As Janet Yellen’s Federal Reserve prepares to tighten its belt, the world is poised to feel the squeeze
Dan Steinbock says the American central bank will find it far from easy to increase rates or reduce its balance sheet in the way it initially hoped, but caution is key given the uncertainties involved
Before the Trump era, the Federal Reserve hoped to tighten monetary policy more often and aggressively than the markets anticipated. But since November, US economic prospects have fluctuated dramatically. In its May meeting, the Fed left its target range for federal funds rate steady at 0.75-1 per cent, in line with market expectations. It is likely to climb to 1.3 per cent by the year-end and exceed 3 per cent by 2020.
In other major advanced economies, the monetary stance has remained broadly unchanged. The European Central Bank held its benchmark rate at zero per cent in April. Even if the ECB begins rate hikes in 2018, they are likely to be low and slow. The rate could climb to 1 per cent by 2020.
In Japan, Abenomics has failed, despite a slight uptick in short-term growth prospects. As introduced by the Bank of Japan, negative rates and huge asset purchases will continue. The rate may remain negative (-0.1 per cent) until 2020, by then Japan’s sovereign debt will exceed 260 per cent of its GDP.
Yet, rate normalisation is only part of the story. After the Fed began its historical experiment with quantitative easing, its then-chair Ben Bernanke accumulated a portfolio of some US$4.5 trillion. Now the question is how his successor Janet Yellen plans to reduce it. Adding to the uncertainty, she is likely to be replaced at the end of her term in 2018 with a Republican with views on the US economy and markets akin to the Trump administration’s.
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 sought. It seems those forecasts were correct. The Fed’s objective seems to be to take rates up to only 3 per cent.
Theoretically, the Fed has a few options to reduce its balance sheet, according to its minutes. In practice, it will opt for one of three scenarios: it can sell some assets at once or over time; it can halt the reinvestment of maturing assets; or taper their reinvestment. The latter is the most likely option since the Fed has 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 US$2 trillion in some four to five years. Concurrently, the role of the remaining US$2.5 trillion could be legitimised as a “policy instrument”, to be deployed as a cushion amid future crises. Before the global crisis and quantitative easing by advanced economies, there was little understanding about the likely impact of balance sheet expansion on monetary conditions. Bernanke deemed such measures necessary, but critics saw them as not just ineffective but as harbingers of an “inflation-holocaust”.
Today, the understanding of the impact of balance sheet contraction remains equally deficient. So critics are likely to portray Yellen’s quantitative tightening measures as ineffective, adverse, or harbingers of an impending “deflation-holocaust”.
What seems certain is that, as the Fed plans to continue increasing rates while reducing its balance sheet, this will translate into tightening monetary conditions – not just in the US but around the world.
But the track record of the Fed’s tightening is dark, even without balance-sheet reductions. In the early 1980s, Fed chief Paul Volcker’s harsh tightening devastated US households. Subsequently, Alan Greenspan’s rate hikes brought down struggling savings and loans associations, and insolvent institutions had to be bailed out. In the early 1990s, Greenspan again seized tightening but then reversed his decision, undermining expansion. In 2004-07, rate hikes by Greenspan and then Bernanke contributed to the global financial crisis.
During the monetary easing era, after traditional monetary policies had been exhausted, the central banks of advanced economies created 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 then finance minister Guido Mantega first warned about “currency wars”, while China’s commerce minister Chen Deming (陳德銘) complained the mainland was being attacked by “imported inflation”.
Assuming a reverse symmetry, impending US hikes have the 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 a late 2010s “cold money” trap.
On the one hand, today’s emerging economies are certainly stronger and better prepared to cope with tightening. On the other hand, global growth is no longer fuelled by major advanced economies as in the 1980s and 1990s, but by large emerging economies, which must cope with their adverse impact.
In 2013, Bernanke’s announcement that the Fed would no longer purchase bonds caused global panic. 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: that’s a different story altogether.
Dr Dan Steinbock is the founder of the Difference Group and has served as the research director at the India, China, and America Institute (US) and a visiting fellow at the Shanghai Institutes for International Studies (China) and the EU Centre (Singapore). See http://www.differencegroup.net/