CHARLES Goodhart gave a talk in London on May 10th, at a lunch organised by Sushil Wadhwani, the economist and fund manager. Mr Goodhart, best known for his law that economic measures tend to misbehave once targeted, was tackling the issue of why repeated monetary stimulus by central banks had failed to stimulate credit creation.
If we go all the way back to Ben Bernanke's "helicopter money" speech, Mr Goodhart said economists accept the argument that:
Inflation is a monetary phenomenon. Central banks can create money. Therefore central banks can create inflation.
Sure enough, central banks have expanded their balance sheets massively since 2008. But the effect on inflation has been non-existent (and the effect on economic growth is still in dispute). The problem is that base money (currency plus commercial bank reserves) at the central bank has lost its relationship with broad money (credit in the wider economy). The banks were not lending out the newly-created money.
In part this was because, in the wake of the 2008 crisis, regulators demanded that banks improve their capital ratios. This had made banks much more cautious about extending new loans to risky borrowers; they have tended to focus on large corporations and on their home markets, the latter approach tacitly approved by central banks (according to Mr Goodhart). Meanwhile, holding reserves at the central bank has become more appealing. In a recent note for Morgan Stanley, Mr Goodhart explained that:
Prior to 2007, reserves held by commercial banks were unremunerated (zero yield) whereas returns on longer-dated riskless assets were positive, and returns on risky assets higher still. So holding reserves at the central bank represented a penalty.
But the use of quantitative easing (QE) by central banks has brought down long-term yields. Bond yields are at historic lows and the risk of holding government debt, should economies return to normal, seem high. In effect, commercial banks are in a liquidity trap. Back to the Morgan Stanley note:
Holding reserves at the central bank is safe, requires no extra capital, adds to liquidity, and has only a minimally lower yield than other longer-dated public sector debt with far less interest rate risk. Under present conditions, the hurdles facing aspiring private sector borrowers from banks become higher. So the path of least resistance is to allow any extra cash reserves generated by QE, LTRO etc to pile up in commercial bank balances at the central banks.
So what next? Mr Goodhart thinks that QE is a "busted flush" - it worked in 2009 when it reduced the risk premium but has had little effect since. Negative rates have been tried but
there is no sign that this move towards negative official rates has done anything to stimulate domestic economies, apart from the exchange rate effect.
And the problem is that commercial banks cannot pass on negative rates to their retail customers, but negative rates do ripple through the markets in the form of lower bond yields and loan rates. The interest income of banks is thus squeezed. This is a problem, Mr Goodhart said today, because
the profitability of commercial banks is a constraint on credit expansion.
In short, the aim of monetary policy has been to expand credit expansion via the commercial banks but the pipeline is blocked.
Negative rates might work, Mr Goodhart says, if governments announced outright that their aim was to reduce the nominal value of retail savings; this would give commercial banks the cover to introduce negative rates on deposits. But such a policy would be electoral suicide, alienating millions of bank customers and sparking talk of confiscation. Thus we have what might be deemed a new variant on Goodhart's law:
The only way of making negative rates effective is politically impossible.
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