. But the best parties always have the right location, the right guests, the right conversations. No punch bowl can replace that.
Monetary policy – Macroeconomic policy set by a central bank involving the management of an economy's interest rates and overall supply of capital.
Secular stagnation – The condition of negligible or non-existent economic growth within a market-based economy.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
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