Getting to grips with monetary policy?

It seems a long time ago that the Federal Reserve first introduced quantitative easing (QE) as a crisis measure following the collapse of Lehman Brothers in 2008. Interest rates were effectively pushed lower than their zero bound to help strengthen a floundering economic and financial system. Combined with other efforts, QE succeeded in bringing a degree of stability to the system and, since then, the Fed’s balance sheet has ballooned as it embarked on QE 2 and QE 3 to shore up confidence in the financial system.

During the ensuing period there have been many calls for an end to asset purchase programmes and ultra-low interest rates. Economists are concerned that extraordinary monetary policies represent a repression tax and are distorting markets. Yet, almost five years after the Fed first embarked on its extraordinary monetary policies, even speculation in May that it would consider a scale-back of QE caused pandemonium in the world’s financial system with billions of dollars of carry trades (where speculators borrow in a low interest rate jurisdiction and invest in a higher yielding location) unwound within a period of days.

The dangers of unwinding
The markets may have misread Fed chairman Ben Bernanke’s May 22 statement – outgoing Bank of England governor Mervyn King summarised the views of many when he said markets had “jumped the gun” in interpreting Bernanke’s comments as an indication the Fed would increase interest rates. But the rapid rise in volatility across asset classes acted as a foretaste of what would likely follow should extraordinary monetary policy actually be unwound – as many central bankers believe it should be.

While the US dollar strengthened and Treasury yields jumped, the impact was also felt keenly in emerging markets, many of which are most prone to rapid changes in sentiment (see Central Bank of Peru governor Julio Velarde’s views). Nonetheless, some central bankers, particularly in Asia, believe the reversal of fund flows from late May represented a useful wake-up call for institutions that have thought of low interest rates as here to stay. The attitude of central bankers in some Asian jurisdictions may not come as a surprise. Advanced-economy quantitative easing has driven up currency, property and equity values, which has necessitated the deployment of macro-prudential tools to cool potential price bubbles. Such actions would be less likely to be required if the Fed was to taper.

Market participants, meanwhile, started to differentiate the risk/return trade-off in emerging markets to bet on which countries and assets would be most exposed in the event of a normalisation of monetary policy. As US investor Warren Buffett said: “You only find out who is swimming naked when the tide goes out.”

There are fears China could be one jurisdiction more prone than it was in the past due to its falling growth rate. Interbank rates spiked sharply in China in June until the People’s Bank of China eventually guaranteed liquidity to the market (see page 61). China has long imposed interest rate restrictions that distort its financial markets and, if its growth rate remains at more than 7% per annum, the Taylor Rule would indicate its interest rates may also need to rise in the future once a planned liberalisation of rates takes place.

The BIS’s opinion
Staff at the Bank for International Settlements (BIS) may have welcomed talk of tapering. As the BIS points out in its annual report for 2013 (see a review on page 55), extraordinary monetary policy cannot continue forever without consequences – and central banks cannot repair the balance sheets of households and financial institutions, ensure the sustainability of fiscal finances or enact the structural economic and financial reforms required to restore economic confidence in national economies.

The BIS states – rightly – that national authorities need to “hasten structural reforms so that economic resources can more easily be used in the most productive manner”. Unfortunately, the time “borrowed” by central banks via accommodative monetary policy has not been used as well as it could have been.

Low rates have also made it easier for the private sector to postpone deleveraging, for governments to finance deficits and made it simpler for authorities to delay financial reform. As the BIS report said: “After all, cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change.”

Dependent on central banks
Financial markets almost everywhere now appear ‘dependent’ on central bank actions, which is creating perverse outcomes. Traders now talk about good economic news having a negative effect on asset prices and vice-versa – the opposite to what used to be true. That is because good economic data could result in an expectation that QE could be withdrawn earlier than expected. Meanwhile, the release of poor economic data raises the prospect of more QE and this is subsequently driving a rise in prices.

A downward revision in US GDP and higher-than-expected unemployment numbers in May caused investors to predict softer US growth in the second half of the year, so bringing an end to any immediate expectation of Fed tapering. Not soon after on July 4, the European Central Bank and the Bank of England started offering forward guidance on interest rates. The Bank of Japan, meanwhile, had already embarked on its effort to double the monetary base by the end of 2014. This means the world’s biggest central banks effectively moved in the opposite direction to recommendations made by the BIS just weeks after the Basel-based body published its annual report.

This does not mean the BIS is wrong. But it does show starkly that what is right for the world as a whole may not be right for a single country and what is right for a single country is not necessarily right for the world as a system. And this raises significant questions about the viability of global co-operation on monetary policy, which still remain unanswered.