Yet another Central Bank (this time Australia’s RBA) has tried reducing the cost of borrowing in the economy that they imagine they are commanding. The theory sounds sensible enough – reduce the base-cost of borrowing and pressure all lenders to pass this reduction through to grateful borrowers – who in turn borrow more or use their increased disposable income to make investments, hire employees or increase their retail expenditure. The problem since the confidence implosion of 2008, is that western economies (private and particularly the public sector) are not interested in borrowing more – in fact they’re de-leveraging their balance sheets wherever possible. Therefore lower and lower rates are not stimulating end-demand.
So will the RBA turn to other monetary policy techniques such as Quantitative Easing when they reach the lower bound of interest rates. That is, when the “price” of money doesn’t help, will they try the “amount” of money next like the BOJ, the FED and the ECB before them?
This will be a dilemma that all central bankers are debating at the moment. They are by now aware that the most fundamental shortcoming of QE – or, in fact, of using monetary policy in general to combat a recession – is that it only “works” if it somehow induces the private sector to spend more out of current income. QE is simply swapping longer dated sovereign bonds for shorter dated reserves – none of this stimulates end consumer demand (except slightly through the temporary wealth effect of rising stock markets). Unfortunately for rate setting central banks the direct route (fiscal policy) is out of their sphere of influence. Given the much-needed deleveraging by the private sector, the best technique would be to target growth in after-tax incomes and job creation through appropriate and sufficiently large fiscal actions. Unfortunately, stimulus efforts to-date have not met these criteria, and the prevailing obsession with “strong public finances”, which dominates policy discourse in the West will ensure that their economies remains stagnant.