Central Bankers Learn to Fly Helicopters…

The original QE framework was essentially a simple asset swap by central banks taking private bond market assets onto their balance sheets against a matching liability, thus creating a displacement effect as those private sector holders use the cash to buy riskier yielding assets, suppressing funding costs across the economy. That has since been extended to other assets, including corporate bonds in Europe and equity ETFs in Japan. QE was a very justifiable response to  initially contracting and then very weakly recovering private sector credit creation after the 2008 systemic shock. What matters for the real economy is the aggregate balance sheet growth of the financial system i.e. central plus commercial banks.

That’s a key point the many observers predicting an inflation breakout in the years following QE adoption missed. The fact that commercial banks hoarded excess reserves post 2008 (partly to meet tougher capital adequacy rules) meant that the velocity of money actually fell, and far from the hyperinflation risk many forecast in 2009/10 we’ve seen persistent deflationary pressure. The BOJ’s balance sheet is now about 80% of Japan’s GDP, compared to ‘only’ 20-25% for the ECB, BOE and Fed. The ECB is now buying corporate bonds in the primary market and willing to hold up to 70% of any single issue, a scenario that would have been greeted with incredulity back when EMU seemed poised to implode in mid-2012.

So far, no central bank has taken the step of simply cancelling the debt it has absorbed, although you could argue that in market collateral and economic cash flow terms that is exactly what has transpired. For instance, the Fed has paid back to the US Treasury about $500bn in profits since 2009, which equates to the interest the Treasury has paid the Fed on its bond holding. It’s not deficit monetization in any formal or explicit sense, but looks a lot like it in practice and it’s increasingly likely that we will see a move to formal deficit funding.

The defining macro issues of the past decade have been slowing trend (and indeed potential) GDP growth as populations rapidly age against a backdrop of rising debt ratios and historically weak productivity growth, all of which of course first became evident in Japan 20 years ago. Despite falling unemployment, wage pressures remain muted globally – jobless claims in the US keep falling to record lows while non-farm payrolls have been trending higher at over 200k/mth, but much of the job growth is low productivity/wage sectors that so far have proved immune to automation trends (e.g. leisure and hospitality has generated almost half of all US new jobs since last September).

For all the armies of PhD economists they employ to calibrate their vast general equilibrium macro models, essentially the framework for what central banks are trying to achieve in restoring is astonishingly simplistic. They have a trend GDP growth path and as the real economy deviates below that trend, an ‘output gap’ opens up which they attempt to plug with loose monetary policy to stimulate faster demand growth and hence inflation as spare capacity reduces. On this basis, the orthodox view is that the lower real rates they go, the more inflationary the economic impact by boosting lending growth etc.

Ultra-low rates have in fact been deflationary in several respects; for instance, they drove an investment boom across commodities in 2010-14 (including US shale oil) and the additional supply helped exacerbate the subsequent price crash. They also depressed the value of annuity style income for retired savers whether relying on bank deposits or bond market holdings, forcing their required savings rate higher (a particular drag on aggregate demand in Japan/Europe).

As for investment, despite soaring house prices from HK to Sweden, the UK, US and even Ireland, we have seen a very muted investment response because of supply side constraints. These range from stricter planning laws limiting development land to tighter credit availability and simply far fewer developers left in the market – we will see something similar in US shale over the next few years i.e. a permanent loss of capacity. Meanwhile, the ‘servers over structures’ digitization of incremental growth has reduced the need for fixed investment outside resources/housing, particularly as technology investment goods have continued to deflate rapidly.

We are now likely in the process of shifting to a nominal GDP targeting framework, likely to be implemented in Japan and China first. That implies that central banks directly fund fiscal stimulus to achieve an overall nominal growth target, which brings us into the realm of ‘helicopter money’. It’s now widely accepted that the world needs fiscal policy to work in tandem with monetary and bizarrely Germany and Japan are being paid by investors to build ‘bridges to nowhere’ although upgrading transport infrastructure is likely to generate a better return in the US even at current yield differentials. Politically, it’s hard to get German or US Republican politicians (who remain obsessed with paying down debt) to accept that wider deficits are part of the solution.

Prof. Milton Friedman coined the term “helicopter drop” in a 1969 essay to describe how central banks could print money and distribute it to citizens to offset deflationary pressure. QE reduces bond yields, lowers borrowing costs, and encourages spending through an enhanced wealth effect (although estimates of the impact of the wealth effect from financial assets and housing have been declining). Ultimately, though, the influence on consumption and output is looser than would be the case with a direct infusion of reserves to households, particularly low income ones with a high propensity to spend the windfall.

Central banks were founded to issue currency, prevent bank panics, and be the lenders of last resort. Over time, their mandate has expanded to include correcting episodes of deficient demand, which tests the border between fiscal and monetary policy. They don’t typically have the legal authority to send out windfall transfers directly to citizens, which is what many understand ‘helicopter money’ to mean.

For example, all members of the Eurozone would have to agree for the ECB to implement this strategy. Congress would have to authorize the Fed to undertake such a plan. In addition, the reserves (i.e. liabilities of the central bank) created by helicopter money do not have a corresponding asset, unlike QE programs to date. The only way around this issue is for helicopter money to work as a fiscal expansion funded directly by the central bank. The helicopters will be hovering over finance ministries to deliver their windfall, not households.

Indeed, in former Fed Chairman Ben Bernanke’s famous 2002 helicopter speech, he noted that the coordination of fiscal and monetary policy amounted to a helicopter drop of money: ‘A money-financed tax cut is essentially equivalent to Milton Friedman’s famous “helicopter drop” of money.’ In his latest blog post for the Brookings Institution, he expanded on that key point:In more prosaic and realistic terms, a “helicopter drop” of money is an expansionary fiscal policy—an increase in public spending or a tax cut—financed by a permanent increase in the money stock.’

He concludes that: ‘Under certain extreme circumstances—sharply deficient aggregate demand, exhausted monetary policy, and an unwillingness of the legislature to use debt-financed fiscal policies—such programs may be the best available alternative.’ Given all the factors he lists are very much apparent in economies like Japan, and the failure of negative rates, which amount to a de facto tax on private bank credit creation, this is where we seem inexorably to be heading. Near term the broad commodity rally and modest China re-acceleration should support stabilizing global inflation trends over the balance of this year, but in the next global cyclical downturn and for Japan quite possibly well before, fiscal and monetary policies look set to converge.