By Dan Steinbock
In the pre-Trump era, the US Federal Reserve had hoped to tighten the monetary policy often and more aggressively than markets anticipated. However, since November, US economic prospects have fluctuated dramatically.
The uncertainty in the monetary policy
In its May meeting, the Fed left its target range for federal funds rate steady at 0.75-1%, in line with market expectations. It is likely to climb to 1.3% by the year-end and to exceed 3% by 2020.
In other major advanced economies, the monetary stance has remained broadly unchanged. The European Central Bank (ECB), led by Mario Draghi, held its benchmark rate at 0 percent in April. While the ECB has signalled impending normalisation, it will continue its asset purchases until the year-end. Even if the ECB begins rate hikes in 2018, they are likely to be low and slow. The rate could climb up to 1 percent by 2020.
In Japan, Abenomics has failed, despite the slight improvement in short-term growth prospects. As introduced by Haruhiko Kuroda, the chief of the Bank of Japan (BOJ), negative rates and huge asset purchases will continue. The rate may remain negative (-0.1%) until 2020 and by then Japan’s sovereign debt will exceed 260 percent of its GDP.
Yet, rate normalisation is only a part of the story. After the Fed began its historical experiment with quantitative easing (QE), its then-chief Ben Bernanke accumulated a portfolio of some $4.5 trillion. Now the question is how does his successor, Janet Yellen, plan to reduce it?
Adding to the uncertainty is the fact that she is likely to be replaced at the end of her term in 2018 with a Republican whose views of US economy and markets are more in line with those of the Trump administration.
Subdued balance-sheet contraction
Since 2008, I have argued that, despite its hawkish rhetoric, the Fed will not be able to increase rates or reduce its balance sheet as early, as often and as much as it initially hoped. Though widely different from the consensus half a decade ago, it seems now that both forecasts have been to the point. The Fed’s current objective seems to be to hike rates up to only 3%.
On paper, the Fed has half a dozen options to reduce its balance sheet. In practice, it will opt for one of three scenarios. It can sell some assets at once or over time, halt the reinvestment of maturing assets or it can taper the reinvestment of maturing assets. The latter is the most likely option since the Fed has officially announced its intention to deploy interest rate as its main instrument (which requires gradual shrinking of the balance sheet).
The Fed’s objective is not to fully unwind its balance sheet. Rather, it may reduce its balance sheet by about $2 trillion in some 4-5 years, according to its minutes. Concurrently, the role of the remaining $2.5 trillion could probably be legitimised as a “new policy instrument,” which would be deployed as a safety cushion amid future crises.
Prior to the global crisis and the QE rounds in major advanced economies, there was little understanding of the probable impact of a balance sheet expansion of monetary conditions. Bernanke deemed such measures necessary, but critics saw them as neither effective nor harmless but as harbingers of an “inflation-holocaust.”
Today, the understanding of the impact of balance sheet contraction on monetary conditions remains equally deficient. Consequently, critics are likely to portray Yellen’s measures as ineffective, adverse, or harbingers of an impending “deflation-holocaust.”
What seems certain is that, as the Fed plans to continue increasing rates, even as it is reducing its balance sheet, both activities will translate to tightening monetary conditions – not just in the US but around the world.
Unfortunately, the track record of the Fed’s tightening is dark – even without balance-sheet reductions.
Reversal of ‘hot money’ flows?
In the early 1980s, Fed chief Paul Volcker resorted to harsh tightening that devastated US households, while leading to a “lost decade” in Latin America. Subsequently, Alan Greenspan’s rate hikes brought down struggling savings and loans associations, forcing Washington and states to bail out insolvent institutions.
In the early 1990s, Greenspan again seized tightening but then reversed his decision, which undermined expansion. In the first case, global growth decelerated to less than 1 percent; in the second, it plunged to 4 percent below zero in developing nations. In 2004-7, the rate hikes by Greenspan and his successor Ben Bernanke contributed to the global financial crisis. In low-income economies, growth stayed at 5-7 percent thanks to China’s contribution to global growth.
During the QE era, after traditional monetary policies had been exhausted, the central banks of advanced economies effectively created what I called the “hot money” trap, thanks to short-term portfolio flows into high-yield emerging markets. As a result, the latter had to cope with asset bubbles, elevated inflation and exchange rate appreciation. That’s when Brazil’s Minister of Finance Guido Mantega first warned about “currency wars,” while China’s Minister of Commerce, Chen Deming, complained the mainland was being attacked by “imported inflation.”
Assuming a reverse symmetry, the impending US hikes have potential to attract “hot money” outflows from emerging economies leaving fragile countries struggling with asset shrinkages, deflation and depreciation. In that scenario, the “hot money” trap of the early 2010s would be replaced by the “cold money” trap in the late 2010s.
Emerging economies might benefit more
On one hand, today’s emerging economies are stronger and better prepared to cope with tightening. On the other hand, global growth is no longer fueled by major advanced economies as in the 1980s and 1990s, but by large emerging economies, which must cope with their adverse impact – which, in turn, has the potential to penalise global growth prospects.
In 2013, when Bernanke announced the Fed would no longer purchase bonds, the statement caused a mass global panic. Today, the central banks of major advanced economies are navigating into new, unknown and dangerous waters. If, in the past, over-ambitious or misguided tightening caused “lost decades,” today the net effect could be far worse.
The brief “taper tantrum” in 2013 was one thing. Multi-year rate hikes, coupled with balance-sheet reductions, in major economies that are highly indebted, suffer from ageing demographics and are coping with secular stagnation – well, that’s a different story altogether.
Dr Steinbock is the founder of Difference Group and has served as research director at the India, China and America Institute (USA) and visiting fellow at the Shanghai Institutes for International Studies (China) and the EU Center (Singapore). For more, see http://www.differencegroup.net/
This commentary was released by South China Morning Post on June 4, 2017.
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