Considering the positive effects seen in the US, UK and Japan following the implementation of their highly expansionary policies, criticism has often been levelled at the ECB for not executing a more authoritative strategy – such as intervening more directly in the eurozone bond markets.
Indeed, the Federal Reserve’s expansionary monetary policy – which has been in place since the beginning of the financial crisis – has arguably put the US economy on the road to recovery. Focused on low interest rates and massive purchases of mortgage-backed securities and treasuries, the strategy has led to a noticeable increase in domestic demand from 2010, concurrent with a rise in household deleveraging and asset prices.
But the ECB is perhaps right to be cautious. Markets are increasingly showing signs of reliance on central bank liquidity supply – lending credence to the theory of these policies’ irreversibility. Indeed, each announcement of a switch to a less expansionary monetary policy (ie the Fed’s statement in May that it may consider tapering QE3 later in the year) has led to a marked deterioration in financial markets. As a result, these announcements have been followed by a counteractive statement emphasising that expansionary monetary policies will actually remain in place – in the Fed’s case, linking tapering to economic conditions.
Likewise, the Bank of England recently announced its intention to tie interest rates – which for the past four years have rested at an historic low – to employment figures.
This is concerning, particularly considering the disadvantages when these levers are in place for an extended period.
A highly-expansionary monetary policy
Certainly, the initial returns of a highly expansionary monetary policy are the main appeal. Theoretically, these advantages include the effects on economic conditions, such as an upturn in household consumption and residential investment, a depreciation of the exchange rate and a speeding up in household deleveraging. Moreover, a resurgence of expected inflation can usually be seen – making it possible to avoid deflation while encouraging consumption in the short-term.
When considering these positive effects, it’s surprising that the eurozone hasn’t undertaken a more drastic position in favour of unconventional methods – particularly as the region is characterised by stationary asset prices and declining domestic demand. Moreover, household indebtedness is not being reduced and the region is battling with declining expected inflation.
In fact, the recent improvement in the eurozone financial markets is – to a large extent – the result of a spreading conviction that the ECB will soon follow in the Fed’s footsteps. Many believe that a rapid increase in liquidity and a decline in long-term rates will – as in the US – generate an improvement in the economy.
But analysts cannot extrapolate the US situation to that of the eurozone. Given the low level of potential long-term growth in the eurozone, it will prove difficult to drive interest rates below the growth rate. Even if asset prices increased, the impact on demand would be limited as wealth effects remain weak.
Another important aspect to remember is that there are significant risks to these unconventional methods.
Certainly, as a result of rapid increases in global liquidity, there is a heightened possibility that international capital flows could become unsustainable, potentially resulting in drastic exchange-rate fluctuations that could distort competitiveness. Meanwhile, thanks to massive asset purchases being carried out by central banks, risk premia could tighten to no longer reflect reality – giving rise to economic bubbles. Several government bonds, for instance, are currently enjoying low levels of interest rates despite high levels of debt ratios.
Further to these dangers, central banks run the risk of inflation returning in the long-term by not correcting the excess liquidity appearing in the capital markets – and low interest rates could lead to a new financial crisis as debt ratios continue to rise.
Policy irreversibility
Beyond these theoretical disadvantages, there of course remains further disagreement over the ‘irreversibility’ factor – which is increasingly becoming a real concern.
The Federal Reserve’s announcement in May that it would slow the pace of its purchases of treasuries and asset-based securities later in the year triggered a rise in long-term interest rates and deterioration in the financial markets. So much so that by mid-July the Fed was pressured to emphasise that it would remain cautious about tapering QE3 – only reducing its asset purchases if several economic indicators improved.
In almost-parallel circumstances, when the ECB extended its optimism about developments in the eurozone economy at the beginning of July 2013 – implying that it would reassess its monetary policy stance – there was a similarly negative effect in the markets. The ECB then sought to make assurances, easing the eligibility rules for the use of asset-backed securities as repo collateral.
Reasons for this irreversibility factor
The longer these central banks maintain their expansionary policies, the more difficult it becomes to make an exit – and this is predominantly due to the expected rise in long-term interest rates when such an exit is made. Indeed, there are three important reasons that reinforce this school of thought.
The first is the fear that indebted economies with lower potential growth cannot shoulder higher long-term interest rates. When private sector debt ratios remain high – and public debt ratios continue to rise – a climb in long-term interest rates would likely lead to another economic downturn for these countries. This is especially so as productivity gains become lower.
In the eurozone, business investment is declining and residential construction is currently stagnant. Meanwhile in the US, growth in productive investment remains weak and the rise in long-term interest rates has been accompanied by a downturn in residential construction. As a result, it seems that further time and additional deleveraging is required before economies can accept higher long-term interest rates.
The second reason for irreversibility is related to the wealth effects on equities and real estate. As these are crucial in terms of jump-starting demand and therefore economic recovery, it’s necessary that they do not disappear. But a rise in long-term interest rates due to a less expansionary monetary policy would push down share and real estate prices – therefore jeopardising the upturn in domestic demand.
And finally, a rise in long-term interest rates would generate unbearable losses for those institutional investors and banks who – for the past four years – have bought a vast amount of bond portfolios at abnormally high prices (due to very low long-term interest rates), and have renewed these with very low-coupon bonds.
Clearly, the irreversible factor is an important one to consider when it comes to weighing up the pros and cons of unconventional tools at a central bank’s disposal – not just on the part of the ECB but also other leading central banks. And this theory is underpinned by the series of indecisive statements from central banks this year. Indeed, these banks now seem to be in a position where they hardly dare announce a slackening of their monetary policy for fear of market reaction. But the longer these policies stay in place the greater the ramifications, which in part explains the Fed’s possible tapering down of QE3.
