Why the Fed can't fix the economy

It has become fashionable to lament that central banks have run out of ammo. While this may be true in some sense, we believe it also obscures the underlying issue — monetary policy intervention is not always the best remedy for an ailing global economy.

In particular, it's time for policymakers to broaden their horizons beyond interest rate cuts towards more meaningful structural and fiscal reforms. After more than seven years of monetary policy intervention, capped by recent shifts from several central banks towards negative interest rates, the economic and investment outlook is murky at best.

The European Central Bank in Frankfurt, Germany
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The European Central Bank in Frankfurt, Germany

This is evident in any number of countries around the world. The move to negative rates has coincided with the falling yields on the 10-year Japanese and German government bonds, proving the diminishing marginal returns of rate cuts. If investors felt that rate intervention was going to be effective in stimulating the economy, we would have seen an increase (rather than a decrease) in the cost of long-term bonds relative to short-term interest rates (a steepening of the yield curve) as they priced in higher levels of growth and/or inflation.

(Remember — when bond prices rise, interest rates decrease, and bond prices typically rise when the debt is perceived to be low-risk).

Things have not worked out that way and there is a clear reason why. Monetary policy intervention, which has now led to negative interest rates, is a continuation of competitive (currency) devaluation pursued by central banks that are attempting to get a larger slice of the global pie without growing the pie itself. Ultimately, everyone cannot get a larger slice of the economic pie without growing global output.

Negative rates would therefore provide limited long-term benefits and increase the potential for significant risks. We believe the most concerning risk is that these low yields would distort how financial markets are priced, which would cause investors to buy securities at incorrectly-valued prices and, unintentionally, push individuals and organizations to take on an unhealthy amount of risk in an effort to avoid losing their purchasing power.

Additionally, we are worried about the impact of negative rates on the banking sector, as this may reduce banks' net income margins. Thinner margins mean banks have less money to lend. A decrease in money being lent means there is less money circulating through the economy, which means people are spending less, which prevents the global economy from growing.

Going forward, monetary policy will likely have diminishing returns and increased risks. Fortunately, monetary policy is just one of the macro tools in the policy kit. We believe policymakers must focus more attention on two other tools — structural reform and a fiscal policy that supports infrastructure — that have the potential to bring about robust and lasting benefits. India, one of the world's fastest growing economies, is a good example of this modernized approach.

Fiscal policy to improve aging or inadequate infrastructure, such as roads and bridges, is another powerful tool that can provide long-term benefits to many areas across the globe. Given the focus on austerity, we have seen limited focus on fiscal policy.

The time has come to reckon with the consequences of a one-dimensional approach to fixing the global economy by moving on to other options such as structural reforms and fiscal policy focused on infrastructure. Until we see a shift in policy, however, we advise investors to remain focused on the underlying fundamentals of their investments and not reach for yield or chase returns.

Commentary by Marc Bushallow, the managing director of Fixed Income at Manning & Napier.

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