Central Banking – the great unwind

One of the salient features of the official response to the Global Financial Crisis and the Great Recession that followed it has been the use of unconventional monetary policies by central banks. Among these we find forward guidance (the elaborate telegraphing of the central bank’s intentions and likely future actions), quantitative easing in its numerous forms, funding for lending type programmes and negative interest rates – and it is probably right to include in this list the ultra-low (though still positive) policy interest rates that started the move into uncharted waters nearly 10 years ago.

By consistently labelling these policies as “unconventional”, central banks have shown that they are intended to be temporary and eventually abandoned as soon as the macroeconomic environment permits. The subliminal message is that at some stage, monetary policy will be normalised and will become “conventional” again.

It is of course attractive, both for central bankers and the general populace at large, to wish to return to the more comfortable times before the Global Financial Crisis, when inflation was low, growth was generally satisfactory and wages were in most countries still rising.  And by labelling that as “Normal” and by seeking a return to that normality, central bankers are doing their best to persuade their populations – and perhaps also themselves – that the Good Times can and will return.

However, this is somewhat disingenuous.  Both the world economy and central banking have changed in the last 10 years, possibly for ever.  Economically, no-one can undo the twin developments of globalisation and the rise of China.  More narrowly, it is for example highly unlikely that central banks will return to a policy of a single instrument (the policy interest rate) to control a single variable (inflation);  as we commented in our article last week, central banks have assumed a much greater responsibility for financial stability after the Crisis (and after the public realisation of what damage financial instability can wreak), and they will struggle to find anyone willing to take that particular burden off their shoulders.

In addition, the increased profile of and focus on central banks in recent years means that, where central bank orthodoxy was once to be impenetrable and to aim to surprise markets, today the accepted tenet is to be much more open, to carefully manage expectations and to ensure as much as possible that markets are on board with policy changes well before they take place. Hence, forward guidance, for one, is likely to remain an essential part of monetary policy – in effect it has moved from being “unconventional” and will from now on be part of the conventional central bank policy repertoire.

As for other measures, those that having been tried have been found helpful (or at least not harmful) are also likely to be retained and used again in case of need. So the “normalisation” of monetary policy is actually more likely to involve the incorporation of more tools in the central bank toolkit, rather than a return to one single instrument.

This being said, central banks have made it clear that two of the unconventional policies will indeed be reversed, namely negative and ultra-low interest rates and the central bank balance sheet expansion. Central banks have never wavered from their stance that these two were genuinely emergency responses to the Crisis, and it is no secret that many central bankers think that, for all that the two measures were necessary at the time, and for all the good they have undoubtedly done, they also create consequences and incentives which risk being profoundly negative in the longer term.

But, just as central banks entered into unchartered waters by first slashing interest rates and then expanding their balance sheets, so they are now also heading into unknown territory as they set about increasing interest rates again and reducing their balance sheets.  And the biggest unknown of all is what the optimal order for undertaking these two “normalisations” is.

In the Great Recession, the order of policymaking was first slash interest rates, and then expand the central bank’s balance sheet. But the Federal Reserve, which acted as the pacesetter on both counts on the way in and which is also showing the way out, has chosen first to end its QE purchases, next to raise interest rates slowly and finally (imminently, probably as early as this September) to trim the size of the balance sheet.  This is not a mirror unwind of the establishment of their current position.

And while markets fully expect the ECB (as well as others such as the Bank of England and the Swedish Riksbank, and presumably one day even the Bank of Japan) to follow roughly the same pattern, there is no overwhelming reason for other central banks to move in precisely the same sequence, let alone at the same speed.

First, although we ourselves agree that central banks should trim their balance sheets, there is a powerful body of thought (richly represented at last year’s Jackson Hole conference and including former Fed Chair Ben Bernanke) which argues the opposite. But, even if all can agree that bloated central bank balance sheets need to slim, there is little or no agreement on by how much or what the ideal size of any central bank’s balance sheet should be. Should it, for instance, be a certain percentage of GDP; or of the banking system balance sheet? And even then, should it return to the pre-Great Recession size or be bigger (or even smaller)? Should central banks get rid of all the banking system’s excess reserves? Or only some?

Second, much of the debate around normalisation implicitly assumes a symmetry between cutting interest rates to ultra-low levels and raising them; and between quantitative easing (central bank asset purchases) and quantitative tightening (central bank asset sales). That may possibly be the case, and certainly the pairing of QT with QE is linguistically neat, but it is by no means certain that this will prove the best course – indeed history argues against such symmetry, and it is actually quite rare in markets for moves up and moves down to be executed at the same measured pace.

Similarly, it is not clear that central bank sales will have an equal but opposite effect to purchases, not least since the central bank’s counterparties (ie the institutions the central bank buys from or sells to) will not necessarily be the same.  The purchases were made on the secondary market, from banks and other private sector holders, whereas the sales – at least in the Fed’s case – will involve not rolling over maturing assets, thus possibly having a direct contractionary impact on the stock of money in the economy.

In fact, as we have seen the Fed is very specifically not moving in the exact reverse order to its introduction of the policies. That would involve first slimming the balance sheet, and only then raising interest rates.  But as noted above, the Fed has raised interest rates first, despite there being arguments for moving first on the balance sheet, since arguably, this can be done more cautiously and piecemeal than raising interest rates, and it would probably be easier to reverse the policy if mistakes are made. Further, many central banks are now paying interest on excess reserves, in order to better control the inter-bank market. Higher interest rates on unslimmed bankers’ balances mean paying more money to banks, something which while justified may not be welcome politically.

Another possible way forward could be to raise the policy interest rate while continuing to buy assets in order to flatten the yield curve and keep long-term borrowing costs down, although this risks giving conflicting messages (is the central bank tightening or easing?) and if carried to excess gets us perilously close to financial repression.

In summary, there is no single way of exiting unconventional monetary policies; there is no historical guide to which of the several possible routes will prove best; and the way out raises at least as many questions as introducing the policies did. None of these questions has yet been answered, nor are they likely to be until the whole process is well behind us – which promises to offer us and other commentators much opportunity to analyse, second-guess and criticise the central bankers trying to navigate this particular minefield.

What can be stated with slightly more certainty is that, with a lack of historical experience to guide policymakers and a lack of urgency forcing them to act (unlike during the crisis, to do nothing and postpone the difficult decisions is a possible option), normalisation – whatever it entails – is unlikely to be a quick process.  All of the central bankers’ traditional caution and reluctance to move hastily will be employed, every step will be carefully trailed in front of markets.

It will, we suspect, be a long time yet before central bank monetary policy is “normalised”.