Everybody seems to agree on the need for full employment and price stability. These twin objectives leave central bankers with a perennial dilemma when managing an economy: act too soon and prevent the attainment of full employment or act too late and damage price stability.
It is less a matter of disagreement over objectives but one over the drawing of a fine line – one may even say precipice – for the correct path of interest rates. The terms of this trade-off are high in normal times but after a seven year famine in new economic activity, it is particularly challenging as growth needs to be nurtured. But in some parts of the financial system, buoyed by ultra-accommodative policy, asset prices look elevated and risks may be building up in an acceptable manner.
The problems facing the Fed are even more extreme as it is faced with not only setting out its plans for the policy rate as it moves back into more normal territory but also explaining to the domestic and foreign holders of US bonds how asset purchase operations will be reversed and gauging the likely impact on overall monetary and financial conditions.
In normal times, economic agents may be able to deal with economic and financial shocks in a reasonable manner so that their actual decisions on matters such as consumption, investment and financial asset accumulation do not vary too much from what would have been their optimal levels in the absence of shocks. But in abnormal times, such as the ones through which we are currently living, an economy may become much more vulnerable to shocks as some of the normal mechanisms that help stability may be impaired. During the global financial crisis, financial markets and households have both undergone a prolonged period of deleveraging that prevented much of the normal smoothing of activity in response to shocks, but also limited the extent to which capital has been recycled to new firms and acted to limit growth itself. Fiscal and monetary policies were also exhausted as public debt levels approached peacetime peaks and interest rates were bound to zero.
The main policy lever to offset this prolonged deleveraging was asset purchases that increased private sector liquidity, helped reduce long term interest rates and shortened the maturity of government debt obligations held by the non-bank financial sector. The cessation and likely reverse of these purchases that will accompany any normalization of interest rates has itself been the cause of much of the increase in financial market volatility. And a mistake at this crucial transition time might plummet us back into a crisis from which escape would become even more difficult.
That said, it seems to me that the prospects for global growth are reasonable and the recovery in many parts of the Atlantic economies is advancing well. But two main risks will ensure that policy makers and growth will continue to emerge tentatively from this long hibernation. First, the Euro Area has entered another phase of crisis on which many paragraphs have already been spilled but will require lower rates for longer than previously anticipated.
Secondly, emerging market firms and sovereigns have issued record amounts of local and foreign currency-denominated debt securities in the past few years, benefitting from a global search for yields, but if yields start to rise in the US, these new borrowers become vulnerable to deteriorating global funding conditions for emerging markets and exchange rate volatility. For that reason, we observe that even though financial markets do expect some tightening in the States compared to the Euro Area, even in two years’ time both sets of rates are still likely to be low by historical standards.
The former general manager of the BIS, Andrew Crocket once said that “[t]he received wisdom is that risk increases in recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materialising in recessions”. As well as the build-up of risk in the upswing, in this deep and extended recession there have been material increases in risk from the recession itself as the financial structures have been distorted by prolonged accommodative monetary policy.
Like the wish for full employment and price stability, we all agree that interest rates must normalise. But it is only when we can be sure that the economy will respond in a normal way that we can get interest rates back to normal. Even though the foundations for robust growth are in place, they are not so soundly set that we can risk anything other than cautious, small steps in monetary policy and what may seem, by the normal metric, a continuation of accommodative policy.