Monetary leash is tightening in the world’s major economies
In all likelihood Wednesday will see the US Federal Reserve’s announcing that next month will see the start of the rollback of the Fed’s bloated balance sheet. Fed chief Janet Yellen expects the process to be “something that will just run quietly in the background over a number of years” but there is a real risk that her nonchalance is misplaced.
Fed balance sheet reduction, which is effectively quantitative tightening, might well have a material impact on global financial conditions and markets, particularly as other central banks, including China’s, are also tightening monetary policy or are poised to do so.
A Reuters poll of economists had expected China’s broad M2 money supply to expand by 9.1 per cent year on year in August, just below July’s 9.2 per cent print, but the actual figure was 8.9 per cent, a new low in a data series going back to 1996. As the People’s Bank of China said in June, a slowdown in annual M2 growth could be “a new normal”.
In the euro zone, the European Central Bank (ECB) will likely soon announce plans to scale back the pace and length of its programme of asset purchases. “It is time to take a decision now on scaling back our bond purchases at the beginning of next year,” ECB board member Sabine Lautenschlaeger said on Friday.
Once Germany’s national elections are safely out of the way on Sunday, perhaps the ECB will feel more comfortable outlining its plans.
Meanwhile in Britain, last Thursday’s Bank of England (BOE) Monetary Policy Committee decision showed that a majority of the rate-setters now think a UK rate rise will be needed in coming months if inflation pressures continue to build. The yield curve for UK government bonds repriced higher. Sterling jumped.
It may be pure coincidence that the BOE took a more hawkish stance just as markets were again focusing on the possibility the ECB will take back some monetary accommodation but such a timely repricing of the UK yield curve could mitigate the risk that capital inflows into Britain might ebb as euro zone monetary policy tightens.
After all, as UK-based Lombard Street Research argued earlier in the month, Britain has been “a prime beneficiary of outflows from the [euro area] triggered by the ECB’s asset purchase programme”.
But if the mere sight of the BOE showing a set of hawkish talons can have such a marked effect on UK markets, investors could rationally question if actual balance sheet reduction by the Federal Reserve is going to be the kind of non-event that Fed chair Yellen thinks it will be.
US bank BNYMellon wrote on Friday with regard to currency movements that quantitative easing is the “policy with the most consistent [foreign exchange] impact over the past five years”.
As the US firm noted, the yen started falling on the foreign exchanges in late 2012 as pressure built for an expansion of Bank of Japan asset purchases even before the programme officially kicked in in April 2013. Last year’s adoption of a policy of yield curve control also hit the yen.
On the flip side, as BNYMellon wrote, the Fed began tapering its quantitative easing from January 2014, “finishing the process in October of that year. By March 2015 the US dollar index was up 25 per cent year on year, making it the sharpest rally since the mid-1980s”.
In recent years, making US financial conditions less loose pushed the greenback higher, while loosening Japanese financial conditions weighed on the yen. So why wouldn’t actual quantitative tightening by the Fed have effects in the real world, especially when other jurisdictions are also tightening policy or thinking of doing so?
And then there’s the question of what the Fed’s efforts to trim the size of its balance sheet will mean for the US Treasury which has been a prime beneficiary of quantitative easing.
Not only has the Fed’s asset purchase programme helped bear down on the US government’s borrowing costs but it has also provided additional returns for Uncle Sam as the income earned by the Federal Reserve on its purchased assets translates into higher remittances paid by the Fed to the US Treasury.
Those dual benefits to the US Treasury may now diminish, with as yet unquantifiable consequences.
The monetary leash in a number of the world’s major economies is becoming tighter. It is to be hoped that Fed chief Yellen is right that a programme of Fed balance sheet reduction can “just run in the background,” but it might be unwise to bank on it.