The Fed and ECB keep a cautious eye on the exit

A fallacious idea of normality is a poor guide for monetary policy


It is testament to the achievements of central banks in fighting recession and deflation in recent years that talk has now turned to removing extraordinary stimulus rather than extending it.

It was revealed this week that the Federal Reserve had begun to debate shrinking its balance sheet, which swelled massively during its programmes of quantitative easing. Meanwhile Mario Draghi, European Central Bank president, moved swiftly to quash rumours that his bank would renege on a commitment to keep deposit interest rates negative at least until it ends its own QE programme, which is planned to continue at minimum until the end of the year.

Both are sensible courses of action. The Fed, already in tightening mode, can afford to start a public conversation. The ECB, at an earlier stage in the process, needs to emphasise continued stimulus.

In both cases decisions must be based on judgments of the world as it currently is, not a premeditated return to a perceived normality that probably no longer exists.

QE and negative interest rates were responses to highly unusual circumstances following the global financial crisis. But even now, nearly a decade later, it seems improbable that advanced economies will snap smartly back to their pre-crisis norms with policy interest rates in America and Europe up above 4 or 5 per cent. Many estimates of long-term real interest rates are very low, and there is little sign of inflationary pressure from wages even in relatively healthy economies like the US.

Super-loose monetary policy and negative interest rates have created some distortions and may have contributed to rapid increases in asset prices. But that is surely preferable to re-running the experience of the 1930s, in which monetary policy was kept too tight for too long. The lesson of the past decade is that central banks should err heavily on the side of keeping monetary conditions loose.
Given that part of the effect of super-easy policy works through expectations, it is also important that central banks time carefully the discussion about removing stimulus. In that context, Mr Draghi was absolutely correct to tamp down suspicions that the ECB will breach its promise of keeping rates negative until at least year-end.

Making a promise to act one way for a certain length of time and then breaking that promise tends to have more severe consequences for central banks than it does in real life, or even in politics. For policymakers, building up credibility for fighting deflation is as important, if not more, than keeping inflation down.

In contrast to the ECB, the Fed felt comfortable discussing at March’s open market committee meeting the prospect of beginning to reduce its giant balance sheet by the end of the year. Unlike the “taper tantrum” of 2013, which came in response to talk of the Fed reducing its asset purchases, there was little market reaction when the news broke this week.

Whether to hold on to assets and how to dispose of them are tricky technical questions. What should be clear, however, is that the Fed should be in no hurry. It has no need to bow to impatience from Congress or from investors who wrongly opposed QE in the first place.

Thanks to their own efforts, central banks have increasingly pleasant tasks to perform, removing emergency measures rather than trying to think of more. But in doing so they must be guided by the same dispassionate technocracy that caused them to go down that route in the first place.

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