The Perils Of Exiting

From Monument Securities

The Perils Of Exiting

The Bank for International Settlements (BIS) has an admirable record in flagging potential threats to global financial stability. When the cadre of central bankers and finance ministers who presided over the financial meltdown of 2008-09 are taken to task for failing to anticipate trouble, their stock response is to say nobody saw it coming. Well, the BIS had given ample warning that much had gone wrong in international banking. If those with their hands on the levers of power had paid heed to these concerns, they might have saved themselves, and the rest of us, a great deal of distress. For the most part, a new set of policymakers has taken the controls, as the generation of 2008-09 troops off into the pages of history. They have a chance to show they are more alert than their predecessors to risks in the financial system. For the BIS, once again, is sounding the tocsin.

In its annual report last month, the BIS invited central bankers to consider what the implications would be of an interest rate shock occurring as central banks seek to quit their current ultra-accommodative monetary stances. The BIS drew attention to the risks that crystallised in 1994 as the Federal Reserve exited a prolonged period of unusually low short-term interest rates. We should recall that the FOMC decided to move to a less accommodative policy at its meeting on 4 February that year. Between February and May, the federal funds target rate rose from 3.0% to 3.5% but that precipitated a surge in the Treasury 10-year benchmark yield from 5.81% to 7.49% in that same three-month period. The bond market guessed correctly that the funds rate would go higher still; it reached 4.25% by end-June 1994. The BIS acknowledged that much had changed since 1994. However, we might well fear that, even if changes that have occurred since 1994 make it, on balance, no more likely now than then that bond markets would suffer a shock should central banks ever initiate an exit from ultra-accommodation, any shock they did suffer would probably now be more severe. It might not be fanciful to envisage long-dated yields rising by as much as three percentage points in such circumstances. For US, UK and German government bonds, that would merely restore them to their long-run historical relationship with rates of inflation. But a rapid movement in yields on that scale could inflict serious damage on the financial system and, even if this were by luck avoided, higher long-dated yields might snuff out corporate demand for external capital and crush business investment. In the USA, higher long-dated yields might also cut short recovery in the housing market. The results could be disastrous.

If bond yields were to escalate, as the BIS is warning, it seems unlikely that central banks would fail to respond. They might be expected to try to counter this movement by indicating that, in moving away from accommodation, they intended to pursue a gradualist strategy. If that were not enough to contain the rise in yields within acceptable bounds, they might even declare that they were postponing their exit. Indeed, should the rise in long yields threaten economic recovery, central bankers might have no difficulty persuading themselves that there were sound fundamental reasons for prolonging the monetary accommodation. Fed officials have rehearsed these stances in recent weeks as they have struggled to limit the markets’ reaction to indications they do not intend to purchase bonds at a monthly rate of $85bn forever. What we, and they, cannot know in advance is how extensive the chain-reactions will be in bond markets when they do decide to moderate their assetbuying (leaving an accommodative policy not quite as ‘ultra’ as at present). As a precaution, the FOMC has signalled that it might raise, as well as lower, the pace of its bond-buying. The Fed might well hope to meet a menacing rise in long-dated yields with re-expansion of its buying programme, while passing off the situation as quite normal.

There is a further potential source of financial instability in central banks’ exiting ultra-accommodation. They will not be moving together. The economies of the USA, the UK, the euro zone and Japan are at different stages of recovery from the 2008-09 episode and its aftermath. Their respective central banks are operating under differing constraints. These central banks are very unlikely to adhere to the same schedule as they attempt to withdraw accommodation. In a global financial system awash with mobile capital principally seeking yield on investments, this situation creates a clear risk that massive international capital flows will occur, back and forth, during the central banks’ exit process. These flows could well be reflected in extreme volatility in exchange rates between the major currencies. Doubtless, the G7 will issue statements claiming that what is happening is fine because central banks are acting with purely domestic monetary goals in view. Nevertheless, the impact of exchange rate fluctuations on international trade and economic growth, even if there is no ill intent, could be so severe as to give significant impetus to protectionism. Further, we have so far assumed that central banks would have it within their power to moderate upward pressure on long-term rates during the exit process. This might not be realistic.

If central banks keep tacking and trimming as they edge away from accommodation, it may come to pass that none of their statements will carry much credibility. They could then lose control of long rates or, at best, stability in long rates might call for ever greater market intervention on their part. The end-result would be to render monetary measures largely useless as instruments of policy because central banks, with their controls jammed open, could never be sure of effecting any intended plan. Mr Bernanke and his co-thinkers may soon discover that, in taking a different line in coping with the current depression from that followed in the 1930s, they have fallen unsuspectingly into a trap from which escape will be painful.