There is no safe exit from unconventional monetary policy

Peter Warburton - 28 September 2017

The synchronisation of global activity indicators, as illustrated in the chart, over the past few months is a welcome reprieve after the sequential concerns over Chinese, Japanese and European growth. Policy largesse over an extended period has finally raised the water level and floated nearly all boats. Pleasingly, after 5 years of stagnation or decline, there has been a noticeable acceleration in global nominal GDP as well. The flipside is that central bankers – and policymakers in general – have no place to hide. The excuse cupboard is bare. Short of an approaching meteor storm, there is no plausible justification for deferring the normalisation of policy any longer.

However tentatively, extreme monetary accommodation is being withdrawn – in US and Canada already and prospectively in the Eurozone and UK. Monetary tightening remains a more distant prospect in Japan and the Chinese central bank is facing the other way, injecting liquidity into its banking system at a prodigious rate.

Scholars have long debated the issue of asymmetric monetary policy, especially in the US context. From 1987 onwards, the Federal Reserve tightened policy with ever greater caution, but eased policy urgently in the face of actual or perceived threats to the economy or financial system. Famously, Alan Greenspan declared himself incapable of spotting a bubble, much less inclined was he to use interest rates to prick one.

It would be hard to understate the fears that central banks now have of premature or inappropriate tightening. The popularity of macro-prudential policies around the world is symptomatic of the unwillingness to use the only instrument that has a reliable case history: short-term interest rates. The cleverness of the US Fed, since it began the sequence of small increases in the Fed funds and IOER rates in December 2015, lies in the contradictory signals it has given through the lowering of the long-term (or terminal) rate of interest. At its latest meeting, this was reduced again, to 2.8 per cent.

The justifiable source of central bank temerity lies in the potentially unruly unwinding of medium and long-term interest rates as they pursue tighter monetary policy. There is no safe exit from zero interest rates and unconventional monetary policy. Instead, the central banks must pick their way through a snake-infested jungle of disturbed convexity trades, risk parity trades and multiple variants of leveraged yield curve trades. And this is entirely their own fault.

A sudden back-up of government bond yields may not be triggered immediately, but as our intrepid heroes delve deeper into the jungle, they will regret the adventurism and experimentation of the past 8 years, and wish that they had laid a clear pathway along which to retreat.

Data source: Thomson Reuters Datastream

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