October 5, 2016 / 2:11 PM / a year ago

Old tools, new reality a struggle for central banks

FRANKFURT/TOKYO (Reuters) - Stefan Moeller’s firm in Frankfurt, which makes baseball caps to the customer’s own design, is an unlikely embodiment of a shift in spending trends that could tear up the monetary policy rule book for advanced economies.

The headquarters of the European Central Bank (ECB) are pictured in Frankfurt, Germany, September 8, 2016. REUTERS/Ralph Orlowski/File Photo

New technology means Moeller can immediately meet any customer order. That cuts downtime and adjustment costs, boosting the firm’s margins.

But now the equipment is in place, the business won’t need further investment for years, a scenario that if repeated could frustrate central banks’ efforts to fuel economic growth and inflation by slashing interest rates to zero or less.

“I can make just a single hat and switch design in a second, or make a thousand in a series,” said Moeller, who reports that trade is brisk. “This is a new type of flexibility in the business and my product line has essentially become endless, so the only investment I have to make is in sales.”

Although super low rates have cut funding costs and all but wiped out incentives to save, borrowing by businesses and households in many places remains stubbornly low, with lending growth close to 2 percent in both Japan and the euro zone.

That suggests the monetary transmission mechanism has broken down, at least in part, and that the Bank of Japan and European Central Bank will not get the anticipated “bang” for the trillions of dollars they have spent buying assets.

Signs that central banks’ influence over inflation and growth is diminishing throw into question the viability of inflation targeting, the cornerstone of modern monetary policy.

The implications of this new reality will be among key topics discussed at the International Monetary Fund’s annual meeting in Washington this week, where central bankers will continue to argue that monetary policy is overburdened and must be relieved by governments.

Underlying the problem are a shift towards services-driven growth, technological leaps, and the ageing of populations in the developed world.

All those factors curb investment from businesses and households and push up savings, holding back growth and putting downward pressure on inflation just as central banks are trying desperately to push prices higher.

As central banks spend more to hit an increasingly elusive inflation target, they also risk inflating property and stock market bubbles.


“The paradigm of central banking is changing. The transmission mechanism has changed and the instruments have changed ... we very much live in a different world and central banks have to respond,” European Central Bank rate setter Bostjan Jazbec said.

“The problems we face are lower productivity growth, slower population growth, increasing life expectancy, and these factors all affect the variables relevant for the central bank.”

The Bank of Japan’s move last month to target yield levels instead of asset-purchase volumes was tacit admission its aggressive money-printing was becoming unsustainable -- a rare acknowledgement that policy was not working as hoped.

“If people’s inflation expectations are backward looking despite 3-1/2 years of aggressive easing, it shows that the problem isn’t about a lack of monetary easing,” former BOJ executive Kazuo Momma said.

“I think there’s already plenty of money.”

Newly created money is instead going into savings as people prepare for a lengthy retirement. Life expectancy is over 80 in many advanced economies, having increased by 10-15 years over the past half century.

After a steady rise in recent years, households now save a record 20 percent of their disposable income in Switzerland, 16 percent in Sweden, and 10 percent in Germany, data from the Organisation for Economic Cooperation and Development shows.

Negative central bank interest rates in all three countries have not induced more spending as intended, instead prompting households to hoard even more of their money even given the negligible returns on cash.

“This challenges central banks’ fundamental belief that inflation is a monetary phenomenon that they can have a direct grip on,” said Nannette Hechler Fayd‘Herbe, head of strategy, Wealth Management, at Credit Suisse.

“They are realising that yes, it’s a monetary phenomenon, but it’s also much more structural and could be a demographic phenomenon.”

With working age populations declining across many advanced economies and life expectancy rising, nearly a fifth of rich countries’ populations will soon be classified as elderly.

The big exception is the United States, where population growth has left the Federal Reserve in an easier long-term position.


Companies are also investing less, partly due to the shift towards services, where productivity growth is low because there are limits to human output. Limited productivity growth also holds back wages, a natural curb on inflation and consumption.

Four out of five new jobs created in Europe since the debt crisis have been in services while productivity has stagnated at pre-crisis levels. The United States fares better, but productivity growth there has more than halved since 2009 and is pinned at around 0.4 percent a year, data shows.

Current spending trends could take as long as 10-15 years to shift, some economists suggest, well beyond the horizon of monetary policy, which typically looks a few years ahead.

In the meantime, central banks risk upsetting financial stability by trying to hit relatively short-term inflation targets, so they need to either extend the time-frame or focus on financial stability indicators instead, economists say.

They also need to moderate their use of extraordinary policy tools and admit that they have overextended their resources, and so force governments to shoulder more responsibility for growth and inflation.

Editing by Catherine Evans

Our Standards:The Thomson Reuters Trust Principles.
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