BIS Working Papers No 448 "The exit from non-conventional monetary policy: what challenges?" by Philip Turner published last week offers some interesting analysis of the risks we can expect in the process of the unwinding of the QE measures and other non-orthodox supports extended by the Central Banks following the GFC. The topic of huge importance for anyone interested in the forward analysis of the advanced economies and the one I have covered over the recent years under my thesis of the impossible monetary policy dilemma both on this blog and in my Sunday Times articles.
Note: link to the paper http://www.bis.org/publ/work448.pdf.
"One legacy of the monetary policies pursued since the financial crisis is that central banks in most advanced economies now have exceptionally large balance sheets. And commercial bank reserves (“money”) have risen by several multiples. These policies have made the exit challenge faced by central banks more complex. But there is no consensus on the New Normal for the balance sheet of central banks.
This paper argues that the crisis has forced a critical examination of some widely-held beliefs about the division of labour between different agencies of government in implementing macroeconomic policies. The central bank has become more dependent on what the government decides – on fiscal policy, on government financing choices and on regulations requiring banks and other financial firms to hold government bonds. The exit will succeed only if central banks remain free of fiscal dominance and financial dominance."
But what does this really mean?
The paper starts by positing three orthodoxies or dogmas that dominated the past thinking on monetary-fiscal policies interlinks and that have been proven to be wrong by the current crisis:
"In recent years, The New Keynesian perspective incorporating rational expectations and perfect asset substitutability also had a number of convenient implications for policymakers. It shaped what has been called the pre-crisis “doctrine” of monetary policy, and
therefore was partly responsible for the severity of the recent crisis… [the] three “dogmas” that are of interest for the purpose of this paper:
a) Open market operations in government bond markets (or in foreign exchange markets) do not change relative prices. … [in other words] any purchase or sale of particular assets would lead only to offsetting changes in private demands, with no impact on prices. One corollary of this is that government debt management (that is, the relative supply of short-dated and long-dated bonds by the Treasury) can be separated from monetary policy.
b) The central bank short-term policy rate is the unique instrument of monetary policy aimed at macroeconomic objectives. The impact of policies on other core financial market prices – such as the term premium in the long-term interest rate – was neglected…
c) The “liquidity” of the balance sheets of commercial banks is irrelevant. If adequate capital standards are in place to ensure the viability of a bank, there was no additional need for bank regulators to worry about the liquidity of banks because a sound bank could borrow readily in interbank markets to meet any “temporary” liquidity squeeze. Hence the failure of international regulators in the 1980s to develop common measures of the overall liquidity of a bank (and the decline in liquid asset ratios) seemed unimportant."
As Turner notes: "…all three “dogmas” have been shown by recent events to be false."
In particular, "Central bank balance sheets matter. Large-scale central bank purchases of bonds (and other assets) have lowered long-term interest rates, leading economists to re-examine the portfolio rebalancing affects that the New Classical school had dismissed. The neat separation between central bank open market operations and government debt management has been blurred. And banks now pay much closer attention to the liquidity of their balance sheets (with bank regulation in this area having been strongly reinforced since the crisis). Equally, the scale of balance sheet measures taken by central banks actually reinforces the fundamental logic behind the New Classical theories. An intertemporal perspective – a key insight of rational expectations – has become even more necessary. Because of the substantial lengthening in the maturity of central bank assets, the decisions taken during this crisis will have more long-lasting (and therefore more uncertain) effects than if policy action had been limited to short-term interest rates or short-dated paper."
How big is that 'long-lasting effects' bit?
And more crucially, as we know the size of the problem, how difficult or painful will it be to undo this QE legacy?
Consider one aspect of the legacy: the link between asset prices (financial markets valuations) and the interest rate risk (the cost of undoing the QE). Per Turner: "Getting long-term rates down has contributed to bringing financial asset prices in the core economies back to pre-crisis levels, even higher. And, ...Gambacorta et al (2012) show that the expansion of central bank balance sheets did
increase real GDP. In this sense, QE policies have worked."
But just because it worked in the past, does this mean unwinding it will be cost-less even if 'handled right'?
As Turner points, "there is a reassuring answer. The massive purchases of central banks have had wealth effects that should, in time, stimulate global demand. In addition, stronger asset prices should raise the value of potential collateral for new loans and therefore ease the borrowing constraints facing firms and households. Once stronger aggregate demand is assured, the central bank
could readily unload the assets acquired during the crisis."
In other words, the idea of the 'well-managed exit' is that it will come at the time of demand boom and this demand boom should reduce adverse costs of the exits. In theory.
"The problem with this reassuring answer is that the recent recession – now more than five years long – has lasted so long. Financial asset prices did get a considerable boost. Yet the hoped-for growth in real GDP that would have allowed central banks to scale back crisis-related asset purchases did not materialise."
The good times arrived, but not for the real economy. 'Well-managed' exits are not really on the books, since "this disconnect between the rapid rise in asset prices and the persistent weakness of demand is worrying. Is this a bubble that could suddenly deflate? Or do forecasters underestimate the strength of real demand over the next couple of years?"
And there is more: "Another worry is that global net interest rate exposures must have risen substantially since the crisis. At the core of this is US Treasury debt outstanding held outside the Federal Reserve. This rose from $3 trillion in early 2007 (yielding an
average of 5%) to $8 trillion (with an average yield of 1%) by mid-2013. The rise of government debt in other advanced economies – financed at yields that track US Treasuries – is well-known. Much of this risk is in the banking system: sovereign exposures accounted for 19% of total banking book exposures of large international banks in mid-2012, compared with 11% at end-2008. Lower-rated corporations have also benefited from the negative or zero term premium in government debt markets, so credit risks have probably risen too." Turner does not mention households, but they too were allowed breathing room on funding their debts - as policy rates scaled back, cost of funding mortgages and other debts fell. But debt levels did not fall significantly enough, with exception of bankruptcies and foreclosures cases.
"Furthermore, the link between US yields and yields on EM bonds has increased substantially over the past decade, and EM bond issuance has risen."
In plain English: we are all (governments/taxpayers, corporates, households and even emerging markets) are sitting on a ticking time bomb: once rates start rising, we start feeling the pain of higher debt funding costs. What miracle of 'well-managed exit' strategy can deliver us from this predicament?
The latter is the rhetorical question. "The scale of market turbulence in global bond markets from May to September 2013 demonstrates the importance, in any correction, of the outstanding stocks of assets. Quantities matter. The vastly increased volume of bonds outstanding, some held in leveraged portfolios, means that volatility will rise much more when market sentiment changes than it did in the past when outstanding stocks of bonds were much lower." What's that I hear? More volatility than in previous crises? Surely this cannot be good.
"The turbulence also illustrates the dominance of US Treasuries. A substantial rise in US long-term rates took place without any change in the policy rate in the United States." In other words, the Fed did not pause priming the pump, but rates went up… oops… "Such a strong and global market reaction suggests some sudden unwinding of leveraged positions and powerful contagion across markets."
Bingo! In the markets bubbly high on cheap liquidity, there is no 'well-managed exit' feasible.
Turner is, of course, all BIS on this point. "It is difficult to know what lies ahead."
Except this: rates will go up. "Central banks in the advanced economies are not comfortable with the size and structure of their balance sheets. From September 2009, governors of the major central banks (including Messrs Bernanke and Trichet) expressed the hope that they would soon be able to begin their “exit” from unconventional policies. But such hopes were dashed by the deepening euro crisis from mid-2010. Not only have central bank balance sheets further expanded but – equally important – the maturity of their assets has become much longer."
And with this 'staying in QE', Central Banks are gaining a new risk / problem: "Since their liabilities have remained of very short maturity (typically bank reserves), central banks have a growing maturity mismatch. A sizable term spread gives the central bank a positive running yield: this has boosted its profits typically remitted to the Treasury, often creating a favourable impression with parliaments." (Do recall my recent article on Irish Central Bank annual report published in Sunday Times… Bingo!)
"But higher short-term rates could at some point lead to central bank losses. This has no fundamental significance because the central bank does not face the financing constraint in its own currency that a private agent faces: it can print money." Oops… not Irish Central Bank can't… and ECB does not like to…
"Likewise, the government can raise taxes." Oops again, Irish Government can barely run a deficit at less than double European SGP limits on already sky-high taxes. Raising taxes further would be committing political seppuku.
So the conclusion is that "There will be many years ahead when central banks will have government and other bonds on their balance sheets. The accumulation of such substantial holdings was warranted only by the crisis situation that confronted central banks. It is difficult to know at present what the new “normal” size of such holdings will be. How quickly central banks reduce their bond portfolio will depend on (unknown) macroeconomic or financial developments over the next several years."
That's it, folks, the drunk will have to be primed with whisky for years ahed, lest he wakes up with a horrific hangover. That's the 'solution' to the 'exit' dilemma.
And this might not even solve the problem either. Here is why. Per Turner: "Could central bank sales or purchases of government bonds become viewed as a second policy instrument once monetary policy begins be tightened? Policies of Quantitative Tightening could well moderate any increase in the policy rate." In other words, can Central Banks hold off sales of government paper to allow higher liquidity in the system to offset interest rates increases?
Not so fast: "…one practical difficulty is that it is impossible to quantify how bond markets would react to central bank sales. Using estimates based on past experience of the policies that change the volume and maturity of government debt to be sold (such as those mentioned above) fail to take account of signalling effects. News of central bank selling even on a modest scale could send markets a signal that is more powerful than the actual sales (“They are testing the water for further, larger sales”). …The hyper-sensitivity of markets to guesses about future central bank sales was very well illustrated over the summer of 2013. The mention by Chairman Bernanke of what should have been obvious – that at some point the Fed would reduce the pace of its purchases – wreaked havoc in global bond markets … even with the very clear commitment of the Fed to keep short-term rates close to zero for a considerable time. The size and spread of this market adjustment suggest that many investors had highly leveraged positions."
What about the option of just allowing bonds to mature, thus preventing the need for sales? As Turner points out, this still will not be a neutral policy choice. "It would mean central bank balance sheets remaining large beyond 2020. And it would also mean that the timing of shrinking – which would have effects on financial markets and the macroeconomy – would depend only on the pattern of past purchases and be quite independent of future economic conditions. It could even continue into the next recession." Ah, the dreaded bit no one mentions at all, but the BIS grim reaper… the next recession. You know, while all Governments and Central Banks keep droning on about the next expansion, one has to remember the simply fact of nature: there will be another recession. And given the duration of the current anaemic recovery, it might arrive well before the economies have fully recovered from the previous shock.
Where's me parachute?.. cause this saucer is increasing looking likely to crash.