Akash Prakash: The tightening dilemma

The imbalance among monetary policy transmission channels will pose a dilemma to monetary authorities

The message from the recent G-20 meeting was crystal clear; do not expect central banks to take the risk of short-circuiting fragile recoveries, either through premature tightening of monetary policy or phasing out of fiscal stimulus. The assembled cast of policymakers seemed to be in total agreement, there is no question of reversing the emergency measures until a global recovery is totally secure. While the media devoted countless pages to the eye-catching headlines around proposals  to curb banker bonuses, much less attention was devoted to the consensus over macro-economic policy that emerged from the G-20 meeting.

All the assembled finance ministers and central bank chiefs seemed to agree that the greatest danger facing the world economy would be a premature reversal of the monetary and fiscal measures taken, and market worries around inflation and excessive stimulus and debt were dismissed. Ignoring warnings of many market pundits concerning the long-term buildup of inflationary expectations or a rising government debt mountain, preventing a second leg down in the global economy seemed to be priority number one.

 

For fiscal policy, the clear message coming out of the meeting was that budget deficits should not be cut back for at least a year, despite growing nervousness in the US in particular about ballooning debt burdens. On monetary policy, the assembled central bankers seem to be clear that there can be no question of raising rates for at least a year, if not longer. Even someone as hawkish as Trichet seems to have signed up for this new-found consensus as outlined in an article he wrote for the Financial Times.

Despite the seeming clarity on the part of the assembled policymakers, the reality is that central banks have an exceedingly tricky task ahead in deciding how and when to calibrate their exit strategies from the emergency policy actions of 2008. While changes in fiscal policy are largely political decisions, central banks in most of the OECD economies have independence over monetary policy.

Monetary policy has different channels through which it acts to stimulate the real economy. It works through falling interest rates and lowering of risk spreads, increased lending by banks and increases in asset prices and risk appetite. A combination of these metrics and other factors like currency normally go into calculating a financial conditions index which is able to express the true level of monetary easing. Short-term interest rate reductions are not the only way monetary easing stimulates the economy. The interplay between all the above-mentioned channels boosts consumer and business spending and hence improves economic growth.

This cycle has, however, seen only a partial working of the normal transmission mechanisms.

When central banks cut policy rates, other interest rates respond very quickly, and by providing cheap funding, central banks aim to encourage spending and production. This interest rate channel will typically be the first line of defence in reviving the economy, and do most of the heavy lifting to kickstart economic growth. However, in this cycle interest rates that are relevant for borrowers have fallen very slowly and, due to the crisis, much later than policy rates. The clogged financial system had prevented an immediate rate response. A further complication is the lack of desire to borrow on the part of households (in the US particularly) as they seek to rebuild decimated balance sheets. Sticky rates to the downside and an unwillingness to leverage up on the part of households have thus rendered this channel of monetary policy transmission far less potent than normal. The shrinkage in credit outstanding among households in the US over the past few months is a testament to how weak this channel of monetary transmission has become in this cycle.

The flow of credit to the private sector is also likely to be weaker than normal as deleveraging among financial institutions has sapped their ability and willingness to extend credit. Banks are happy to use the positive carry from an engineered steep yield curve to rebuild their own balance sheets as opposed to taking on more credit risk. The demise of the shadow banking system has reduced system-wide credit availability. Measures to force banks to further increase the quantum and quality of capital adequacy (also discussed at the G-20 meeting) will only further accentuate the difficulty of the banking system in lending aggressively.

Risky asset prices have, however, performed extremely well since the rally began in March, with risk appetite slowly coming back. Risk assets are currently in a sweet spot, with strong expansionary policies in place, and likely to remain so, combined with a clear bottoming out of the economic fundamentals. This channel of monetary policy transmission has been far more powerful than the others in this cycle, trumping the interest rate and credit channels by a large measure. We have seen record issuance of corporate debt, and a thawing of the equity capital markets to new issuance.

It is this imbalance among the various channels of monetary policy transmission that will ultimately create complications for the monetary authorities and pose a dilemma.

If asset prices keep moving higher, and the central banks decide to do nothing, in effect accepting higher asset prices to compensate for the very weak transmission of monetary policy through the interest rate and credit channels, then we are setting the stage for another bubble in asset prices. It would be ironic if the policy solutions to the current crisis set us up for another bust down the road. No central bank willingly wants to go down this road, but there may be no choice.

On the other hand, learning from the last 18 months, if they target the building asset bubble, while the other monetary transmission mechanisms are still weak, the authorities could jeopardise the whole economic recovery, by causing a premature tightening of policy. This would seemingly go against the emerging consensus coming out of the G-20 meeting. Having come so close to economic collapse, no policymaker wants to risk another economic downdraft.

Thus the central banks have a real dilemma, and one fraught with political risks. The structural nature of the problems confronting consumers in the US seems to preclude a vibrant recovery in the other channels of monetary transmission. An overleveraged consumer and financial system will not correct its imbalances overnight. Central banks may have no choice but to willingly let loose another asset bubble, and this time emerging market assets are a prime candidate to be at the centre of this growing frenzy.