Fed Chairman Ben Bernanke sent a shiver through financial markets worldwide late last month when he said that if the Fed saw 'real and sustainable improvement in the labour market' it could 'take a step down' in the volume of its quantitative easing (QE), possibly 'in the next few meetings'. Bond yields jumped just about everywhere, Abenomics euphoria in Japan deflated, and capital flows to emerging markets reversed direction.
But Bernanke was just pointing out the obvious, going on the say 'we could raise or lower our pace of purchases going forward'. Why were financial markets so startled?
QE is not just a simple extension of conventional monetary policy. For the US and the UK, it was a bold venture into unexplored territory, new for policy makers and market participants alike. QE's original rationale was to reduce longer-term interest rates; it was hoped that this would encourage more borrowing and investing. In fact it's hard to see any close relationship between QE operations and the fall in US government bond yields, but longer-term yields did end up significantly lower than expected, given the likely profile of future short-term rates.
This isn't surprising; it was the intention of QE. But even working as intended, QE will inevitable have a bumpy ending. At some stage during the unwinding of QE, bond holders will suffer a painful capital loss when yields revert to normal. Bernanke's innocuous remarks reminded bond holders that they need to be ahead of the pack when the moment comes to lighten the bond portfolio. With everyone on tenterhooks, the adjustment could easily be a sudden tipping point, and just as easily involve the bond price overshooting.
Capital losses on bonds are not the only tipping point ahead. The most prominent and consistent QE effects have been on equity prices and exchange rates, effects which were not explicitly foreshadowed when QE began. These distortions are likely to reverse when QE is withdrawn. Equity markets and the international capital carry-trade have become as dependent on QE as any drug addict.
If markets had a clear understanding of how QE operates, they might anticipate the impact of its unwinding and soften the tipping point. Some (perhaps many) market participants have, however, misunderstood the nature of QE. They expected an automatic expansion of bank lending through the credit multiplier together with a boost to the money supply (QE was almost invariably referred to as 'printing money'), hence pushing up inflation. In fact, money just maintained its trend growth. Credit growth has been weak. Underlying inflation has actually fallen.
None of this should have come as a surprise. There was never going to be CPI inflation while unemployment was high and the slow cyclical recovery explains lethargic credit demand.
But when outcomes have been far from market expectations, participants are confused. In these disorderly circumstances, market responses have been based on expectations of policy changes rather than on fundamentals. Asset prices untethered to fundamentals will be volatile. If market participants don't understand how we got here, they will be ready to panic at the thought of how we will exit.
Unwinding QE doesn't have to be too traumatic. Central banks can shift short-term policy interest rates up when appropriate, while leaving the disposal of their abnormally large bond holdings to a later date. Even if central banks make capital losses in the process, they can absorb these without too much drama. Concerns about inflation from 'printing money' were always totally misplaced.
That said, some of the private sector capital losses discussed above will fall on vulnerable sectors, especially the banking system. The reversal of capital flows from emerging markets puts these shallow financial markets at risk, susceptible to price over-reaction.
QE was never going to be an answer to structural problems. At best, it bought time, which has been largely frittered away. Banks in the US and UK are over the crisis but far from robust and de-leveraging is incomplete. Budget deficits have been reduced, but this reduction has crimped the recovery and left unemployment high. Structural reform which might have underpinned recovery has been given a low priority.
We are witnessing the tug-of-war between financial markets that are pressuring the authorities to keep QE going and those who see it as having served its purpose, with continuation making the unwinding more problematic.
If the balance of these forces results in QE being wound down soon, this will occur in economies which are still far weaker than hoped. Policy makers might also have hoped for a better understanding in financial markets of how the unwinding will work and thus more ability to make the transition with composure. There is still time to achieve this better understanding, but the flightiness of markets since Bernanke's tentative attempt to prepare for the unwinding is a reminder of how difficult it is to have a sensible conversation with the financial sector.
Photo by Flickr user Gerald R Ford School of Public Policy.