Monetary policy has been a successful shock absorber since the global financial crisis.
In Britain and across western economies, low rates and quantitative easing have helped underpin economic growth.
But a prolonged period of cheap money has had its consequences. It has led to markets not pricing properly for risk. It has fed asset price inflation. Low rates have lowered the price of borrowing and contributed to an increase in debt. There has been a misallocation of resources, as forbearance has allowed zombie companies to be kept alive. The list of side effects continues.
This should heighten the awareness of risks associated with monetary policy normalisation.
Central banks are mindful of this, and are expected to proceed cautiously when they exit their cheap money policies. Indeed, the Fed has embarked upon its tightening in a gradual and well-telegraphed manner to keep financial markets on-side.
Britain begins to think about normalisation
In the UK, the normalisation process is only now beginning. The signs are there from the recent vote and subsequent public comments from the Monetary Policy Committee (MPC). While the focus is frequently on the UK’s twin budget and current account deficits, it is often the rise in private sector indebtedness that derails the economy, and the FPC is responding correctly to the rise in consumer credit. Their Financial Stability Report commented on market volatility measures failing to “reflect fully the downside risks implied by very low long-term interest rates”.
Perhaps one of the issues is that a prolonged period of low rates has also raised questions as to what constitutes a risk-free asset? In which case an immediate challenge relates to the status of banks’ balance sheets and whether banks are right in their assessment that bonds and property are “risk-free”.
With the prices of both high, the prospect of policy normalisation raises the heightened chance of volatility and disruption.
For bonds, it may well be that globalisation and the benign inflation environment acts as a stabilising force for now. There are still disinflationary forces at play. Here in the UK, inflation looks set to peak in the second half of the year, allowing real incomes to start rising again next year, underpinning growth in 2018.
Up to now the thinking in the markets has been that UK rates will stay low, rise gradually and peak at a low level. While the first two parts of that make sense, the wider issue of where rates need to peak to combat asset price inflation and ensure financial stability may become a new focus.
Perhaps rates need to normalise back to higher levels or we will need to see even more effective use of other measures to ensure future financial stability. In the UK, this is helped by the close coordination between the MPC and the FPC at the Bank of England.
The global outlook
Global reflation has been evident over the last year. There are now more reasons to be positive about the global growth prospects. This suggests more central banks may wish to follow in the Fed’s footsteps.
Domestic conditions will naturally play the leading role in policy tightening. With western economies at different stages of their economic cycles and political uncertainty persisting, the likelihood is that central banks across developed markets will embark upon policy normalisation at a different pace for both rate rises and balance sheet reductions.
This will mark a shift from the era of globally coordinated easing and predictable monetary policymaking.
In this context, global interlinkages via currency moves and financial stability will warrant attention. There are many moving parts. One example is the interplay between monetary policy and the regulatory environment during policy normalisation.
The Fed’s normalisation is coinciding with potentially significant regulatory changes domestically. The US Treasury’s recent report reviewing financial regulations highlights a shift to more accommodative supervision and less need for legislative changes than previously expected – such proposals contradict with regulators’ mood across the Atlantic. And fissures in the global regulatory landscape could introduce conflicts of interest for global banks.
Monetary policy has provided a stable underpinning to economies and financial systems since the crisis.
But as western economies embark on their policy normalisation, a global, concerted regulatory environment must continue to help anchor financial stability.