The internal contradictions of macro-monetary policy

Charles Goodhart, Geoffrey Wood 24 January 2020



Has there ever been a time when monetary policies, and the analysis thereof, have been as blatantly self-contradictory as now?  Consider some examples.

At a time when interest rates, throughout the yield curve, are at an all-time low, should not the public sector, the biggest debtor, be trying to lock in such rates by shifting to ever longer maturities and duration?  But if one adjusts for central bank swaps – buying much longer debt in exchange for their own sight deposits – the overall maturity/duration of public sector debt has, in most countries practicing quantitative easing, been going down, not up.

Fear not, we are told, because such central bank deposits need not, should not, ever get repaid, and hence they are, or should be, ‘really’ the equivalent of Consols – quasi-permanent debt.  In Robin Greenwood, Samuel Hanson and Jeremy Stein’s paper presented at the 2016 Jackson Hole symposium, the authors argue that satiating liquidity needs enhances financial stability, while monetary policy can continue by varying the interest paid on central bank deposits (which may, courtesy of FinTech, become available in future to an ever wider range of private sector agents to hold).  So, they argue that the enlarged central bank balance sheets should remain a permanent feature.  But since such reserve deposits are now interest bearing, the huge volume of central bank deposits increases the public sector interest rate roll-over risk just as much as if the Treasury had issued a similar amount of Treasury Bills.

But if liquidity needs are thus satiated, at a time when debt ratios have been climbing at a rate hitherto unparalleled during peace time, and are forecast to be prospectively unsustainable at current tax and expenditure rates, why do we still have claims that interest rates are being held down by an excessive demand for ‘safe’ assets? Is this claim consistent with the narrowed risk premia that we now observe?

If the demand for liquidity, and reserves, by banks is to remain satiated, thereby consigning the concept of the monetary base multiplier to the dustbin of outdated ideas, what then constrains and determines the aggregate money stock, mostly consisting of commercial bank deposits and bank lending to the private sector?  The answer, we would presume, is the availability of bank (equity) capital.  But capital will only be made available if the business is sufficiently profitable to earn a competitive return (unless the public sector injects the capital itself).

But what has been the effect of macro-monetary policy on bank profitability?  Negative interest rates, a flat yield curve, and the imposition of massive fines on the banking institution (rather than on the bankers who perpetrated, or failed to prevent, the misdeeds) are hardly conducive to greater profitability.  Profitability is anyhow procyclical.  Has policy been aggravating this?  Has policy been actively damaging to bank profitability and hence to the growth of money and credit?  

In most academic studies of the efficacy of monetary policy, none of the above matters.  All that matters is the direct link between riskless official short-term rates, and future expectations thereof, and the real economy.  In David Reifschneider’s influential 2016 paper, the words “bank”, “money supply” and “credit” never appear!  Has mainstream monetary economics lost its bearings, or are we old-timers just too old to understand the new paradigms?

The same official insouciance about the profitability of financial intermediation goes wider than just banks.  Insurance companies and pension funds are pressured to hold matching assets against their liabilities, and then policy serves to reduce the availability and yield of such assets!

If the effect of monetary policy has been to weaken the profitability of financial intermediation, might this help to explain why the otherwise massive monetary expansion measures undertaken by central banks have had so little impact on the real economy?  Perhaps QE has now become ‘quite erroneous’.



Topics:  Macroeconomic policy Monetary policy

Tags:  quantitative easing, macro-monetary policy

Emeritus Professor in the Financial Markets Group, London School of Economics

Professor Emeritus, Cass Business School and University of Buckingham

CEPR Policy Research