Last May the Federal Reserve, America's central bank, first hinted that it could soon begin to reduce its monetary stimulus of the economy, by tapering its $85 billion (€62.5billion) of monthly purchases of assets - bonds and mortgage backed securities. The news temporarily destabilised financial markets in some emerging market economies. And the result was strong capital flight from those markets, as nervous investors took fright and - anticipating a stronger dollar and higher interest rates - opted to take less risk in safer financial havens - such as the US. However, a tapering exercise anticipated to start in September failed to materialise. Uncertainty continues both on the timing of tapering- with US employment data on Friday next providing a clue - and its likely impact.
The Federal Reserve has already faced international criticism for its failure to communicate its policy intentions on monetary easing more clearly. The Fed chairman, Ben Bernanke has said that tapering would begin once the US economy was close to a full recovery. Last week the European Central Bank (ECB), in its latest financial stability report, warned of the risks to the euro zone financial system that may follow the Fed's tapering of asset purchases.
The ECB is concerned about the impact that any market shocks could have on struggling euro zone economies, as global bond yields start to rise from historically low levels, and bond prices fall. In particular, the central bank is worried about just how well prepared banks, insurers and pension funds are for this inevitable adjustment to a more normal monetary policy. The ECB has identified some of the potential hazards that could imperil financial stability; notably, the weak profitability of banks and the threat that unexpected bank recapitalisations may pose. Equally, it warns, that failure by member states to maintain the pace of fiscal and structural reform could revive difficulties in the sovereign debt market. The ECB, however, has limited scope for action, given last month’s interest rate cut, and its lack of other tools to provide a monetary stimulus. But its warning is timely – stable, predictable policies would help smooth “the exit from easing”.