Masaaki Shirakawa, the governor of the Bank of Japan, gave a subtle and interesting speech this weekend that may not have been totally comfortable for his hosts at the Federal Reserve.
Mr Shirakawa set out four problems with aggressive monetary easing in the wake of a financial crisis. These are closely mirrored in the US debate about Fed policy but on several points he took the argument further:
(1) Mr Shirakawa’s first point is that loose monetary policy mitigates the pain as households repair their balance sheets, but reduces their incentive to do so quickly, not just for the private sector but for governments as well. However, he also suggests that the effectiveness of loose policy may fall over time as households that weren’t damaged by the crisis bring forward such spending as they want to.
“Needless to say, the effect of low interest rates is extended to those economic entities that have not suffered any damage to their balance sheets. If they bring forward future demand to the present by taking advantage of a low interest rate environment, this leads to an increase in aggregate demand. As balance-sheet adjustment continues for a long period of time, however, the amount of future demand that could be brought forward gradually diminishes even in a low interest rate environment.”
(2) The second point seems the most dubious to me but would be profoundly important if true. Mr Shirakawa suggests that low interest rates might induce companies to make investments with really low returns – Japan’s endless public works, perhaps – and so low interest rates could actually cause potential growth to go down. (He doesn’t say this but I can’t imagine how this works unless some economic actors are credit constrained).
“If low interest rates induce investment projects that are only profitable at such interest rate levels, this could have an adverse impact on productivity and growth potential of the economy by making resource allocation inefficient. While central banks have typically conducted monetary policy by treating a potential growth rate as exogenously given, when the economy is under prolonged shocks arising from balance-sheet repair, we may have to take into account the risk that a continuation of low interest rates will affect the productivity of the overall economy and lower the potential growth rate endogenously.”
(3) Point three is the more standard argument that flattening the yield curve too far for too long will undermine the profitability of the financial sector.
“Beyond a certain threshold, however, further monetary easing could instead squeeze the margins and discourage financial intermediation, resulting in lower efficiency in resource allocation and lower growth potential in the long run. A similar problem arises for institutional investors in the form of a negative spread – that is, investment returns on assets fall below the promised return on long-term liabilities.”
(4) Mr Shirakawa’s fourth point is an argument about why banks such as the Fed should worry about the effect of easy policy on global commodity prices. In essence, he says that individual central banks that concentrate on domestic inflation targets could end up causing global problems, which in turn make it hard to hit domestic inflation targets. That contrasts with Ben Bernanke’s fairly clear statement in the wake of QE2 [quantative easing] eighteen months ago, that if developing countries want to import US monetary policy, then they will have to live with the consequences. Mr Shirakawa said:
“Even though such a rise in commodity prices is affected by globally accommodative monetary conditions, individual central banks recognise that the fluctuation in commodity prices is an exogenous supply shock and focus on core inflation rates which exclude the prices of energy-related items and food. The resulting reluctance of individual central banks to counter rising commodity prices, when aggregated globally, could further boost these prices. From a global perspective, such a situation represents nothing more than a case where a hypothetical “World Central Bank” fails to satisfy the Taylor principle, which ensures the stability of global headline inflation. While it is understandable that the central banks would pursue the stability of their own economies in the conduct of monetary policy, it is increasingly important to take into account the international spillovers and feedback effects on their own economies.”