Does monetary policy still hold key to growth?

This year, fittingly, marks the 20th anniversary of Japan’s zero interest rate policy (ZIRP). The Bank of Japan’s decision to reduce rates to zero to reboot its flagging economy in 1999 was seen as radical at the time, and looked on by US and European central bankers as a kind of Japanese idiosyncrasy not to be tried anywhere else.

That was until the 2008 financial crisis hit, and the rest of the world went down the same zero-rate wormhole.

Rather worryingly for the US and Europe, Japan, 20 years later, is still locked into this negative-rate regime. The Fed and the European Central Bank (ECB) had expected to be out the other side by now, but flatlining growth and weaker-than-expected inflation is drawing them back in.

Both are expected to announce fresh stimulus measures in the coming weeks, having previously signalled a move to normalise monetary policy. The Fed had already embarked on a cycle of rate hikes, but is now planning to put the stick in reverse.

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Expectations of further policy easing have helped soothe global recessionary fears, which reached fever pitch last week when the US yield curve – supposedly an ironclad indicator of future recessions – became inverted for the first time since 2007.

They also sent bond yields to further record lows, with Germany’s 10-year benchmark bond yields falling to -0.73 per cent. This means lenders have to pay for the pleasure of lending money to the German government, such is the topsy-turvy post-crash world we live in.

Critics say by keeping interest rates at or close to zero for an extended period, conventional monetary policy is rendered redundant. In other words, how do you provide a monetary stimulus when rates are already at zero? Economists use the term liquidity trap to describe this scenario.

Frankfurt could, in theory, shift its main refinancing rate – the interest it charges on one-week loans to banks – from its present 0 per cent level into negative territory but this is considered unlikely as it is considered harmful to banks.

It’s more likely to cut the deposit rates it pays to banks who deposit overnight funds. These are already at -0.4 per cent but some analysts see them at -0.6 per cent by the end of the year.

Bond-buying

It could also restart the quantitative easing (QE) programme, potentially setting out on another round of bond-buying to stoke further lending and investment.

When lower interest rates failed to restore growth and inflation after the crash, the ECB embarked on a massive three-year, asset-purchasing programme which ended last year, but Mario Draghi signalled last month that all options were on the table, including a potential restart of QE.

Critics of his easy-money agenda are, however, growing. They say the central bank has maxed out on monetary policy, claiming the ZIRP experiment has already undermined bank profitability and curtailed their lending activities, the opposite of what was intended, citing it as a factor in the current slowdown.

As a result there has been a renewed focus on fiscal policy as a stimulus to stave off recession.

The White House has said it is considering a fresh round of tax cuts to boost the economy, possibly funded by tariffs on Chinese goods. Even Germany, the bastion of European fiscal hawkishness, is said to be considering a €50 billion rise in public spending to bolster demand, dispensing with its long-standing balanced-budget policy.

It’s hard to say what sort of example Japan sets for the rest of the world. After all it has a very different financial and political profile to Europe, and embarked on its low-rate agenda at a different time. Yet its inability to re-establish “normal” monetary policy seems all the more relevant.