The ‘Brexit’ vote has left the spotlight on the Bank of England (BoE), and follows signs the market’s confidence in central banks has started to wane. But can a central bank ever run out of ammunition? Stewart Robertson, senior economist, considers the evidence.


The head of the Bank of England didn’t waste any time in seeking to reassure investors in the wake of the UK’s June 23 vote to leave the EU. Within an hour of the result being announced, Mark Carney said that while some market and economic volatility could be expected, the bank was “well prepared”. He outlined a plan to support financial markets and the domestic economy. The question is: will it work? 

Although he stressed that the country’s banks were resilient, having raised more than £130bn of capital over the past seven years, Carney said the BoE was ready to provide more than £250bn of additional funds to support lending to businesses and households during potentially “challenging” times.

And Carney went on to say the bank will in the coming weeks assess economic conditions and consider “any additional policy responses”.

Financial markets are now speculating interest rates are heading towards zero by the end of this year. It also appears further ‘quantitative easing’ might be on the cards. But in the event the economy takes a severe turn for the worse, will the central bank have any other options to support growth?

Central banks around the world have been the dominant actors since the onset of the financial crisis in 2008. Whenever the global economy has come under threat since then central bank medicine has seemingly been the antidote. For most of that period, the majority of investors have been prepared to give central banks the benefit of the doubt.

This is perhaps little wonder, given that deliberately boosting asset prices has been a key plank of their strategy.

However, in recent months we have arguably seen the first signs that markets may be starting to question the omnipotence of central banks. Where the market reaction to policy measures was once entirely predicable recent central bank actions have led to an almost counterintuitive response. Some commentators now seem to be wondering whether central banks are running out of options.

First, we saw a US Federal Reserve (Fed) that felt sufficiently confident in the recovery to raise rates in December. But it wasn’t long before the move had contributed to sending financial markets into a tailspin; forcing the central bank to rapidly backtrack on its threat to steadily tighten policy this year. Seven years into the recovery, real US interest rates remain stuck in negative territory.



Then we witnessed a perverse reaction to the Bank of Japan (BoJ)’s adoption of negative rates, as the market bid up the price of the yen. Since the January 29 decision, the Japanese currency has rallied by almost 14 per cent against the US dollar.

The economists’ arguments

Within the field of economics, monetarists refute the idea that a central bank can run out of ammunition since there is no limit to its ability to create new money. Furthermore, historical evidence shows that money supply and GDP tend to grow at the same pace over time.

Keynesians, by contrast, argue that as interest rates approach zero, a liquidity trap can render monetary policy ineffective. In such instances they argue fiscal expansion is needed, with the government required to make up for inadequate demand from the private sector.

The ‘real world’ evidence of recent years offers some support to both schools of thought. On the one hand, while the recession of 2008 was the most severe since the 1930s, there is widespread agreement that early and aggressive action by the Fed thwarted a much sharper downturn.

Similarly, as chart 2 demonstrates, money supply within the euro zone has risen strongly since the European Central Bank (ECB)’s belated adoption of quantitative easing at the start of 2015. And there are encouraging signs that has started to feed through into stronger economic output.



Conversely, as chart 3 shows, more than 20 years after the Bank of Japan cut interest rates to just 0.5 per cent, and 15 years since it adopted unconventional monetary policy measures, the Japanese economy is still flat on its back. Incredibly, nominal economic output is no higher today than it was 21 years ago.



Unintended consequences

Whatever the merits of each of these schools of thought, what is beyond dispute is that eight years into the era of unprecedented monetary policy stimulus, world economic growth remains worryingly sluggish. Arguably, part of the problem is that such a prolonged period of abnormal monetary policy is having widespread unintended consequences.

Perhaps most concerning of all is the sluggish pace of investment. Since the start of 2008, US private non-residential investment has grown at an annualised pace of just 1.4 per cent. That is less than a third the rate of increase recorded over the previous decade.

One of the main aims of monetary policy has been to encourage increased business investment. However, it appears that companies, unsure of the strength of final demand, have been extremely reticent to invest in new productive capacity. Instead, they have used record low interest rates to take on more debt in order to fund acquisitions, buy back shares or raise dividends.

Another worry surrounds the toll such extremely low interest rates are taking on banks’ profitability. While the impact is impossible to quantify; the lower the level of interest rates, the less profit margin banks can make. This suggests central banks will reach a point beyond which they will struggle to boost credit creation any further.

Meanwhile, according to recent media reports, one of Europe’s largest banks, Germany's Commerzbank, is considering hoarding billions of euros in cash in vaults to avoid paying to hold the cash with the ECB, thanks to the bank's negative deposit rate.1

It doesn’t appear hoarding cash is confined to banks. Japan’s finance ministry recently said it plans to boost the number of ¥10,000 bills in circulation, amid signs that households are withdrawing cash from deposit accounts.

Helicopter money

This is leaving many to wonder what tools, if any, central banks may turn to next in the event the world economy takes a fresh turn for the worse. The most commonly proposed solution is the creation of ‘helicopter money’.

The term, coined by the Nobel-prize-winning economist Milton Friedman, refers to the idea that in extremis, central banks can simply print money and hand it out to their citizens to encourage them to spend, thereby lifting aggregate consumption. If it’s in any doubt as to the private sector’s willingness to spend the money, the central bank can instead hand it to the government to spend, for example, on infrastructure projects.

Originally developed by Friedman to illustrate a solution to a hypothetical situation, the concept was revived as a serious policy proposal by Ben Bernanke when in November 2002, as a Federal Reserve Board governor, he famously delivered a speech on preventing deflation in the wake of Japan’s economic woes. In recent years, the idea has been discussed by growing numbers of economists as a serious alternative to monetary policy measures such as quantitative easing.

The efficacy of such a policy experiment remains to be seen. For now, it is not clear helicopter money is required, although the seeming inability of Japan to break out of its prolonged economic struggles suggests it might be only a matter of time before we see its introduction.

From a theoretical perspective, it may even have a chance of success. Certainly, many people from both the monetarist and Keynesian camps would be advocates. But a third school of economists argue that it would be a futile exercise, just like the other monetary policy experiments undertaken in recent years.

The so-called Austrian school argues that economic cycles are driven by money and credit growth, with excessively loose monetary conditions leading to credit booms and malinvestment. The longer the period of loose money, the worse the malinvestment and the more painful the ultimate correction. According to this line of reasoning, central banks have in recent years merely borrowed consumption from future generations and, in doing so, have simply postponed the day of reckoning.

To return to the original question, it does not appear central banks are yet out of ammunition. If things do take a fresh turn for the worse, there are new steps they can take. Only time will tell, however, if their arsenal contains anything other than blanks.



Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 8th July 2016. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

Issued by Aviva Investors Global Services Limited, registered in England No. 1151805.  Registered Office: St. Helen’s, 1 Undershaft, London EC3P 3DQ.  Authorised and regulated by the Financial Conduct Authority and a member of the Investment Association.  Contact us at Aviva Investors Global Services Limited, St. Helen’s, 1 Undershaft, London EC3P 3DQ.

Approved for Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the UK.