As the Fed prepares to raise interest rates again and actively considers how and when to start exiting QE, it appears that the process of normalising monetary policy across the Western world is slowly but surely getting into gear.
Global conditions for unwinding crisis-fueled stimulus look fertile: the strongest economic growth in years, historically low bond yields, inflation and credit spreads, and an unrecognisably healthy banking system compared with 2008.
The U.S. Federal Reserve has already raised rates three times without any notable economic or financial fallout, and the growing likelihood that it will soon start to reverse its QE stimulus hasn’t destabilised the U.S. bond market.
Where the Fed leads, other central banks usually follow, eventually. If central banks can’t normalise policy in that benign environment, will they ever?
The trouble is, conditions aren’t so benign. Policymakers are rightly worried that economies and financial markets won’t be able to bear the weight of higher yields, interest rates and borrowing costs that will come with “normalisation”.
Global debt is higher than any time in history, inflation across the Western world remains below target, and global stocks and bonds are at or near record peaks. Withdrawing stimulus, particularly the never-before-tried process of unloading trillions of dollars of bonds back onto an already overloaded debt market, carries huge financial and economic risk.
And there’s a lot of stimulus to withdraw. Central banks’ balance sheets have ballooned by more than $10 trillion over the last decade to $15 trillion.
If the Fed’s tapering window is a narrow one, it’s even smaller for its peers. The U.S. post-crisis economic expansion is already the third longest in history, so it probably won’t be long before it rolls over and drags global growth down with it.
Steen Jakobson at Saxo Bank reckons the chance of a global recession by the end of next year is as high as 60 percent. If not outright recession, the flattest U.S. yield curve since October is certainly pointing to weakening U.S. growth ahead.
While global borrowing costs are near the lowest levels in history, asset prices and debt levels are at record peaks. World debt rose to more than 325 percent of global GDP last year, up $11 trillion to more than $217 trillion, according to the Institute for International Finance.
Wall Street and world stocks as measured by the MSCI global index are at record highs. Some 44 percent of fund managers surveyed by Bank of America Merrill Lynch say equities are overvalued. That’s the highest response in the survey’s 19-year history, even higher than the peak of the dotcom bubble.
Recent history shows that once a central bank goes down the path of unconventional monetary policy – zero lower bound interest rates, negative rates, hoovering up financial assets – it’s hard to ever fully normalise policy again.
Policymakers burned by raising rates from the zero lower bound only to be forced to cut them again include the European Central Bank (twice), Reserve Bank of Australia, Bank of Canada and Bank of Japan.
Comparisons with Japan are difficult to escape. It’s been over two decades since the BOJ’s overnight target rate was last above 0.5 percent, and 16 years since the BOJ first officially adopted QE. Yet the BOJ today has negative interest rates and is expanding its balance sheet faster than ever.
The consensus view of the ECB after last week’s policy meeting and updated economic projections was that it was more dovish than expected. Economists at Societe Generale now expect the ECB to extend QE bond-buying through early 2019, which would be over a decade since the financial crisis.
And with political chaos and Brexit blighting the UK economic landscape, the Bank of England is years away from shrinking its balance sheet.
Stephen Jen at Eurizon SLJ Macro Partners draws the analogy with martial law. When martial law is imposed in peace time, the unintended consequences and conditions it creates, like asset price bubbles, become so “perverse” it is difficult to ever be lifted.
That may not be entirely fair because central banks didn’t adopt unconventional policies in financial or economic peace time. But the persistence of sub-target inflation across the western world suggests that the economic peace remains elusive, despite decent headline growth.
Analysts at Citi expect a combination of Fed balance sheet reduction, ECB tapering and less BOJ asset purchases will lower overall central bank net asset purchases from 4.4 percent of developed world GDP last year to 2.9 percent this year, and roughly zero in 2018.
But they admit that it “remains to be seen whether markets will be able to absorb the retreat smoothly.”
Source: Reuters (Reporting by Jamie McGeever; Editing by Tom Heneghan)