A Fed fallout shelter for Europe

Europe's bulwark against repercussions from the end of QE includes options for new rate cuts and liquidity injections, as well as close communication from central banks. But policy makers are still right to be scared.

FT.com

The US Federal Reserve’s massive experiment with economic stimulus will be wound down. Get used to it. Less certain is whether central bankers in Europe, as well as emerging markets, can avoid destructive consequences.

By its actions, the Fed arguably averted a global depression and, indisputably, fed global equity and bond market rallies.

When and by how much the Fed decides at its policy meeting today to scale back its asset purchase programme, or who succeeds Ben Bernanke as chairman next year, will probably make only a marginal difference to what happens next.

The bigger picture is that as the US economy recovers, “quantitative easing” and historically low US interest rates will be phased out. As all market veterans know, when the central bank started a tightening cycle in 1994, bond markets crashed globally. So should Europe worry as the Fed heads for the exit?

Yes, if one takes at face value comments last week by Jorg Asmussen, a European Central Bank executive board member. “If spillovers were large in 1994, we can expect them to be even larger today in an even more deeply interconnected world,” the former top German finance official told a Brussels think-tank.

The turmoil developing economies have seen so far on talk of “tapering” Fed QE suggests Asmussen was right to sound the official alarm. Emerging market bonds had a relief rally on Monday’s news that Larry Summers, a perceived sceptic on quantitative easing, was pulling out of the race to succeed Bernanke, boosting the chances of the more dovish Janet Yellen, Fed vice-chairman.

However, European markets have remained stable so far – remarkably perhaps in the southern eurozone “periphery” – although UK gilts and German 10-year yields, which move inversely with prices, have risen. Moreover, Asmussen did not mean to sound so cataclysmic. Rather he was arguing in German fashion: raising the spectre of disaster to then explain how it could be averted.

ECB research, yet to be published, has looked in depth at what exactly happened in 1994. One observation is that eight out of the 10 largest daily increases in 10-year US Treasury yields that year were on better than expected economic data. In other words, markets worried that central banks would react to positive news by tightening faster than warranted.

The lesson Asmussen drew in his Brussels speech was that central banks should ensure their “reaction functions” were as clear as possible – so markets knew exactly how they would behave. Another lesson was to keep the lid firmly on inflation expectations. The ECB and Bank of England have already shored up their defences. Both have introduced “forward guidance”, intended to make clear that they will be in no rush to raise official interest rates. They have had some success in influencing short-term rates, where volatility has fallen, as has the dispersion of interest rate expectations.

Were monetary conditions to threaten the eurozone’s fragile recovery, the ECB could cut interest rates further or launch fresh offers of liquidity to eurozone banks – perhaps over an even longer period than the three-year loans announced in late 2011, or on better terms, or conditional on banks lending more to the real economy.

Another part of the ECB’s plan to strengthen its communication is the future publication of the minutes of policy meetings. Historically, the ECB has kept secret the position of individual council members, most of whom are national central bank governors in eurozone states. The fear was of undue domestic political pressures to vote in particular ways. Ironically, the word in Frankfurt is that it is older members of the governing council with better memories of 1994, such as France’s Christian Noyer and Portugal’s Vítor Constâncio, who oppose publication of minutes.

But even if ECB minutes are published, it all may not be enough to prevent financial turmoil and premature rises in European market interest rates.

Influencing a lot of thinking these days in European policy circles is a paper on global capital linkages presented at August’s summit of central bankers in Jackson Hole, Wyoming, by Hélène Rey, professor of economics at London Business School.

Rey identified how the Fed drove a common global financial cycle influenced by investors’ risk appetites that often rendered impotent actions by other national authorities. Her paper has helped crystallise how global investors should think about emerging market economics – and may have been in Asmussen’s mind when he spoke last week. Not a few policy makers in Europe fear the continent will be caught in the same trap.