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With Rates Near Zero, What Options Do Central Banks Have Left?

  • Kathleen Moore

There's nothing lower than zero

There's nothing lower than zero

With access to credit tight, and many economies across the world in recession, central bankers have been doing what comes naturally -- cutting interest rates.

But the rate cuts haven't had the desired effect of getting credit flowing again and bringing down the cost of borrowing throughout the economy.

And if rates go near zero, as in the United States, what else can central banks do?

One option is "quantitative easing."

"If we strip away the economic jargon, what that means is that the central bank uses its balance sheet effectively to print money," says Neil Mackinnon, an economist with ECU Group in London.

That doesn't mean they have to actually switch on the printing presses.

"Money" is more than the notes and coins in our pockets; it includes other things like bank deposits and bonds.

And central banks can essentially create money electronically.

"The conventional tool of quantitative easing," says Jonathan Loynes of Capital Economics in London, "is for the central bank to buy assets in the market. And therefore, if it's buying government bonds, it's taking government bonds out of the market and putting cash into the market. And it normally at least starts off by buying those from banks, which increases the amount of money that banks have available to lend to companies and households in the wider economy."

Money From A Helicopter

So, boosting the money supply should encourage banks to lend more to people and businesses.

If we strip away the economic jargon, what that means is that the central bank uses its balance sheet effectively to print money.
And buying up those long-term government bonds drives up their prices. That reduces their yields, and since government bonds influence rates on other types of debt like mortgages, those rates would come down, too.

That's the theory.

Ben Bernanke, before he became U.S. Federal Reserve chairman, once famously likened it to dropping money from a helicopter.

The Fed -- by some definitions -- already has been engaging in quantitative easing, and it now says it's prepared to go further by buying longer-term government bonds. Britain, too, says it's ready.

But does the method work?

Japan tried it in the 1990s, and its record is mixed, says Loynes.

"Although Japanese authorities increased the amount of money the banks had available to them, the banks were then reluctant to lend that to companies and households," Loynes says. "So you never actually saw a significant increase in the broader measures of money supply in the economy. Nonetheless it did seem to serve some purpose in at least bringing longer-term interest rates down to quite low levels because of the purchase of government bonds in the market."

Inflation Targets

But the approach also carries risks, especially if it is a success.

Boosting money supply can push up inflation, which leads to another tool still available to central banks -- inflation targets.

Britain's Bank of England and the European Central Bank (ECB) have explicit inflation targets; the Fed does not.

In recent years they've set interest rates to keep inflation down.

It might be hard to see the merits of this kind of target at a time when rates are at record lows and deflation -- falling prices -- is a greater risk.

But inflation targets, the argument goes, could help prevent expectations that deflation will develop.

Exit Strategies

That's because an important role for the central banks is to manage market expectations about what they will do and convey the message that they will try to keep inflation -- and deflation -- under control.

"In the past, it's been a successful policy in terms of getting inflation down," Mackinnon says. "Now, inflation targeting has to be used to ensure that there is a degree of moderate inflation that is controllable. In that regard, a new type of inflation targeting in order to ensure deflation doesn't take a grip of the major economies will be a major part of the exit strategies away from zero-interest rate policy and quantitative easing."

As for that quantitative easing, two further potential downsides.

One is that it can be bad for a currency.

Another is that -- as in Britain -- central banks may risk losing their independence through working increasingly in tandem with politicians

Get ready for those helicopters.
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