A generation of market participants has grown up knowing only the era of central bankers and the 'Great Moderation' of (most of) the last two decades elevated the status of central bankers significantly and while central bankers are generally very well aware of the limits of their own power, financial markets seem inclined to overstress the direct scope of monetary policy in the real world. Monetary policy impacts the real economy because it is transmitted to the real economy through the money transmission mechanism. This has become particularly important in the current environment, where, as UBS' Paul Donovan notes, some aspects of that transmission mechanism have become damaged in some economies. Simplifying the monetary transmission mechanism into four very broad categories: the cost of capital; the willingness to lend; the willingness to save; and the foreign exchange rate; UBS finds strains in each that negate some or all of a central bank's stimulus efforts. In the current climate, it may well be that the state of the monetary transmission mechanism is even more important than monetary policy decisions themselves. Some monetary policy makers may be at the limits of their influence.

UBS Investment Research, Global Economic Comment: Memento Mori (Remember You Are Mortal)



Victorious Roman generals accorded the honour of a triumph through the city were treated as demigods for the celebration. To remind them of the limits of their powers, a slave was required to ride alongside the general, whispering from time to time some ego deflating phrase. Apocryphally this was “memento mori” – “remember you are mortal”. A similar process could well be applied today to the world’s central bankers. To be fair, central bankers are generally aware of the limits of their own powers. The problem is that financial markets have embraced the cult of the central bank, and it is central bank watchers who need to be told “remember they are mortal.”



The great moderation of the last two decades elevated the position of central banks. By the 1990s central banks in the OECD had generally reduced inflation, and in doing so reduced the inflation uncertainty risk premium. This had lowered not only the nominal but also the real cost of capital (quite justifiably). This in turn facilitated investment, capital gains in asset classes, and fortuitously accompanied an extended period of economic stability for most economies.



This period raised the status of central banks. Fiscal policy ceased to concern markets too much, with the possible exception of Japan (where monetary policy was demonstrably failing). Changes of government were not generally a macroeconomic concern, although specific sectors could still be impacted by specific policies. Stimulus was to come through monetary policy, and moderation would be enforced by the same means. Perhaps inevitably, at a time when a lower real cost of capital was driving economic prosperity, the arbiters of the cost of capital were seen as the drivers of economies.



A generation of investors and financial market participants has thus grown up knowing only the era of central bankers. The modern communication age further encouraged this. With twenty four hour business news, having a whole host of central bank speeches to cover must be something of a godsend. Federal Reserve Presidents (voting or not), ECB board members and participants in the Bank of England monetary policy committee all provide a wonderful way of generating newswire headlines and filling airtime.



Time to ask “why?”



With the dominance of monetary policy seemingly established in the OECD, why should investors commit the economic blasphemy of viewing central bankers as merely mortal? Central bankers need to be considered mortal because monetary policy has its limits. Those limits are now being reached, or at the very least approached, in some economies. We need to remind ourselves that the potency of monetary policy in the real world depends on the effectiveness of the monetary transmission mechanism as well as the level of policy accommodation.



Investors need to remember to ask “why?” when questioning the need for monetary policy. With an almost Pavlovian response function investors tend to see an economic problem and expect a monetary policy reaction. If markets fall, investors need only to run to central bankers and Ben Bernanke and his ilk will put on a sticking plaster and offer a liquidity lollipop to the investment community for being such brave little soldiers in the face of adversity. However, as Japan showed, there are limits to the effectiveness of monetary policy.

The concept of monetary policy “pushing on a piece of string” has become an almost hackneyed idea, but it is something that has to be remembered nonetheless. For monetary policy to have a direct impact on the real economy, the accommodation needs to be transmitted to the real economy through some medium. That can be via borrowing costs, incentives to lend, disincentives to save or the exchange rate. But in each instance monetary policy requires some catalyst to produce a real economic reaction. It is reasonable to ask whether those catalysts are present today. In short, the question in analysing the impact of monetary policy across the OECD is not primarily where central banks put interest rates or liquidity; it is increasingly how the monetary transmission mechanism is situated.



1. Borrowing costs



The transmission from monetary policy to real world borrowing costs is automatic in a select number of instances. A UK base rate tracker mortgage, for instance, is directly connected to the monetary policy interest rate of the United Kingdom. In such instances borrowing costs fall mechanically if monetary policy is eased. Those who have already borrowed money will receive an improvement in cash flow. This is effectively a transfer of disposable income from savers to existing borrowers. Generally speaking savers spend less and borrowers spend more (why else would they be borrowers?), so lowering interest rates costs in a direct sense can stimulate economic growth through this income transfer.



For new borrowers the transmission via borrowing costs is not so clear. There is no necessity for a rate cut to be passed on to a marginal borrower. Before considering the role of banks in this regard it is worth acknowledging the importance of the non banking sector. Large companies, generally speaking, are able to borrow from financial markets. If a monetary policy easing lowers corporate bond yields, then large companies may benefit from that market response. The benefit can be transmitted to smaller companies. Inter-company credit is the single most important form of credit for small businesses. If large companies experience lower borrowing costs, they may transmit some or all of this reduction in a more accommodative provision of inter-company credit to smaller businesses.



This process is contingent on investors being willing to drive corporate yields lower, and on large companies having a sufficiently low liquidity preference as to be willing to transmit that borrowing cost benefit to their smaller business customers. One of the peculiar problems of this downturn compared to previous downturns is that this willingness to transmit credit to smaller businesses has been lacking – and central bank policy easing has done little to change the provision of intercompany credit.



The classic theoretical transmission of monetary policy is via banks lowering borrowing costs for new borrowers. That transmission assumes a static risk environment for banks. If banks are risk adverse they may increase the premium they charge on lending to the real economy, negating the impact of the policy rate cut. Indeed, in extremis the marginal interest rate for new lending could be infinite. If banks do not wish to lend, then new credit cannot be obtained at any price, at least as far as a prospective borrower is concerned. The change in the policy interest rate is then entirely ineffectual.



2. Incentives to lend



This brings us to the incentive a bank has to lend in the wake of monetary policy accommodation. There is an obvious arbitrage to be exploited if the cost of funding to a bank (the policy interest rate) is lower than the rate that is charged to the customer of the bank. However, this remains contingent on the willingness to lend. If banks are under pressure to reduce the size of their balance sheets (as Euro area banks are today), then the disincentive to lend may outweigh the inducement offered by arbitrage arising from the lowering of a policy interest rate.



There is also a somewhat more subtle potential stimulus from lowering policy interest rates. A combination of lower policy interest rates with unchanged (or largely unchanged) bank interest rates means an increased profit margin for banks. The immediate transmission of central bank accommodation in such circumstances is nil as there is no increase in lending into the wider economy. However, the profits that the banking sector make by exploiting a widening interest rate differential (commercial bank rate less policy rate) could lead to a more rapid repair of balance sheets, and therefore hasten the normalisation of the banking system.



Helping banks achieve better profits does seem to be a compelling argument for accommodation, but there is a risk. Just such arguments were presented when Japanese banks tried to repair their balance sheets in the 1990s. Supported asset prices (e,g, Japanese government bonds propped up by the Bank of Japan’s rinban operations) and very low costs of liquidity were supposed to generate profits from the yield curve, repairing balance sheets, leading to a stronger transmission mechanism through more bank lending. It never happened of course.



The market’s scepticism about banks outweighed the benefit of earnings, and the fall in asset prices outside of the government’s operations (real estate, most obviously) ended up doing damage to balance sheets faster than bank profitability could repair them. This is not to say that the monetary policy method can never work through this transmission mechanism. It is merely to point out that in a liquidity trap the monetary policy method of improving bank balance sheets needs to be treated with a healthy dose of scepticism.



3. Disincentive to save



Lowering the return on liquid savings through monetary policy accommodation is supposed to be a disincentive to save. If the objective of saving is to earn a rate of return on one’s money, then this is of course entirely logical. Lowering the rate of return on liquid savings gives an incentive either to spend, or to move into higher risk assets (causing those asset prices to increase, and creating a positive wealth effect).



However, if there is extreme liquidity preference in a financial system the impact of changing interest rates is minimised. Investors basically ascribe a value to liquidity which overwhelms the absence of any return earned on it. The extreme of this is of course the negative T-bill rates evidenced in US during the more stressed episodes of the recent global financial crisis, or indeed in Switzerland recently. Liquidity (and associated safe haven status) is so prized that investors area actually prepared to pay for the privilege.



4. Foreign exchange rates



Superficially, monetary policy and exchange rates are intimately intertwined. New Zealand makes a formal virtue of this through considering the combination of trade weighted exchange rates and interest rates in a monetary conditions index. How is monetary policy supposed to influence an exchange rate?



There are two critical transmission mechanisms from domestic interest rates to foreign exchange. The first is the relative rate of return, or the relative borrowing cost of a currency. If the interest rate in a domestic economy goes down then there is less incentive to invest in the fixed income assets of a country. There may also be the fabled and at times mythical “carry trade”. Investors will borrow in one currency (where it is cheap), sell that currency and purchase higher yielding assets in a second currency.



The second possible transmission mechanism is simply relative money supply. If monetary policy expands the domestic broad money supply, then there is in theory more money available for the foreign exchange markets. Increase the supply of something, and you should reduce its price.



Both of these transmission processes run into problems via liquidity preference. If liquidity preference is high then the international demand to hold cash balances in a currency is unlikely to be related to the return earned on those balances (it is the old adage of “return of capital not return on capital” that directs investor strategy – as Switzerland demonstrates). If there is liquidity preference in the economy then borrowing for carry purposes becomes more difficult. Finally, the supply of domestic liquidity to the foreign exchange market is not contingent on the expansion of the domestic money supply alone. If there is an increase in domestic money supply relative to domestic money demand (or liquidity preference) then there will be a weakening of the currency. If domestic money supply increases are simply absorbed by the sponge of liquidity preference then the supply of currency to financial markets will not change, and can have no impact on the currency value.



Watch the transmission



We are not arguing that monetary policy is redundant in the OECD. That clearly is not the case. What we are arguing is that the money transmission mechanism is now at least as important, and perhaps more important, than central bank policy decisions in assessing the impact of monetary policy on the real economy. The Bank of England is demonstrating this with its policy actions – the Mansion House speech showed a central bank paying as much attention to the monetary transmission mechanism as to direct forms of liquidity intervention. We believe that further quantitative policy from the Bank will be rendered economically useful through the medium of better transmission via the banking system (the liquidity preference of which is actively being reduced by policy changes). The efficacy of the transmission mechanism in the United States is evident from the bank lending numbers themselves, as well as surveys like the NACM (of borrowers) and the Fed’s Senior Loan Officers’ Opinion Survey (of lenders). Our US team’s forecasts reflect a belief in the effectiveness of monetary transmission such that the Fed may well moderate the degree of monetary stimulus next year.



Where monetary policy transmission is moot is the Euro area. The need to improve bank capital adequacy coupled with the risk aversion of an economy beset by structural problems has reduced the ability of monetary stimulus to transmit to the real economy. Central bank policy for the Euro area seems to be directed at minimising basic liquidity concerns (the failure of the interbank market to function effectively). Bank, corporate and saver liquidity preference seems likely to remain high. The ECB must hope that the banking system (or, if necessary, the corporate sector outside of a disintermediated banking system) can be made a more effective transmission mechanism than it is at the moment. Our concerns about the speed with which this can be accomplished are one of the reasons we think the Euro area will persist in a sub trend environment for so long a period.