Staring at the Fed
As U.S. investors and economists continue to debate the wisdom of the Federal Reserve’s unconventional monetary policies and the timing of the gradual exit from them, all is quiet on the European front. The European Central Bank’s (ECB) governing council will convene next week, but nobody expects any new dramatic move. Some in the media have tried to find new or old cracks between central bankers in core and peripheral countries, and a fight is looming between advocates of tighter and looser monetary policy. In truth, this is an understandable attempt to see a juicy story where there is none.
Meanwhile, European central banks, including the Bank of England (BoE), are much too worried about the effects that the impending “tapering” of the Fed’s asset purchases could have on global markets and the real economy. In an attempt to spur lending and quell market expectations that interest rates could rise sooner rather than later, BoE’s governor Mark Carney said that interest rates would remain at record lows even after unemployment had fallen below 7 percent—the current threshold—and offered to ease liquidity rules for financial institutions that meet capital requirements.
The United Kingdom’s economy still suffers from a credit crunch—just like most of the European periphery. Indeed, the latest data released by the ECB show that bank lending is still contracting in the euro area. The so-called monetary transmission channels are still clogged by uncertainty about the growth potential of Europe. Banks are repairing their balance sheets to meet international capital requirements and are getting ready for the ECB’s asset quality review later this year. Under current plans, it will become much more difficult than in the past for banks concealing bad loans. Hence, financial institutions are reluctant to increase their exposure to riskier borrowers.
When the ECB’s president emerges from his meetings with his peers next week, Mario Draghi will no doubt reiterate that rates in the euro zone will remain low for a prolonged period of time. Ewald Nowotny, a member of the ECB’s governing council, explains that this “means the central banks are giving markets a certain security that we will have low level interest rates for the foreseeable future, no rise but rather steady or lower.” His cautious words echoed those of the European Commission’s economic chief Olli Rehn, who simply dismissed any premature talk of an end to the crisis. A member of the ECB’s executive board, Joerg Asmussen, says that one of his biggest fears is complacency and reform fatigue. He could have added fears of a sudden crisis in some key emerging markets, which in Europe would also hit some of the brighter spots, such as Germany.
All of this brings us back to where it all started, the United States. It is surprising how many economists recently presented papers that are deeply critical of the Fed’s unconventional monetary policies—namely the asset purchases known as quantitative easing. Current turmoil in emerging markets is a powerful reminder of the fact that most of the liquidity created by the Fed in the past few years did not fuel U.S. economic growth, but rather the ebullience of emerging markets. Common sense would also suggest that inflationary pressure in the U.S. was subdued because of that. Does that mean that a repatriation of capital could cause suddenly rising prices? I am sure the Fed is looking at the data very carefully.
Yet, some of the critics of the Fed’s unconventional policies have more fundamental misgiving. In one of the papers presented at the annual central banking gathering in Jackson Hole, the authors Arvid Krishnamurthy and Annette Vissing-Jorgensen write that contrary to what the Fed thinks, buying treasuries has a negligible effect on the prices of a broader spectrum of bonds and therefore has “little economic benefits.” (See Arvid Krishnamurthy and Annette Vissing-Jorgensen “The Ins and Outs of LSAP’s”). The two economists assert that buying mortgage-backed securities (MBS) was by far more successful. They encourage the Fed to wind down treasury purchases while continuing to buy MBS. Robert Hall, an economist at Stanford University, is even less nuanced in his criticism. He writes that “five years of flat-out expansionary policy has failed in all cases to restore normal conditions of employment and output. These countries—the U.S. and other advanced economies—have been in liquidity traps, where monetary policies that normally expand the economy by enlarging the monetary base are ineffectual.”
It is telling that the markets obsession with “tapering” is now compounded by very vocal academic criticism of its effectiveness and it is receiving a lot of attention. It would indeed be a very bad omen for the U.S. and European economies if the Fed abandoned some of its unconventional policies hastily because they were utterly unsuccessful. It would be by far more reassuring to learn that the slow exit is only possible because quantitative easing finally put us back on the right track.
Unfortunately the jury is still out.