The caution of central banks

While expectations of economic recovery have heightened in the United States, the United Kingdom, the eurozone and Japan, questions remain over the pace of monetary policy normalisation – particularly for the US and the UK. When will we witness the start of a real slowdown in the growth of monetary supply, for instance, or a hike in interest rates?

Though much market conversation has been dominated by such propositions – with no shortage of official announcements hinting at certain intentions – definitive action by central banks has yet to be taken.

In September, the Fed delayed the unwinding of QE3, its asset purchasing programme, which pumps US$85 billion in to the economy per month. As any change in the pace of QE3 hinges on economic indicators, analysts now anticipate tapering to begin in the coming months. But even these predictions may falter as we approach December’s meeting of the Federal Open Market Committee (FOMC).

Certainly, leading central banks seem to be sticking with their expansionary monetary policies.

What are the reasons behind the hesitation for a hike in rates, particularly when many are at record lows?

When it comes to decisions that could lead to a rapid or substantial rise in long-term interest rates, two factors contribute to the caution of central banks. And both of these reasons make the current situation vastly different from past recoveries.

The first is the high level of indebtedness gripping larger economies. Due to a rise in public debt that has more than offset the fall in private debt, the total level of indebtedness – including both public and private sectors – is extremely high. In fact, current total debt is markedly higher than pre-crisis levels across the US, UK, eurozone and Japan.

With this in mind, a rise in long-term interest rates would have detrimental effects on the capacity to spend – for the public as well as for the private sector – which is of concern at a time when spending is needed to boost the recovery.

… central banks are most likely to avoid any premature tightening of monetary policy, as this will lead to a significant and rapid rise in long-term interest rates with consequences too great to risk.

The second cause of caution among central banks is the existence of huge bond portfolios that were bought at very low interest rates. In the time that long-term interest rates have remained at low levels – a far longer period than in past recessions – institutional investors and banks have built up large bond portfolios at low interest rates. Meanwhile, old high-coupon bonds have been replaced by new low-coupon bonds.

Of course, the concern now is that, if long-term interest rates are raised, the move would generate large capital losses that would prove too difficult for institutional investors and banks to shoulder – particularly in the UK and Japan.

Japan, in fact, is an extreme case where – because of the size of the public debt and the banks’ bond portfolios – the central bank has made the stabilisation of nominal long-term interest rates a key monetary policy objective, even when expected inflation rises.

Interestingly, theory shows that central banks are forced to buy government bonds when a divergent dynamic of inflation appears during the stabilisation of nominal long-term interest rates. This may further increase liquidity and hence drive up expected inflation, which increases the likelihood of a rise in nominal interest rates ex ante (before the event).

Both the Fed and Bank of Japan have implemented programmes of massive bond purchases, which prove their intention to stabilise long-term interest rates. As for the ECB, it is feeling the pressure to also implement quantitative easing.

The Bank of England, meanwhile, has stopped buying gilts. But to prevent gilt yields from rising too rapidly, it recently announced its willingness to maintain short-term interest rates at very low levels for an extended period of time, through its new strategy of forward guidance. According to this strategy, short-term interest rates will remain unchanged as long as the unemployment rate is higher than 7%. Recent comments suggested that even a fall below this threshold would not automatically trigger an interest rate rise.

With all this in mind, it has become clear that – compared with the economic recoveries seen in 1991 and 2003 – we are currently in a situation where debt ratios are markedly higher and where investors and banks hold much larger bond portfolios with low coupons.

Because of this, central banks are most likely to avoid any premature tightening of monetary policy, as this will lead to a significant and rapid rise in long-term interest rates with consequences too great to risk.

_______________________________

Patrick Artus is chief global economist at Natixis, a member of the council of economic advisors to the French Prime Minister and Professor of Economics at University Paris I Panthéon-Sorbonne where he combines these responsibilities with his research work. He is also a member of the Board at Total and Ipsos.