Global credit: Searching for an exit strategy
Policymakers on both sides of the Atlantic are now thinking about when and how to reverse quantitative easing. Stephen Foley and Sean O'Grady report
Wednesday 24 June 2009
The view from the US
When Ben Bernanke turned the taps wide open and flooded the crisis-stricken global credit markets with liquidity, he had no time to wonder whether there was an easy plug that could be taken out to drain the system when he was done. Now that the Federal Reserve, which he has chaired through its biggest test since the Great Depression, has moved from crisis-fighting mode into more normal recession-busting, the question of how to reverse all those emergency measures is on the agenda.
The Fed's open market committee, which has been conducting a two-day meeting that finishes up at lunchtime today, used to just have to contend with setting interest rates. Now it surveys a vast array of acronymic programmes to lend money to banks, to players in the secondary market for business and student loans, and to foreign central banks whose countries were running low on dollars, and now also a half-completed $1.5trillion (£920bn) programme to buy up US Treasuries and mortgage-backed securities, in an attempt to bid up prices and therefore push their interest rates lower. Treasury bond yields are the benchmark against which many other loans are measured, directly affecting mortgage rates and indirectly affecting all other classes of loans.
As the central bank has pumped in more than $1trn into the economy, its balance sheet has more than doubled in size. It is not just conservative politicians who look at that and worry it could have inflationary consequences down the line.
With the economic recovery still looking fragile, and few economists predicting more than anaemic growth for the foreseeable future, the question is not whether the Fed will begin to drain some of the liquidity from the system right away. But to nip any expectations of future inflation in the bud, the brainiacs at the central bank are under pressure to show that they can unwind all these programmes quickly, should the economy strengthen. If that happens, with cheap money from the Fed still sloshing about, banks would use the cash to make cheap loans out into the economy. Ben Bernanke hardly wants to follow his predecessor Alan Greenspan into the reputational mire by being accused of keeping market interest rates so low that they stoke another bubble and bust.
"There are two ways for this all to unwind," says Michelle Meyer, senior US economist at Barclays Capital. "One is the passive unwind, which is already in play. The usage of all those short-term lending facilities has been declining over the past few months. What's offsetting that is that the Fed is still engaged in buying Treasuries and other assets. The next step would be active unwinding, and the Fed is faced with a big challenge to do it in a safe way."
Those short-term lending programmes are indeed fading in importance. Lending to players in the commercial paper market, for example, on which US businesses rely for working capital, has more than halved since the start of the year. Private players have regained enough confidence in the commercial paper market to operate themselves, and they do not want to have to deal with the Fed, which demands full collateral, when they can raise money in the credit markets at similar rates.
Few participants expect that these innovative Fed schemes will be formally withdrawn for a long time, if at all, since they have proved themselves vitally important in an emergency. If the Fed wants to discourage their use, though, they can simply make the terms tighter, to drive players back into the private markets.
The options for active unwinding are still being hashed out, and the Fed seems to be leaning towards letting its balance sheet reduce slowly over time, rather than trying to shrink it quickly by saying it would sell the Treasuries and mortgage-backed securities it has been buying. The various technical schemes that are being debated include getting the Treasury to issue even more debt on its behalf, or issuing bills of its own. The risk is, though, that with the US government needing to issue so much debt of its own to fund massive deficits over the next five years, that investors may prove unwilling to absorb so much issuance. That could send interest rates much higher, much more quickly than the Fed wants, says Ms Meyer.
"The concern is that there is no one easy solution. The good news is that they are actively considering all the options and thinking ahead. The Fed has proved itself incredibly innovative over the course of the credit crisis, so it wouldn't surprise me if they come up with a completely different way that no one has yet thought of."
John Lonski, the chief US economist at Moodys.com, says that the US government is going to have to help out – by signalling that it will rein in its debt issuance, by which he means reining in the deficits. "It is asking too much of the Fed to be solely responsible for the level of Treasury bond yields."
The view from the UK
Mission accomplished? The Bank would never dream of being so brash, but there are grounds, hinted at by its own chief economist, Spencer Dale, yesterday, for believing that its ambitious programme of "quantitative easing" – the biggest in relation to national income in the world – has been successful.
Mr Dale declares that "initial indications remain encouraging", adding to the belief that an extension to "QE" will prove unnecessary, and it will soon be halted, and reversed in the new year. He pointed to the growth rate of money supply, the fall in gilt yields, though they have drifted back up, borrowing costs in commercial paper markets and the narrowing of spreads in the corporate bond market, though he agreed that this last was a global phenomenon. Mervyn King, the Governor of the Bank, told the Mansion House dinner last week that, "it is not too early to prepare such 'exit strategies' and to explain how they would work".
Sooner than expected, it seems, the Bank may be preparing itself to reverse its policy of quantitative easing, or at least end the loosening of monetary policy that will mark the first stage in the next interest rate cycle. QE has seen some £96bn injected into the economy in just three months. The Bank rate was cut to 0.5 per cent in February: it had stood at 5 per cent last autumn.
It was a radical policy, unprecedented in peace time. The Bank has extended its cash injections to £125bn from an initial £75bn planned in March, and over the next few weeks it will probably complete its purchases of gilts and some private securities. Many think that it might as well spend the last £25bn of the total of £150bn released to the Bank by the Chancellor in March, just to smooth matters along. But that may be that: tentative signs of an earlier than expected recovery in output would suggest that the Bank's radical policy may indeed have averted the dangers of a 1930s-style slump, and induced sufficient inflation to see the rate return to its target of 2 per cent next year, having fallen far from that in the coming months (The worry of some is that the Bank may have succeeded too well in this, and threatened the nation with an inflationary "spike".)
In all events, by its August meeting the MPC may well be ready to announce "mission accomplished", and the beginning of the end of this experiment in monetary expansion, and the policy allowed at least a "pause" for its full effects to work through to the real economy. The timing is difficult, as Mr Dale admits. "The most difficult issue concerning the exit strategy will be deciding the timing at which policy should begin to be tightened," he says.
"Although that decision will be highly uncertain and subject to intense scrutiny, the strategy guiding the decision – and the primacy of the inflation target within that strategy – should be clear."
The most recent indications are that British inflation may well be more "sticky" than many hoped; "core" inflation, stripping out volatile items and tax changes, even ticked up last month. Thus there is just the suggestion in the data flow that the UK may see a very weak recovery next year combined with inflation above the official target of 2 per cent.
If such a vista is indeed to be glimpsed in the next Inflation Report, then the noises about reversal of policy, still relatively muted, will become more insistent and early next year we can expect higher interest rates – including mortgage rates – too.
One hugely complicating, and political, factor is the sheer scale of Government borrowing and gilts issuance over the next year – more than £200bn. Without the Bank there to underwrite the activities o f the Debt Management Office, UK government debt may become more and more difficult to market. There are also technical issues to grapple with. Policymakers talk of the "cliff" problem – too abrupt an alteration in policy – and the distortions that can bring. Mr Dale says: "When the time comes, the Committee can tighten policy both by raising Bank Rate and by selling assets." Economists at Morgan Stanley agree on such a simultaneous approach. "The central bank's control over bond yields and spreads is far from perfect. Selling Quantitative Easing assets back to market is fraught with risks because central banks are unwinding their most effective policy measure with less-than-perfect control. Raising policy rates and unwinding QE simultaneously would allow central banks to sell assets at a slower clip, which might mitigate some of these risks".
However no one believes that the recovery will be rapid, and the exit strategy will need to be executed as carefully and incrementally as QE has been: it could take many months longer to unwind than it did to implement. Announced in a blaze of headlines about Zimbabwe-like "printing money", QE will go much more quietly into its twilight.
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