"Normalizing monetary policy” when and how?

10 min read
15 October 2021
Dino Kos
Special Advisor to the CEO

Dino Kos explores when is the right time to normalize monetary policy and what the priorities should be.

Mervyn King, former Governor of the Bank of England, recently said that unconventional monetary policy “tends to be deployed in response to bad news, but isn’t reversed when the bad news ends.” Indeed, central bank balance sheets have expanded massively since 2008. For example, the Federal Reserve’s balance sheet has grown ten-fold in several stages, and attempts to shrink it or increase interest rates in the period since the global financial crisis (GFC) have all but been abandoned. The Federal Reserve quickly reversed its messaging in 2013 in response to the “taper tantrum”; stopped a tightening cycle after risk assets sold off in late 2018; and of course reduced interest rates to zero and resumed massive asset purchases when the pandemic arrived in March 2020. Looking back at the 13-year period since the GFC, United States interest rates have mostly been at or near zero, typically accompanied by some form of unconventional lending or asset purchase program.

“The problem is not about how to normalize monetary policy. It’s the impact this will have on markets.”

Dino Kos
Special Advisor to the CEO

The series of measures taken by the Fed, and other central banks, were “emergency” tools in response to crisis conditions. Arguably the “emergency” has passed, and fiscal policy has responded aggressively in this cycle, which should give central banks more flexibility. GDP is growing vigorously. But alas the Fed has been unable to unwind (nor has it yet signaled a willingness to consider an unwinding of) its emergency measures.

The Federal Reserve is not alone in this scenario. The Bank of Japan too has held interest rates near zero (and negative at times) for more than two decades. Several initiatives to normalize policy were introduced; in each case they were quickly abandoned, then reversed, and then ultimately supplemented with ever larger asset purchases, including acquisition of riskier assets such as equity exchange traded funds.

In both cases the problem was not about “how” to normalize or what sequence of actions to take.   Those issues have been well studied. The problem is the impact such a “normalization” will have on asset markets. Normalizing monetary policy such that (1) interest rates can move off the zero bound and (2) asset purchases align with future growth of liabilities such as currency implies that bank reserves would contract. Overall liquidity would also contract, and long duration assets, such as equities, would fall – perhaps quite sharply. We saw glimpses of this in 2013 and 2018, when asset prices fell modestly, and the Federal Reserve quickly reversed itself.

To get a better appreciation of this dynamic one should go back to the origin of quantitative easing (QE). Recall the raging debate a decade ago whether QE was “effective”. Scholarly papers showed that acquiring government bonds both reduced financing costs (and so spurred investment) but also affected other asset markets by pushing investors out the maturity and risk curve. This would also raise those prices and thus have an impact on consumers through the “wealth effect”.

If that is the channel where central banks are buying, then the reverse should also apply. Indeed, investors seem very conscious about the elevated valuations in both equity and bond markets.  They will be sensitive to any hint of a reversal and ready to run through what will, no doubt, be a very small door.

Alas the central banks know this, and the Federal Reserve has been especially sensitive to asset markets. So much so, that it is now communicating its intention to keep policy steady even if inflation rises (which it recently has with easing of pandemic restrictions), so long as any uptick is “transitory”. The Fed knows that a true “normalization” of policy would devastate markets and force another reversal. And so, it is stuck: it cannot and will not normalize policy pre-emptively and will only do so if forced by circumstances, which is to say by higher inflation. But if inflation really gets going then a tightening will happen “too late” and will not avoid the asset market cataclysm. 

The bottom line is that full normalization will come, but much later than many expect, and when it does come the adjustment will be severe. Since central banks seek to push back that day of reckoning well into the future, investors will continue to take disproportionate risks and simultaneously keep one eye on that small exit door.

First published in “Views – The EuroFi magazine”, September 2021