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Economic and monetary challenges - Prospects of the EU economy and the Eurozone

How to engineer more confidence at the Zero-Lower bound?

By Pereira da Silva Luiz Awazu - Deputy General Manager, Bank for International Settlements (BIS)

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Almost eight years on, the Global Financial Crisis continues to challenge us in many analytical and policy dimensions. First, the good news: we understand the dynamics global financial cycles much better; we were able to use old and new monetary policy tools to affect financial markets sentiment; and we have managed to avoid a 21st Century Great Depression.

Yet, despite all that, we seem to be stuck in a relatively mediocre low-growth and volatile macroeconomic and financial environment. One reason might be a lack of confidence: somehow, markets still cannot firm up their expectations about what is the post-crisis long-term sustainable growth rate, a reasonable benchmark return on savings through investing in safe assets, and a sensible method for pricing assets and risk-taking. The differences between current competing and yet plausible narratives about the future are simply too big. Are we in a more structural secular stagnation trap or in a simpler post-crisis debt deleveraging process? Markets thus remain unanchored and, as seen in early 2016, highly volatile.

Market signals are not encouraging. Even though bad outcomes started to materialise just now, their underlying risks had been identified previously and are at least in part related to the unbalanced mix of unprecedented monetary stimuli with insufficient structural reforms during the window of opportunity that unconventional monetary policies bought us. We therefore ended up with excessive valuation in bond markets in advanced economies, excessive foreign currency borrowing in emerging market economies, and excess supply in some key commodity markets, especially oil.

All these excesses are now unwinding. Markets are now seeing that overvaluation of assets is not supported by the current growth outcomes and future productivity prospects; central banks’ asset purchase programs are unlikely to sustain current valuations; and emerging market economies’ growth will slow down due to a combination of intentional changes in growth models, paying down of corporate debt, local idiosyncratic political economy developments and classical sudden stops of capital flows.

In addition, each of these factors produce feedback loops. For example, lower growth in China produces weaker oil prices, global deflationary pressure, more stress in debt repayment, etc. These developments add to worries about global growth. Accordingly, risk premia in financial markets have risen sharply, government bond yields have fallen further, often into negative territory, and yield curves in major advanced economies have flattened.

Moreover, market confidence may be further hampered by a growing market perception that central banks now have less and less room for manoeuvre. Rather than positively influencing expectations and consumption demand, the use of negative interest rates might have actually prompted worries about financial stability and higher savings needs. In short, the cost-benefit trade-offs are uncertain at best and worsening.

How could we re-anchor markets’ faith in the future and avoid a negative spiral? First, using positively the impulse coming from the US recovery and the tail winds from low oil prices while continuing the gradual normalisation of monetary and financial conditions there. Second, examining how best to rebalance the mix of fiscal and monetary policies domestically and globally. Central banks have done more than their part. It is now for fiscal policy-makers to convince all that we are capable of sensibly investing in productivity-enhancing activities without creating fears of Ricardian equivalence. At the zero-lower bound, fiscal might dominate monetary policy options. Third, strengthening structural reforms that are part of, and should lead to a more sustainable socioeconomic equilibrium. That, in turn, should begin addressing some of our entrenched and widespread disputes about current and intergenerational resource allocation, our societies’ “social contracts”. This is well beyond macroeconomics but our dismal science can perhaps contribute with some useful elements for our societies to choose from.