Everybody seems to agree on the need for full employment and price stability. But these objectives leave central bankers with a perennial dilemma when managing an economy: act too soon in normalising monetary policy and they’ll prevent the attainment of full employment; act too late and they’ll damage price stability. It is less a matter of disagreement over objectives than one over the drawing of a fine line – a precipice, perhaps – for the correct path of interest rates.
The terms of this trade-off are normally high, but after a seven-year famine in new economic activity, it is particularly challenging. 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 unacceptable manner. The problems facing the Fed and the Bank of England are even more extreme. They must not only set out plans for moving policy rates back into more normal territory, but also, having ended asset purchases under QE, explain to the domestic and foreign holders of US and UK bonds how these operations will be reversed while gauging the likely impact on overall monetary and financial conditions.
In normal times, economic agents (whether individuals or businesses) 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 asset accumulation do not alter too much from what would have been their optimal levels. This means that, while policy mistakes (for example, raising interest rates too soon) may be costly, the effects may be reversible. But in abnormal times, such as the ones in 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.
Since the global financial crisis, financial markets and households have both undergone a prolonged period of deleveraging. This process has prevented much of the normal smoothing of activity in response to shocks and has also limited the extent to which capital has been recycled to new firms, acting to limit growth itself. Fiscal and monetary policies were also exhausted as public debt levels approached peace-time peaks and interest rates were bound to zero.
The main policy lever to offset this prolonged deleveraging was asset purchases through QE, which increased private sector liquidity, helped to reduce long-term interest rates, and shortened the maturity of government debt obligations held by the non-bank financial sector. The cessation and likely reversal of these purchases, accompanying any normalisation of interest rates, has itself been the cause of much of the increase in financial market volatility. And a mistake at this crucial time of transition might – Japanese-style – plunge 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 Eurozone has entered another phase of its ongoing crisis, and 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, benefiting from a global search for yields. When yields start to rise in the US, these new borrowers will become vulnerable to both deteriorating global funding conditions for emerging markets and exchange rate volatility. For that reason, even though financial markets do expect some tightening in the US compared to the Eurozone, both sets of rates are still likely to be low by historical standards.
The former general manager of the Bank of International Settlements Andrew Crockett 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.” But in this deep and extended recession, there have been material increases in risk from the recession itself as 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.
Jagjit Chadha is the Mercers’ School Memorial Gresham professor of commerce, and professor of economics at the University of Kent. A fuller discussion of this issue will be given in the free public lecture The Science of Monetary Policy, at Gresham College EC1, tomorrow evening at 6pm. www.gresham.ac.uk/lectures-and-events/the-science-of-monetary-policy