Careless tapering talk may cost the economy
It is hard to manage a policy whose effects depend on expectations. But it must be done better – this tightening of monetary policy is premature
If the Fed had been more careful, this premature monetary-tightening might not have happened. As it is, the fall in prices of the world’s most important financial securities could materially damage recovery, as it lowers prices of riskier assets across the world, not least in emerging countries. Gavyn Davies highlights the dangers of such a correction, citing Warren Buffett’s remark that we only discover who is swimming naked when the tide goes out.
The BIS argues that if yields were to rise by 3 percentage points across the maturity spectrum in the US, mark-to-market losses would be more than $1 trillion, or almost 8 per cent of gross domestic product. Losses elsewhere would be even bigger. Financial shocks are possible, as “carry trades” in which investors have borrowed short to lend long or borrowed in low-interest currencies to lend in higher-interest ones, unwind sharply. Indeed, one of the reasons policymakers must be careful is that investors in such trades know how vulnerable they are to a rush for the door. They will flee as soon as they fear others may do so, creating a big danger of self-fulfilling panics.
The challenge in unwinding current policies is not technical. As Fed chairman Ben Bernanke explained in February 2010, exit from QE and bloated central bank balance sheets is technically straightforward. Since the Fed pays interest on reserves, it can even raise short-term rates before QE is reversed. Furthermore, such an exit is desirable, provided it occurs only when the recovery is in place.
There are three true challenges. The first is proper management of expectations. This may be too late. But the right way to proceed, as Mr Bullard has argued, is to stress only conditions, not timetables. Nobody knows when the conditions for tightening will emerge, because nobody knows how the economy will perform.
The second challenge is to address the vulnerability of the financial system to big declines in prices of safe-haven bonds. This is purely market risk, not credit risk. That can be managed by a mix of lower leverage and, if necessary, regulatory forbearance. It is unlikely that markets would cease to fund systemically significant financial institutions that have only mark-to-market losses on safe-haven government bonds. Yet the authorities will need to have plans to address this.
Can they cope?
The third challenge is to manage the global consequences. The likely result of a credible exit will be a shift towards assets in the recovering high-income economies. For emerging countries that should be welcome, in the medium run. But they need to ensure their systems can cope.
We should look forward to a world of higher long-term interest rates on safe-haven bonds. But we should not need to enter that world yet. Policymakers need to speak softly about exits. But the regulatory stick must be big enough to ensure the economy copes when it comes. – (Copyright The Financial Times Limited 2013)