How and when will central bank policies – of low interest rates and quantitative easing – be reversed? Markets want to know the plan. Central bankers wish they had one. One thing is for sure: it is going to be a rocky road.
As of last week, the notion that a policy exit will prove challenging became conventional wisdom. But in order to navigate the twists and turns to come, it might be helpful to understand just why economic and market volatility is likely. Central banks worry about four things: inflation, the economy, financial stability and political pressure. Between 2008 and 2012, all four factors favoured aggressive easing. Inflation was not the concern; deflation was.
What about the economy? At the time, depression loomed – growth was a distant dream. Financial stability? Panic was in the air to the extent that any measures that might restore confidence and liquidity were justified. Political pressure? Elected officials welcomed every intervention that might calm markets and restore growth. In short, the key concerns all pushed in the same direction.
By contrast, we are now in a time when these same four factors pull in different directions. Concern over deflation has faded in favour of divergent views on inflation, and rather than stagnation being the issue, policymakers now debate the likelihood or speed of recovery. Meanwhile, the prospect of market instability caused by fears of central bank inaction has been replaced by worries over what form the next actions will take. And politicians, finally, continue to press for any measures to pump up the economy.
So what should we expect?
* First, policy statements will be confused and confusing. Although central banks understand the importance of clarity of communication, they will be unable to offer as clear a direction and pace of travel on the way "up and out" as they did on the way "down and in." For example, a policy of forward guidance could be consistent and credible when the economic challenge was clear and compelling. How can it possibly be as effective a tool on the bumpy road back?
In the jargon of the trade, the policy path will be "economy-dependent". And the economy will throw off mixed signals. Different central bank officials will interpret these differently – and say so publicly. This is already the case. And even in the unlikely event that consensus is reached within a central bank, that view may not correspond to the policies of key central banks abroad – much less with the preferences and pronouncements of elected officials at home.
* Second, authorities will continue to underestimate the magnitude of the market's reaction to what will appear to them a sensible and modest course of action. Resultant price swings will surprise regulators while worrying bankers and the body politic.
* Third, financial institutions have not used the time bought by those extraordinary central bank policies to meaningful effect. Five years on from the onset of the crisis, levels of leverage in the banking system are dangerously high and the challenge of "too big to fail and too big to bail" is still unresolved.
Thus each hint of policy change will trigger political pressures to slow down or back off. Such exhortations may well find sympathy among the regulators. The result will be contradictory statements and signals. Testing the waters before taking the plunge is likely to result in a series of false starts and timid retreats. Central bankers are cautious by nature, so probabilities will favour backing off rather than pressing on.
Just as authorities have retreated from many necessary financial reforms, so governments and their central banks may well find reasons to postpone indefinitely the great unwind. So instead of asking how and when those central bank policies will be reversed, we might ask if they will be reversed at all? One could be forgiven for betting that "too little, too late" is more likely than "too much, too soon".
Robert Jenkins is a professor of finance at the London Business School and a former member of the Financial Policy Committee of the Bank of England