The limits of central banking

Prior to the great crash of 2008, investment bankers were – at least in their own minds – regarded as masters of the universe. No more. As their fancy clothes, woven from cloth so fine that the eye could not see it, were revealed to be non-existent, they were usurped by central bankers who used the muscle of zero interest rates and the power of their balance sheets to rescue the global economy from meltdown. More than a decade later and questions are increasingly being raised as to whether the tools which were deployed in 2009, and which are still in use today, are fit for purpose. Worse still, central bankers can be forgiven for wondering whether they have been hung out to dry by politicians who seem increasingly unwilling to provide the necessary degree of support to allow them to do their job effectively.

The BoE: A relative oasis of calm

The BoE finds itself in a slightly easier position than either the Fed or ECB although it has been sucked into the political fallout from Brexit, and with a new Governor set to take over from Mark Carney in just over seven months’ time, his successor may face an unenviable task in steering a post-Brexit course. One criticism that can be levelled at the BoE is that its forward guidance policy, which has often hinted at rate hikes which never materialise, may be about to miss the mark again. Indeed, recent hints that the next rate move will be upwards flies in the face of economic data, which point at below-target inflation in H2, and trends in the global monetary cycle. In common with many central banks, it has failed to create space to ease policy in the event that the economy cools. Central bankers dismissed this line of reasoning when conditions were propitious for a rate hike in 2014, and whilst Brexit has complicated the picture, it is hard to avoid the feeling that the BoE will go into the next economic slowdown with precious little ammunition.

The ECB: Taking flak from all sides

Across the channel, the ECB’s situation is even more desperate. Despite having cut the main refinancing rate to zero and the deposit rate to -0.4% whilst boosting its balance sheet to almost 40% of GDP, a meaningful economic recovery in the euro zone remains elusive and inflation continues to undershoot the ECB’s target. There are now expectations that the ECB will counter current economic conditions with even more monetary easing – a view that Mario Draghi reinforced this morning. The ECB is all that has stood between the integrity of the euro zone and disaster: It has done all the policy easing whilst governments have stood idly by without deploying any of the fiscal ammunition at their disposal. Draghi, who will leave his post as ECB President in October, deserves great credit for doing “whatever it takes” to keep the show on the road. Those who have criticised Draghi, including Bundesbank President Weidmann and various northern European politicians, should take some time to reflect on what might have happened in 2012 had the ECB not opened the taps.

However, the criticisms levelled by Weidmann at least come from someone with skin in the game. Draghi’s hints of further easing were met today by a Twitter blast from the self-styled stable genius in the White House accusing the ECB of weakening the euro against the dollar “making it unfairly easier for them to compete against the USA. They have been getting away with this for years, along with China and others.” This sends two messages: (i) Trump is a lobster short of a clambake and more seriously (ii) he threatens to open a new front in the war of economic nationalism, dragging the euro zone into a conflict which has hitherto been confined to the US and China.

The Fed: Managing in the presence of a stable genius

Imagine, therefore, what it must be like to be in Jay Powell’s shoes. The Fed has done what the textbooks recommend by taking away some of the excessive stimulus as the economy recovered. Unfortunately, Trump has determined that the Fed is the main obstacle to the ongoing US upswing and has been excoriating the FOMC for not cutting rates. Worse still, a story surfaced today suggesting that in February the White House explored the possibility of stripping Powell of his chairmanship and leaving him as a Fed governor. This is an unprecedented attack on the independence of the central bank. Not that politicians have refrained from dictating to the Fed in the past. One story, recounted by Reuters journalist Andy Bruce, recalls instructions from the White House to former Fed Chairman Paul Volcker ordering him not to raise interest rates during an election campaign. “Volcker, knowing the command was illegal, left the room without saying anything.” But the attacks on Powell are far worse – and lest we forget, he was appointed by Trump in 2018 with the endorsement that “He’s strong, he’s committed, he’s smart.”

The FOMC has recently revised down its assessment of the need for future rate hikes and it is increasingly likely that the next move will be a cut. It is not clear whether this is a direct response to the President’s attacks or whether the Fed has misread the economic outlook so badly that it feels the need to ease policy rather than tighten, as it believed necessary at the start of the year. However, to the extent that the Fed may be trying to head off further attempts by Trump to impose his own candidates on the FOMC, following the failed attempts to appoint Stephen Moore and Herman Cain, it is likely that the Fed is acceding to the pressure. Perhaps the Fed’s view is that by throwing a few small scraps in Trump’s direction, it will be better placed to maintain its independence in the longer run. But whilst it has long been evident that the Fed is not as free from political influence as it portrays, selling out in such an obvious manner could have the reverse effect by undermining its perception of independence in the market.

Dealing with the lower bound

The common themes across the central banking universe are that they are running out of tools to deal with the low-inflation world which we inhabit today, whilst also coming under much greater pressure to deliver on politicians’ objectives. With regard to instruments at the central banks’ disposal once interest rates reach the lower bound, there are essentially just three: QE, forward guidance and driving interest rates into negative territory as the ECB has done. At a recent Fed monetary policy conference (a so-called “Fed Listens Event” which deserves more in-depth coverage another time), a paper by Sims and Wu highlighted that QE is the most useful tool of the three; forward guidance depends on a central bank’s credibility (cf. the Fed’s position) and that negative rates become less effective the larger is the balance sheet (cf. the ECB’s position).

With central banks having tried all of these instruments to a greater or lesser degree, it is difficult to avoid the conclusion that we are near the end of the road with regard to monetary policy. After all, central banks have largely failed to stimulate inflation and there are serious concerns that if the floodgates are opened even further, this will serve only to store up greater problems in the future. Indeed, I have long argued that we will only know the full impact of low interest rates in the very long term once we see what our pensions are worth. What this does suggest is that much more of the burden of managing the economy will have to fall on fiscal policy in future – an issue I will deal with in my next post. The good news is that this will at least take central bankers out of the firing line and make politicians take some responsibility for what they should have been doing all along.

Asynchronicity

Comments by new Fed chair Jay Powell in Congressional testimony, suggesting that US interest rates might rise more rapidly than the markets currently anticipate, did nothing to assuage a jittery market which has been on edge since the beginning of the month. Powell indicated that his “personal outlook for the economy has strengthened since December” which has been interpreted as an indication that the Fed may be inclined to raise rates four times this year rather than the three that markets are currently expecting.

Such a pace of tightening would then put the upper limit of the Fed funds rate target corridor at 2.5% by year-end compared with just 0.5% in November 2016. That is not quite as aggressive as 2004-05 when the funds rate rose by 200 bps in the space of just 12 months, and a further 225 bps between May 2005 and June 2006, but having got used to a prolonged period of central bank inactivity over the past decade, that would represent a big move by the standards of recent years.

In addition, the Fed has already clearly set out a path for running down its balance sheet. Last June, it announced that it would reduce its holdings of Treasury securities at a rate of $6bn per month, rising by $6bn each quarter until it reaches a maximum drawdown of $30bn per month. Mortgage-backed securities are expected to decline by $4bn per month initially, with the drawdown rate being increased by $4bn per quarter up to a maximum of $20bn per month. By the end of this year, we can thus expect the balance sheet to decline at a pace of $50bn per month (ceteris paribus) which implies a $600bn reduction per year. If we assume that the minimum size of the balance sheet required to meet the cash needs of the US economy in future is around $2.5 trillion (it is currently at $4.4 trillion), the planned rate of reduction would enable this level to be reached by the middle of 2021 (see chart). This is at the lower end of the time period given by Powell in today’s testimony, when he said that a “normal” level will be reached in “three, four, five years.”

To the extent that the US economy looks to be back on its feet, posting solid growth and levels of unemployment consistent with full employment, monetary normalisation is clearly desirable. But with the duration of the US economic cycle already highly extended in the context of previous upswings, the fairly rapid degree of policy normalisation could be one of the factors which trips up either the economy or markets over the next one to two years. As the economist Rudi Dornbusch once remarked, “None of the post-war expansions died of old age. They were all murdered by the Fed.”

This also raises a question of how other central banks could or should respond. The ECB is well behind the Fed in the monetary tightening stakes, and is indeed still expanding its balance sheet even as the Fed is reducing its own. If the ECB starts to raise rates in 2019, it will be almost four years behind the US. The Bank of England may be less than happy about having to aggressively tighten if the UK economy suffers from any Brexit-induced weakness whilst the BoJ continues its extensive monetary easing. Such an asynchronous global monetary cycle might be expected to put upward pressure on the dollar. This is all very reminiscent of the situation in the late-1970s/early-1980s when Paul Volcker’s efforts to squeeze inflation out of the US economy necessitated a tight monetary stance which forced the greenback higher. This ultimately led to the Plaza and Louvre Accords of 1985 and 1987 which respectively attempted to weaken, and then stabilise the dollar.

Even today, old-timers in the FX market hark back to these agreements as an example of how to coordinate global monetary policy. We were reminded again in 2008-09 of the value of a co-ordinated policy stance. Today, we are nowhere near this position, and we can hardly blame the Fed for other central banks’ tardy efforts to remove the policies put in place in 2009 to combat conditions which are far different from those prevailing today. Whilst everything today appears to be going swimmingly, particularly in the euro zone, there will come a point where central banks elsewhere will have to start the process of taking away the punchbowl. Man cannot live by bread alone, but nor can he continue to rely on ultra-cheap credit.

Janet Yellen: A job well done

Today’s FOMC meeting was effectively the last act of Chair Janet Yellen, whose four-year term expires on 3 February. It is unusual for a one-term Chair not to be offered another term: Her tenure marks the shortest since G. William Miller’s ill-fated 17 month spell in 1978-79 and is indeed the second shortest since 1934 (beating the curtailed chairmanship of Thomas McCabe by a mere 14 days). The Fed Chair is in the gift of the President, so he is quite within his rights not to renew Yellen’s term. Nonetheless, I cannot help thinking that the Administration may be missing out by not giving her another four years.

Compared to her two immediate predecessors, Yellen came across as relatively unflashy and low key. She never sought the limelight in the same way as Alan Greenspan, and as good an academic economist as she is, Yellen never seemed to exude the same star quality as Ben Bernanke (maybe that’s an unfair characterisation but it is purely a personal impression). Yet in her understated way, Yellen has moved the dial further forward as the Fed seeks to move away from the crisis measures of 2008-09. In many respects, Bernanke’s inheritance was the result of years of loose monetary policy and a relaxed attitude to markets under Greenspan. Accordingly, much of his eight years were spent trying to prevent the economic and financial system from collapsing and Bernanke scored high marks for recognising the symptoms of the Great Depression and introducing a massive monetary expansion to combat it.

When Yellen took over in 2014 the economy was on a solid footing but monetary policy was still jammed in high gear, with interest rates at zero and the central bank balance sheet all but maxed out. The decision to start raising interest rates in late-2015 – the first increase in almost nine years – passed off without incident and an additional four increases, each of 25 bps, have not done any damage to the economy or to markets. Yellen also presided over the decision to start running down the Fed’s balance sheet although it will be up to her successor (Jay Powell) to fully implement it.

On the whole, it is likely that Yellen will be judged as a safe pair of hands who navigated the Fed through some difficult waters. It appears that her only failing was to be a Democrat at a time when an avowedly Republican Congress was in place. Whilst it was conservative lawmakers’ distrust of the Fed’s QE policy, fully supported at the time by Yellen, which counted against her, it is ironic that she has overseen the start of balance sheet unwinding – a process which has never been tested in the modern era.

As of next week, Jay Powell will be occupying the big chair and although he is widely seen as the continuity candidate, he may have his work cut out. For one thing, the US expansion is already long in the tooth, and assuming nothing goes wrong beforehand, May will mark the second longest expansion in recorded history. Quite how the Fed will respond if the economy starts to wobble may be an issue for the latter months of 2018. Then there is the question of how the Fed deals with any market wobble. For the last nine years, markets have generally only gone in one direction – upwards – but with valuations looking stretched it may not be too long before the bubble of optimism starts to deflate.

In the past, Greenspan and Bernanke were not averse to nudging monetary policy to help markets along. Whether Powell will act in the same way remains to be seen. But Janet Yellen will not be around for these issues to blot her copybook, which is a pity because the true test of how good central bankers are at their job is determined by their reaction to adversity. So we will never know how good she could have been, but as it is, Yellen can reflect on a job well done over the last four years.