The limits of central banks

Central banks are credited with almost magical power. But their tools have limits, and recent history has hit all of them.

First limit: zero. For a long time, people thought a rate could not go below it.

In two thousand fourteen, the European Central Bank did the unthinkable: a negative deposit rate. It would go down to minus zero point five per cent.

Negative means: a bank that deposits money at the central bank pays to do so.

For the example, one hundred million euros deposited at minus zero point five per cent: five hundred thousand euros lost a year.

The idea: push banks to lend rather than hoard. But you cannot go very low.

Because there is still cash. If the rate becomes too negative, people withdraw everything in notes, which pay zero but cost nothing.

The euro area left negative rates in two thousand twenty-two. The experiment lasted eight years.

Second limit, deeper: the liquidity trap. It was the economist Keynes who set out the idea.

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The central bank cuts rates, again and again. But nobody borrows more. Households and companies are afraid.

You can lead a horse to water, says the proverb. You cannot make it drink.

Japan lived through this from the late nineties: rates close to zero, and an economy that would not restart.

Third limit: fiscal dominance. When a state's debt becomes so heavy that it dictates monetary policy.

Say public debt of three trillion euros. One more point of rate, once all the debt is rolled over, is thirty billion a year.

The central bank would like to raise rates against inflation. But it knows it would put the state in difficulty.

If it holds back for that reason, it no longer fights inflation. It funds the state. That is the slope history fears.

Hence the fourth question, which comes back at every election: central bank independence.

A government likes low rates before an election. Credit is easy, jobs rise. The bill, inflation, comes afterwards.

In the early seventies, American president Nixon pressured the Fed for low rates. The tapes showed it.

The inflation of the seventies followed. That is partly why so many countries made their central bank independent.

In the euro area, this independence is written into the treaties. But no text protects against a loss of trust.

The twist: a central bank is powerful as long as people believe it can act. Its limits come when people stop believing.