As the global economy gradually decelerates, central bankers around the world are changing their tune. No longer are the solons discussing how to withdraw stimulus and normalize policy. Now they’re trying to figure out how to reprise the extraordinary monetary policies used during past crises in an effort to rejuvenate growth.

Nowhere is the change more obvious than the US Federal Reserve’s “180” from tightening in December 2018 to its first rate cut in over a decade just seven months later. Likewise the European Central Bank (ECB) is in full retreat, prepping markets for a deeper plunge into negative rates and pondering which assets to buy (although it’s not clear there are any suitable assets left). Until now, most of the discussion has been conjecture related to when, what, and how much. When will they begin lowering rates and buying more assets? What will they buy as part of their large-scale asset purchases? By how much and how fast will they lower rates? All good questions to be sure, but in this month’s note, we ask a more important question: “Will it work?”

Big Picture: Post-Crisis History
The short answer is, “maybe, at the margin” – but investors should hold their expectations in check. There are limits to what monetary policy can achieve on its own. And make no mistake, central banks are alone in this fight. Fiscal gridlock and negligible appetite for real structural reform dominate the largest developed economies.

History doesn’t suggest that extraordinary monetary policy is a growth elixir either. Japan has seen no sustainable pickup in growth after 20+ years of absurdly loose policy. Europe has seen little cyclical improvement in growth since the banking crisis. And while the US economy has done better than Europe or Japan in recent years, the post-Global Financial Crisis (GFC) recovery and expansion have been the slowest in history – averaging just +2.1% real GDP growth over the last decade.

To be clear, we aren’t implying that extraordinary central bank policy has been unsuccessful. It was arguably very successful at bolstering confidence and providing much needed liquidity during both the GFC and European Banking Crisis. That is, it probably kept things from getting much worse. We say “probably” because we can’t prove the counterfactual – no one really knows how much worse it would have been if central banks hadn’t come to the rescue. But history suggests that extraordinary monetary policy works better as a safety net during times of crisis than as a precision tool for fine-tuning economic growth.

Headwinds to Policy Efficacy
Apart from history, there are many reasons to think that central banks will struggle to jumpstart growth with lower rates and more quantitative easing (QE).1

First, while we concede that further lowering rates should boost economic activity, the credit impulse will be less powerful than investors think. The relationship between interest rates and the demand for funds is complicated, variable, and path dependent. For example, today’s 30-year US mortgage rates are roughly similar to where they were for much of 2017, and a full 0.50% higher than prevailing rates in the second half of 2016. Will lower rates boost mortgage lending and refinancing activity? Somewhat, but not as much as they would have, given that many homebuyers and homeowners have already taken advantage of lower rates.

US 30-Year Mortgage Rate – Bankrate National Average
30 year US mortgage rates
Source: Bloomberg, Natixis Investment Strategies Group, Jan. 2014–July 2019 (weekly).

Second, the wealth effect is likely to be more limited. Yes, QE and ultra-low rates drive up portfolio values, but valuations for both stocks and bonds are already stretched. In the US, the first round of QE occurred while stocks were trading at a paltry 12x forward earnings. Several years later, stocks traded at a still-reasonable 14x during QE2 and QE3. Today, the S&P 500®2 trades at 18x. Likewise, when the ECB embarked on large-scale asset purchases in the wake of the banking crisis, the STOXX® Europe 6003 traded at 10x. Today it trades at nearly 15x. Will more QE swell portfolio values? Maybe, but stocks have far less room to run given today’s valuations. Arguably, this is a timing problem to some degree. Much of what central banks hoped to accomplish (falling yields and rising stock prices) has already been achieved. Since the Fed’s 180 in late December, the MSCI World4 is up over 20% (in both US dollar and local currency terms) while sovereign bond yields have plunged.

Third, in Europe, further rate cuts will only continue to punish banks that have to hold reserves at negative rates. This is problematic, because banks are the key transmission mechanism for monetary policy. The ECB has talked about tiering deposit rates to mitigate collateral damage, but the system is still fighting against itself.

Fourth, central banks are working against each other through the currency markets. With most of the major banks turning more dovish at the same time, we are rapidly escalating a war of “beggar thy neighbor” policies. The US administration would like to see a weaker dollar, but so would the ECB and, in turn, the Swiss National Bank, the Bank of Japan, and so on. Using monetary policy to weaken the currency and stimulate export growth won’t work if everyone does it at the same time.

Broad US Dollar – Rising in Spite of the Fed's Dovish Turn
Broad US Dollar
Source: Bloomberg, Natixis Investment Strategies Group, 8/1/18–7/31/19 (daily).

Fifth, inflation expectations in the developed economies are stuck in neutral. Few are predicting higher inflation, so the disincentive to current consumption persists. Central bankers continue to talk about raising their inflation targets, but if you can’t generate 2% inflation, how credible will consumers and businesses find higher inflation targets?

Sixth, additional stimulus is designed to boost confidence, but a large jump in consumer, business, and investor optimism seems unlikely. Surveys indicate consumer and business confidence are already strong, while credit spreads are still fairly tight and stocks recently hit all-time highs. Where is the panic? Other than some weakness in business investment, is anyone holding back? We don’t see it. Moreover, if central banks get overly aggressive (e.g., 50 bps rate cuts), accommodation might backfire as it would serve to undermine confidence in the global economy, not bolster it.

Finally, much of the weakness seen in the global economy in recent quarters has been due to trade, export, and (related) manufacturing problems – side effects of the US/China trade and tariff war. As the positions of Presidents Trump and Xi have hardened, it isn’t clear that additional monetary stimulus is even the right tool for this job.

Why It Matters
How fast and how sharply central banks pivot back toward super-accommodative policy is a fascinating guessing game, but says little about whether the dovish turn will actually work to stave off what some see as recessionary forces.

Markets have already rendered their verdict: Stocks have skyrocketed YTD despite lackluster earnings growth. As the economy continues to show signs of weakness, investors are clearly betting that central banks will be able to ride to the rescue again. That would be a tall order. The benefits of additional extraordinary policy are both highly uncertain and perhaps already priced in.
1 Quantitative easing refers to monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.

2 The S&P (Standard & Poor’s) 500 Index® is an index of 500 stocks often used to represent the US stock market.

3 The STOXX® Europe 600 Index is derived from the STOXX® Europe Total Market Index (TMI) and is a subset of the STOXX® Global 1800 Index. With a fixed number of 600 components, the STOXX® Europe 600 Index represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

4 MSCI World Index (Net) is an unmanaged index that is designed to measure the equity market performance of developed markets. It is comprised of common stocks of companies representative of the market structure of developed market countries in North America, Europe, and the Asia/Pacific Region. The index is calculated without dividends, with net or with gross dividends reinvested, in both U.S. dollars and local currencies.

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This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed are as of August 2, 2019 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.

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