Peter Warburton - 30 August 2017
Any hopes that keynote speeches at Jackson Hole would illuminate the road ahead were comprehensively dashed last weekend. Both Janet Yellen and Mario Draghi steered clear of monetary policy issues and the Fed chair went a stage further, in failing to advance the state of knowledge in any dimension. This leaves the financial markets with the expectation of quantitative tightening – either the tapering of existing asset purchases or the unwinding of previous asset purchases – but no guidance as to its expected or intended effects.
Figure 1 leaves us in no doubt that the combined effects of large-scale asset purchases in US, Japan, Eurozone, UK and elsewhere have been massive. The only comparable episode of central bank balance sheet expansion was during World War 2. The post-war period was characterised by heavy economic involvement of governments for several years and painful financial losses for holders of government bonds.
In terms of median central bank size, the era of quantitative tightening has already begun. It is expected to become equally obvious in terms of average central bank size as, first the US Federal Reserve, then possibly the Bank of England, actively reduce their holdings of bonds. The tapering of asset purchases by the ECB is expected to intensify and the Bank of Japan has been de facto tapering since the announcement of the Yield Curve Control policy last September.
In a helpful and forensic examination of the economic and financial impacts of QE last October, Andy Haldane and co-authors concluded that “these central bank balance sheet expansions had a discernible and significant impact on financial markets and the economy.” Importantly, the authors identified strong cross-border spillover effects such that the proportionate impact of US QE on UK economic activity may have been as large as the impact on US economic activity.
US and UK QE programmes are believed to have lifted the level of domestic GDP by almost 1 percentage point and respective consumer price levels by a similar amount. Impacts on government bond yields range from a lowering by 15 basis points to 50 basis points, with corresponding boosts for stock prices and the narrowing of corporate credit spreads.
If QE is judged to have been successful in its multiple stimulatory impacts – through policy signalling, portfolio balance, risk premia and confidence channels – then surely quantitative tightening must be associated with the reversal of these impacts? Curiously, this is not what central banks are arguing at all. They maintain that it is the stock of QE that matters not the flow, and hence the dribbling away of the stock will be a non-event.
Financial markets are unlikely to buy in to this asymmetry. Central banks are signalling the dissolution of a powerful additional policy stimulus and the likelihood is that asset prices will adjust more abruptly, knowing that the tightening programme is intended to run for years and that the US will be joined ultimately by all other central banks with bloated balance sheets. In other words, asset prices will discount the cumulative shrinkage of central bank balance sheets. When the US Fed announced QE, it specified the instruments, the maturities and the scale and pace of the programme. All purchase programmes were fulfilled. Will this apply to asset sales, if adverse economic and financial market consequences begin to unfold?
Figure 1: Aggregate central bank balance sheet size since 1900 as percentage of GDP
Source: Ferguson, Schaab and Schularick (2015)
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