Davos 2018: the monetary policy trick is managing a return to ‘normal’

A spectre haunts the world economy. As the exceptional monetary policies of the past decade tighten, many fear asset prices will collapse and the financial system implode. Prophets of doom predict (or hope) that the world will at last suffer for the sins of activist central bankers.

The view that the actions taken by the authorities were dangerous emerged almost as soon as the global financial crisis erupted in 2008. In June 2010, the Bank for International Settlements (BIS) argued: “The time has come to ask when and how these powerful measures [support for the financial system, fiscal deficits, near-zero interest rates and quantitative easing] can be phased out. We cannot ignore the fact that the cumulating side effects themselves pose a danger that, at the very least, implies exiting sooner than may be comfortable for many.”

In the event, monetary policy remained strongly supportive — indeed, in the cases of the European Central Bank and the Bank of Japan, became far more supportive — in subsequent years. Yet now, at last, the idea of “normalisation” is gaining hold. The Federal Reserve has raised its policy rates five times, from 0.25 to 1.5 per cent. The Bank of England has raised its policy rate once, albeit only back to 0.5 per cent. Even the ECB is indicating it might cut its crisis-era stimulus programme faster than expected (see charts).

The main reason normalisation is on the agenda is the recovery. The world economy is at last enjoying reasonably strong and synchronised growth. Notably, consensus forecasts for growth this year have improved since a year ago for almost every significant economy.

It is not surprising that the Fed has been far ahead of the other central banks. In the aftermath of the financial crisis, the US authorities acted both sooner and more decisively than the Europeans and Japanese. The US recovery is substantially more advanced and core inflation is also far closer to target than in the eurozone and Japan.

The process of normalisation is complex. This is because in addition to ultra-low (even negative) intervention rates, central banks expanded their balance sheets and, in the Bank of Japan’s case, have engaged in controlling the yield curve.

A central bank normally affects the short-term interest rate by adjusting the rate at which it lends to banks. But when banks hold huge reserves at the central bank (an automatic byproduct of quantitative easing) this ceases to work. Instead, central banks raise market rates by adjusting the rate they pay on reserves. The Fed buttresses this with “overnight reverse repurchase operations”, which decide rates earned by non-bank financial institutions.

The Fed can let its balance sheet shrink by ceasing to reinvest the proceeds of bonds that come due. In that case, borrowers would need to replace the maturing bonds previously held by the Fed with ones held by other investors. The latter will use their bank accounts to pay for the new bond. The banks, in turn, use reserves at the central bank to settle their liability. In the end, the Fed’s assets and liabilities will shrink, at measured pace. Other central banks are likely to follow suit, in time.

While technically, then, policy normalisation is quite simple, bigger questions concern the timing, consequences and even meaning of normalisation.

On timing, the BIS is far from alone in arguing that policy should have tightened long ago. Others argue that, with inflation surprisingly low, even in the US, tightening should have been delayed, or should now be slower than seems likely (or both). Presently, debate in the US on timing seems to have stilled, largely because the economy has been so robust, but it is increasingly active in the eurozone.

As to the consequences of normalisation, alarmists argue that, with real and nominal yields on bonds exceptionally low, prices of real assets (notably US stocks) exceptionally high and the overall debt burden very heavy, tightening is likely to trigger economic disruption.

Yes, it is likely that real and nominal interest rates will rise everywhere from their recently very low levels. Yields on US 10-year treasuries are already well above levels in Europe and Japan and more than a percentage point above their floor. Fed asset purchases halted some three years ago and policy rates started to rise just over two years ago.

Yet none of this has had any untoward effects on asset prices or the financial system, at least so far. Big falls in stock prices from their current exalted levels are quite plausible. But banks are also somewhat more robust than a decade ago. Whether huge problems will emerge in other parts of the financial system, with dire economic consequences, is still quite unclear.

Finally, this relates closely to what normalisation might mean. Given the headwinds to growth, both real (ageing and low productivity growth) and financial (elevated levels of debt and asset prices) interest rates seem unlikely to return to pre-crisis levels. But, if rates do stay relatively low, central banks will have much less room for manoeuvre, in response to a recession, let alone a crisis, than they did in 2008 and 2009.

If central banks do not deliver a robust economic take-off, they will surely fail to achieve the policy room they would like. Yet, even if they do achieve such a take-off, they may still not gain that room because the new normal turns out different from the old one. Worse, if pessimists are right, the policies used to achieve take-off may raise the chances of a subsequent crisis.

The techniques of tightening themselves seem straightforward. Where the economies and policy will end up is not.