It's hard to appreciate a truly extraordinary period in time when we are immersed in it, but this is one of those times. Central banks in all the major developed countries of the world have abandoned the familiar highways paved by a century of precedent and gone off road, searching for an uncharted route back to growth and stability. Let us hope they are not racing toward a bluff.
The European Central Bank is the latest institution to venture off the beaten path. Last week, ECB President Mario Draghi announced a series of actions aimed at boosting economic growth in the Euro area. For his previous promise to do "anything it takes," the central banker had earned the sobriquet of "Super Mario." How effective or risky his actions prove to be is unknowable, but without question they cannot be found in the textbooks.
First, President Draghi announced a further cut in the interest rate on large deposits at European banks from minus 0.1 percent to minus 0.4 percent. Let that sink in for just a moment: charging bank customers to accept and hold their deposits. Perhaps more remarkably, the announcement elicited relatively little commentary since the ECB was already imposing slightly negative rates and Japan moved its deposit rate into negative territory in January. Draghi merely steered the car further off the road.
Negative rates are a sign that traditional monetary policy can no longer operate effectively through the primary channel of regulating lending. At this stage of the game, the unspoken objective is to devalue the currency (the Euro) in order to make exports more competitive and support domestic manufacturers. This is a very long way from the primary mandate for a modern central bank.
Next, Super Mario announced an expansion in the current bondbuying program, known colloquially as quantitative easing or QE. This weapon was rolled out in 2014 and was patterned after the Federal Reserve's own six-year bond-buying spree that ended about the same time. In a nutshell, the central bank creates money and uses that new cash to buy and hold bonds issued by governments of EU member countries. Draghi said the ECB will increase bond purchases from 60 billion Euros per month to 80 billion (U.S. $87 billion).
Only here, another problem appears: the ECB is already buying up most of the government debt issues in Europe. So beginning next month, the central bank will start purchasing corporate bonds as well. This move is highly unorthodox, as most central banks operate under constraints that require holding only bonds guaranteed by governments or agencies within governments. Mario veers further into the weeds.
Just as negative rates clogged up the loan channel, quantitative easing has distorted price signals in the bond markets. What materialized instead in the U.S. and is likely in Europe is a migration of investor capital out of bonds and into riskier assets like stocks and real estate. Of course, this gambit has had the unintended (or maybe intended) consequence of increasing wealth and income inequality, with the hope that some of the benefit will trickle down.
There is little debate that central banks have ventured far from their traditional routes. The question to be resolved is to what effect when measured against the eventual costs, yet to be determined. What is clear is that monetary authorities are responding to the refusal of elected officials in Europe, Japan and the United State to adopt progrowth fiscal policies like tax reform and regulatory relief. And that dynamic seems unlikely to change in the near term. Enjoy the ride.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.