Since the beginning of May, monetary policy has undergone a substantial tightening. This has taken the form of a rise in the yield on the bonds of highly rated governments. The yield on 10-year US Treasuries rose by 88 basis points between May 2 and the end of last week, to 2.51 per cent. This is a clear tightening of monetary conditions: a rise in these yields lead to rising borrowing costs for the private sector.
It is, however, not clear that it is deliberate: longer-term bond yields are not an explicit target for monetary policy. Moreover, part of the reason for the jump in rates is rising confidence. But talk of 'tapering' US quantitative easing is also a factor. It is hard to manage a policy whose effects depend on expectations. But it must be done better: this tightening is premature.
That is surely not how it would appear to the Bank for International Settlements, whose annual report calls for an early end to loose policies: “Authorities need to hasten structural reforms so that economic resources can more easily be used in the most productive manner. Households and firms have to complete the repair of their balance sheets. Governments must redouble their efforts to ensure the sustainability of their finances. And regulators have to adapt the rules to an increasingly interconnected and complex financial system and ensure that banks set aside sufficient capital to match the associated risks.”
This is central bank bromide. Worse, it is hard to understand how the BIS thinks its recommendations add up across the world economy. In essence, it suggests that the private sectors should run bigger financial surpluses, as heavily-indebted agents repay debt, while governments should run smaller deficits. Unless one assumes that advanced countries will run vast current account surpluses with the rest of the world, this is a plan for a depression. The BIS does not even consider the possibility that monetary policy has been ineffective because it is competing with the fiscal tightening the BIS has recommended.
At least three further points stand out. First, the two crisis-hit economies that have made greatest use of unconventional monetary policy – the US and the UK – are also the least affected by structural rigidities – so there is no moral hazard there. Only sadists can argue that supportive monetary conditions have cushioned southern Europe against the need to reform. Second, it ignores the fact that one of the reasons for failure to reduce debt faster is economic weakness caused by the austerity it supports. Third, core inflation is low and falling in the US and eurozone. Rapid tightening risks tipping these economies into outright deflation – a risk the BIS does not even mention.
Indeed, in a critique of the Federal Open Market Committee’s latest policy statement, James Bullard, president of the Federal Reserve Bank of St Louis, argues that the FOMC “should have more strongly signalled its willingness to defend its inflation target of 2 per cent in light of recent low inflation readings”. He is right: the Federal Reserve’s forecasts show core inflation at or below 2 per cent up to and including 2015. Second, he argues that “the committee’s decision to authorise the chairman to lay out a more elaborate plan for reducing the pace of asset purchases was inappropriately timed”. It should have waited “for more tangible signs that the economy was strengthening and that inflation was on a path to return toward target before making such an announcement”. I agree.
If the Fed had been more careful, this premature monetary tightening might not have happened. As it is, the fall in prices of the world’s most important financial securities could materially damage recovery, as it lowers prices of riskier assets across the world, not least in emerging countries. Gavyn Davies, writing in the Financial Times, highlights the dangers of such a correction, citing Warren Buffett’s remark that we only discover who is swimming naked when the tide goes out.
The BIS argues that if yields were to rise by 3 percentage points across the maturity spectrum in the US, mark-to-market losses would be more than $1 trillion, or almost 8 per cent of GDP. Losses elsewhere would be even bigger. Financial shocks are possible, as “carry trades”, in which investors have borrowed short to lend long or borrowed in low-interest currencies to lend in higher-interest ones, unwind sharply. Indeed, one of the reasons why policy makers must be careful is that investors in such trades know how vulnerable they are to a rush for the door. They will flee as soon as they fear others may do so, creating a big danger of self-fulfilling panics.
The challenge in unwinding current policies is not technical. As Fed chairman Ben Bernanke explained in February 2010, exit from QE and bloated central bank balance sheets is technically straightforward. Since the Fed pays interest on reserves, it can even raise short-term rates before QE is reversed. Furthermore, such an exit is desirable, provided it occurs only when the recovery is in place.
There are three true challenges. The first is proper management of expectations. This may be too late now. But the right way to proceed, as Bullard has argued, is to stress only conditions, not timetables. Nobody knows when the conditions for tightening will emerge, because nobody knows how the economy will perform.
The second challenge is to address the vulnerability of the financial system – especially the systemically significant parts – to big declines in prices of safe-haven bonds. This is purely market risk, not credit risk. That can be managed by a mix of lower leverage and, if necessary, regulatory forbearance. It is unlikely that markets would cease to fund systemically significant financial institutions that have only mark-to-market losses on safe-haven government bonds. Yet the authorities will need to have plans to address such an eventuality.
The third challenge is to manage the global consequences. The likely result of a credible exit will be a shift towards assets in the recovering high-income economies. For emerging countries that should be welcome, in the medium run. But they need to ensure that their financial systems, too, can cope.
We should look forward to a world of higher long-term interest rates on safe-haven bonds. But we should not need to enter that world yet. Policy makers need to speak softly about exits. But the regulatory stick must be big enough to ensure the economy copes when it comes.
Copyright The Financial Times Limited 2013.