Politics & Policies

Monetary Policy – We have reached the limit of what it can be expected to do

Though the U.S. economy is apparently at or close to full employment, wages have barely budged above the level that would be justified by productivity increases and inflation alone. There is little or no inflationary pressure. The so-called Phillips curve that once mapped the inverse relationship between unemployment and inflation is not serving as a useful guide to policy.

Some think this is due to the pressures of globalization and the weakness of trade unions. Others blame the concentration of power in the hands of huge employers for the lack of worker bargaining power. Or perhaps the United States is not as close to full employment as the official figures suggest. A “reserve army” of discouraged workers may be exerting a dampening pressure particularly on the low-wage, low-skilled end of the labor market. In any case, there is little reason to fear an inflationary surge if the Fed eases.

If not the labor market, is there no other force that will exercise restraint on the policymaker? Where are the bond vigilantes who famously haunted the Clinton administration in the early 1990s? The answer is that they have gone over to the other side. If there is pressure in the financial markets, it is toward demanding even larger cuts than either Draghi or Powell is comfortable with delivering.

It is a topsy-turvy world in which unemployment is at record low levels, but the Fed is worrying not that that the economy is overheating but that inflation is too low. Powell is trying to sell the rate cut as no more than a “mid-cycle correction,” but for the Fed to be cutting rates as “insurance” at the peak of the cycle is hardly conventional. Meanwhile, the U.S. government is set to issue more than $2.5 trillion in new debt in the space of two years, and the markets have not blinked. Investors consider the risk of inflation so low that they will hold $12.5 trillion of European and Japanese bonds at negative yields.

Faced with BlackRock’s shameless demand for public support of equity markets, one Financial Times commentator exclaimed that the proposal amounted to claiming that “the only way to save capitalism is to begin to nationalise it.” True. But why, in light of the measures taken to rescue the banks in 2008, is that surprising? The question today is not whether the state should act to support the feeble rate of economic growth but which policy tools will actually work.

During the crisis, the talk was of “shock and awe” and “big bazookas.” Former Treasury Secretary Timothy Geithner and his colleagues described themselves in martial terms, as fighting wars and putting out fires. Today, with Trump breathing down its neck, the Fed seems more like an anxious hiker shielding the dwindling flame of a campfire, desperate not to let the embers of America’s slow-burning recovery blow out.

Tending that flame is so vital because we are far from confident that if it goes out the monetary fire starters will still work. How will further interest rate cuts help if rates are already at rock bottom? Despite its enormous asset purchases, the Bank of Japan has consistently failed to boost inflation toward its target of 2 percent.

Thankfully, we do not at the present moment face anything like the financial heart attack of 2008. The warning signs of a potential recession in the eurozone are serious, but in the United States the evidence pointing to a hard landing is far from overwhelming. What we do face is a scenario reminiscent of the economist Larry Summers’s vision of secular stagnation. Low interest rates are not a conspiracy of central bankers against savers. They reflect the extraordinary ease of funding on money and capital markets. If low rates don’t stimulate energetic investment, then we need to look to the broader factors—such as demographic and social change, technology, and geopolitics—to understand why opportunities for profit seem so scarce.

What the latest round of desperate central bank action suggests is that we have reached the limit of what monetary policy can be expected to do. The question now is whether governments are willing to match the unconventional measures being taken by the central banks. To the extent that fiscal policy is deadlocked (as in Europe) or captured by a self-serving elite whose only priorities are defense spending and tax cuts for the wealthy (as in the United States), the outlook is depressing. But it’s at least possible to imagine a world in which the public directed the cheap funding that is so readily available toward investments in education and research, global development, and a renewable energy transition that would handsomely pay for themselves.

Chosen excerpts by Job Market Monitor. Read the whole story at The Global Economy Lives in Wonderland Now – Foreign Policy



  1. Pingback: The Phillips Curve – Yes, there is a trade-off | Job Market Monitor - August 9, 2019

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