Time to face the consequences of central banks' intervention
The Federal Reserve, European Central Bank, Bank of Japan and other central banks have used a range of tools to try to spur growth and fight crises in their nations; the Fed, for example, is on track to soon own about $US4 trillion in assets, up from the $US800 billion it held before the crisis.
Christine Lagarde, managing director of the IMF, has been broadly supportive of these efforts, and she stresses that they should be unwound only as economic conditions improve.
But in a speech to leading central bankers and economists at an annual economic symposium in Jackson Hole, Wyoming, she urged more reckoning with some of the less pleasant side effects for global finance, particularly the risk of bubbles and instability.
It was important, "to communicate the risks on both sides of the equation - the risks to recovery from exiting too soon, and the risks to financial stability from exiting too late," she said.
In the past couple of months, there have been signs that the unwinding of the extraordinary interventions will be a bumpy ride. In the US interest rates have risen dramatically since June as the Fed has signalled it will soon slow the pace of its bond purchases. That prospect has also sparked a selloff in the Indian rupee, and many other emerging nations' bonds.
The gush of money injected into the financial system may well be a cause of the instability, with the big swings in currency and bond markets a reflection of "hot money" sloshing around the globe.
Ms Lagarde floated the idea that nations may need to intervene in foreign exchange markets to help moderate this volatility, that restrictions on the flow of capital can be useful "in some circumstances".
It is the latest example of the IMF, long an advocate of the free global flow of capital and flexible exchange rates, taking a more open-minded view towards policies aimed at reducing the hot-and-cold nature of modern financial markets.
Ms Lagarde expressed a fear that, while the interventions of central banks gave other policymakers the time to make deeper reforms in how their economies work, those officials haven't done enough to use the time.
"I do worry that all the hard work of central banks will be wasted if not enough is done on other fronts - to adopt the admittedly more difficult policies needed for balanced, durable and inclusive growth ... [Unconventional monetary policy] is providing the space for more reforms."
Frequently Asked Questions about this Article…
Central bank intervention refers to actions like large-scale bond-buying and other unconventional monetary policies used to support growth and stabilise markets. The IMF, via Christine Lagarde, says it's time to face the consequences because these policies can create side effects — notably asset bubbles and financial instability — that must be dealt with as economies recover.
The article notes the Federal Reserve is on track to soon own about US$4 trillion in assets, up from roughly US$800 billion before the crisis, reflecting the massive scale of its bond purchases and other support measures.
Unwinding means scaling back emergency policies such as bond purchases and low rates. The IMF warns there are two key risks: exiting too early could jeopardise the recovery, while exiting too late could fuel financial instability and asset bubbles — outcomes investors should watch closely.
Recent signs include a sharp rise in US interest rates since June as the Fed signalled it will slow bond purchases, and knock-on effects like a selloff in the Indian rupee and weakness in many emerging-market bonds — examples of volatility as policies shift.
When big central banks reduce stimulus or raise rates, 'hot money' can flow out of riskier assets. That can trigger sharp moves in emerging market currencies and bonds, causing selloffs and increased volatility, as the article describes with the Indian rupee and other emerging bonds.
Lagarde floated the idea that countries might need to intervene in foreign exchange markets and that restrictions on capital flows can be useful in some circumstances — signalling the IMF is more open-minded about measures to smooth volatile cross-border flows.
The IMF views unconventional monetary policy as having bought policymakers time to undertake deeper reforms. Lagarde warned, however, that those other policymakers haven't always used that space sufficiently to implement the harder policies needed for balanced, durable and inclusive growth.
Investors should recognise that central bank support has helped markets but also raises risks as it is withdrawn: expect potential volatility in rates, currencies and emerging-market assets, pay attention to policy signals (like Fed tapering), and consider diversification and risk management while watching for structural reforms that could affect long-term market stability.
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