In focus

What is left in the toolkit for central banks in developed markets?

A long and shallow recovery since the 2008-09 Global Financial Crisis means interest rates still stand at record lows in many developed economies. The exception is the US, where the Federal Reserve (Fed) has been raising rates. But even there, rates have peaked at a lower level than many expected.

This means that if the global economy were to experience another downturn, central banks have limited room to cut interest rates in order to provide stimulus.


Cutting interest rates is, however, not the only tool that central banks can use. Other possible options include quantitative easing, forward guidance, tiered interest rates, yield curve control and “helicopter money”. Below, we take a more detailed look at these options.

Restarting quantitative easing (QE)

Quantitative easing is the large scale purchase of assets such as government bonds from institutions such as insurers and pension funds. This lowers bond yields, thereby reducing the cost of borrowing. It also boosts the price of financial assets, generating a wealth effect.

QE can impact interest rate expectations by signalling the central bank’s commitment to looser monetary policy. Many central banks turned to QE after cutting rates to the lowest possible bound in the wake of the Global Financial Crisis.

However, central banks are beginning to run out of government bonds to buy. For example, the European Central Bank (ECB) has an ownership limit of 33% of the market, and the scarcity of German government bonds in particular is an issue. This limit is self-imposed and could be changed. But one could argue that the impact of further QE would be minimal anyway because bond yields are already very low. 

Central banks could expand the range of assets they buy under QE. In the US, QE was limited to government bonds and mortgage-backed securities whereas in Europe the ECB also bought bonds issued by companies. The Bank of Japan (BoJ) is buying shares and real estate under its QE programme.

However, buying shares and corporate bonds raises governance concerns; for example, how would a central bank exercise shareholder voting rights? The Fed is currently barred by law from buying corporate assets although it is legal for the ECB to buy shares.

Forward guidance

Forward guidance simply means signalling future monetary policy intentions. It helps central banks to steer interest rate expectations without actually changing rates. Probably the most famous example is ECB President Mario Draghi’s comment in 2012 that he would do “whatever it takes” to preserve the euro. This proved successful in easing financial conditions and helping to end the sovereign debt crisis that plagued the eurozone in 2011-12.

But forward guidance has its limitations and central banks tie their hands by committing to future policy. Failing to follow through on forward guidance can damage credibility. For example, Bank of England Governor Mark Carney earned the nickname “unreliable boyfriend” after changing his stance on rate rises.

Tiered interest rates

Low and negative interest rates stimulate the economy by keeping borrowing costs low and encouraging banks to lend. However, they have harmful side-effects for the banking sector because they squeeze profitability (as borrowers pay less interest on their debt to the banks). If central banks could make negative rates more sustainable, then they could commit to keeping rates low for longer.

Regulators require banks to hold a certain amount of deposits. But central banks could apply negative rates only to any deposits that are in excess of that amount. A higher rate could then be applied to the remaining deposit balance.

By limiting negative rates to only a part of a bank’s overall balance, the policy helps support bank profitability. Tiered interest rates have been introduced in various economies and are being considered by the ECB.

Yield curve control

Yield curve control was introduced by the BoJ in 2016 as part of its QE programme. The central bank alters its government bond purchases with the aim of keeping the yield on the 10-year government bond at zero. This has allowed the BoJ to makes fewer purchases of Japanese government bonds while still keeping yields around zero. This makes QE more sustainable.

In terms of the implication for markets, yield curve control would be likely to reduce the volatility of interest rates and exchange rates (see charts below).


The US Fed has expressed an interest in targeting bond yields and has actually used the policy before. In 1942, the Fed helped the Treasury finance the expense of the Second World War by implicitly capping the long-term government bond yield at 2.5%. However, as inflation became a concern the policy became difficult to reverse, given the different objectives of the government and central bank.

Helicopter money

A central bank could print money and distribute it directly. This is known as “helicopter” money. It’s so-called as the idea is meant to be equivalent to a helicopter flying over a town and throwing out $1000 notes.

The downside is that helicopter money could lead to higher inflation. It also poses a threat to fiscal discipline and the independence of the central bank from the government.

A similar idea is debt monetisation, where central banks finance the government directly (by purchasing the bonds that the government issues to finance its spending). This is currently illegal for most central banks. In practice though, loose monetary policy is already supporting governments by allowing them to borrow cheaply.


Should fiscal policy take the strain?

Central banks have proved that they can think creatively about monetary policy and there are tools available to them. The Fed and BoE can cut interest rates and restart QE. The ECB and BoJ have limited scope to cut rates but can still do so. The ECB can also restart QE and expand its scope by purchasing private assets.

Ultimately though, the limited options for central banks means the task of stimulating the economy may need to pass to fiscal policy (i.e. government tax and spending). Most developed economies have at least some “fiscal space” to increase spending. Italy and Spain are among these with the least fiscal space due to concerns around the sustainability of their debt.  

Countries who can co-ordinate a joint policy response from government and the central bank are likely fare better when facing another economic downturn. Given the political constraints and lower fiscal space, this could prove particularly challenging for the eurozone.  

The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and a trading name of Schroder & Co. Registered Office at 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored. 

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