Negative yields, helicopter money—what will central banks try next?

On the surface, the many causes of market volatility in recent months seem unrelated to one another.

However, they're ultimately woven together by the inability of central banks to address the persistent lack of aggregate global demand. Given that this problem isn't likely to be resolved soon, we expect that erratic financial asset price movements are here to stay for some time.

One trigger of market volatility, cheap oil, has been prompted primarily by oversupply. Supply won't fall out of the market as long as producers are debt financed; the overleveraged players don't have the luxury of cutting supply while they have debt to service. Of course, low oil prices have an impact on all other services and supply chains that crop up alongside the oil patch. These include drillers, shippers, and retail and leisure outfits that serve oil towns, but they also include financial services. Sovereign wealth funds of many oil-producing countries hold significant amounts of financial shares, which they've had to liquidate in order to release petrodollars, one factor sending bank stocks lower.

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The debt overhang that sparked the global financial crisis has only gotten bigger in most major economies, severely hamstringing the ability of most governments to provide fiscal stimulus to stoke demand. Central banks will therefore continue to be the pinch hitters, offering a variety of measures to provide monetary stimulus. They've been playing this role since 2008 and have been pushed into extraordinary monetary policy measures. They've increasingly turned to negative interest-rate policies (NIRP) to try to boost lending and stoke inflation, but the effectiveness of such policies remains unproven, especially over the long term. Moreover, as we've seen in Japan, NIRP could bring about unexpected reactions from the market, not to mention unintended effects on the global banking sector. Negative interest rates not only shift the yield curve lower, but they flatten it significantly, as we have seen in the eurozone and Japan. This has eaten into bank profitability in both regions, also sending bank stocks lower.

One option for addressing the dearth of aggregate global demand is for central banks to do more of the same. The problem here is that most central banks aren't having much luck with the tools they've already deployed.

Policymakers may resort to helicopter money

Central bank governors have done their best to jawbone their currencies lower in recent years. Sadly, the law of diminishing returns has kicked in, making each pronouncement less effective. Given that interest rates for most developed countries are already either at or below zero, there's a limit to how much more policymakers can cut rates before end users start hoarding cash in their homes. Additional asset purchases are likely in Europe and Japan, but quantitative easing is also less effective with each successive round. There's been some question as to whether central banks have any dry powder left in their arsenals to stoke demand and inflation.

One policy that could be employed is coordinated helicopter money—a permanent form of quantitative easing, an unconventional measure in its own right, in which a central bank purchases securities in the market to lower interest rates and increase the money supply. Helicopter money can take many different forms, including tax rebates or simple electronic transfers into bank accounts. If the transfer is permanent, it would, almost by definition, be inflationary, and consequently consumers would have incentive to spend the transfer as quickly as possible before prices get pushed higher.

This idea was viewed with disdain and incredulity as recently as six months ago, in part because it would probably require some coordination between sovereign treasury department officials and their central bank counterparts and could therefore represent a real impingement on central bank independence. However, we would argue that the European Central Bank (ECB) has already deployed a form of helicopter money through a liquidity facility known as targeted longer-term refinancing operations (TLTROs). According to the newest TLTROs on offer, banks can borrow from the ECB at rates as low as the deposit facility, which are currently negative, and lend that money out for a positive yield. This represents a permanent transfer of wealth from the ECB to European banks. In essence, banks are paid to borrow from the ECB and then lend that money out in turn. We expect that central banks will pursue more of the same policies (negative interest rates, quantitative easing), but could ultimately be pushed to implement helicopter money in the event of a recession.