Keeping interest rates for too low for too long risks another financial crisis, warns the Bank for International Settlements (BIS) in its newly published annual report. The concern is that while economic growth is still modest at best, financial markets are “extraordinarily buoyant”, in no small part due to extraordinarily easy monetary policies around the globe. The disconnect, if left unchecked, threatens to foster bubbles that could eventually reverse and create new macro troubles, the BIS says.
The warning isn’t new. The BIS has never been a cheerleader for the quantitative easing (QE) policies of the Federal Reserve of recent vintage–policies that the European Central Bank is slowly embracing (although far too slow by some accounts). “Particularly for countries in the late stages of financial booms, the trade-off is now between the risk of bringing forward the downward leg of the cycle and that of suffering a bigger bust later on,” BIS explains.
The larger issue is whether and how to nip so-called bubbles in the bud before they grow too large and burst. Here too the subject matter and related discussion have been around for a while, although a consensus on policy is still elusive–for a good reason: risk management is tricky. Preventing bubbles is a worthy cause, but so too is minimizing the danger of pricking bubbles too early and causing unecessary damage. Finding the optimal middle ground is, to say the least, a work in progress, in theory and in practice.
This much is clear: The resulting blowback from such pops, as the events of 2008 remind, can be devastating for the real economy. This is a risk worth considering, of course, although it’s also bound up with another hazard: what happens if there’s a new recession with interest rates at zero?
I’ve written about this before, but the BIS report raises the issue anew. In the pre-2008 crisis era, US recessions arrived in part because the Fed tightened monetary policy as a tool to slow an overheating economy. The connection was captured in Rudy Dornbush’s famous quip that “none of the U.S. expansions of the past 40 years died in bed of old age. Every one was murdered by the Federal Reserve.”
Although the US economy appears to be in no danger of falling into a recession at the moment, it’s not too soon to consider what could happen if the macro trend turns wobbly and a new contraction jumps out of the shadows. In the old days, a new recession typically arrived with relatively high rates and tight policy as the Fed sought to keep inflation in check amid a rapidly expanding economy. As such, the central bank was in a position to reverse course to ease the downturn and revive growth. So, what happens if policy is already ultra easy when the business cycle goes negative?
One school of thought says that recessions can’t happen if policy is easy. But this is less of a hard rule than looking in the pre-2008 rear-view mirror. Again, recession risk at the moment is low, but we should think about what might happen if a recession arrives without the capacity to unleash the traditional policy options—cutting interest rates and increasing money supply.
In theory, the Fed could move from ultra-easy policy to a super-ultra stance, whatever that means. But the prospects for success for positively juicing growth is already low at this late date and would probably diminish further if the Fed is forced to up its game beyond its already dovish state.
In truth, we’d be uncharted waters, again, with a new downturn that begins while quantitative easing is running hot. The good news is the US economy appears to be headed for a slightly faster rate of growth, which leaves the Fed with more scope to adjust its policy back to something approximating a normal stance. With a bit of luck, rates will be sufficiently high and policy sufficiently tight so that when the next recession strikes the central bank will have the means to combat the slump.
The question, then, is how quickly the Fed dials down the current QE policy? The BIS worries that the return to normalization is moving too slow. Maybe, but given the still precarious state of growth one might wonder if there’s also a risk of a new recession by pulling back on the monetary stimulus too quickly. Damned if you do, damned if you don’t?
There’s little doubt that the Fed kept the Great Recession from turning into a replay of the Great Depression through aggressive monetary easing. But there’s still no free lunch. The Great Unwinding is still to come, and the final chapter on central bank intervention has yet to be written. Winding down QE needn’t end in tears, but it could, depending on the details and the timing.
In case you haven’t noticed, there’s (still) a grand experiment in central banking unfolding in the summer of 2014. The results so far have been mixed, albeit with some critical successes. The end game, however, is yet to come.