THE world has been in need of monetary support and the leading central banks have duly obliged in taking their interest rates to or near zero, and providing more support through unconventional bond buying, long-term supply of cheap credit to banks and unprecedented forward guidance on future rates (very low for really very long).
The problem that has presented itself is how to go about dialling back this generous policy stance when economies and markets are judged strong enough to proceed under own sail once again, and the cost of these policies (in possibly overheating asset markets, its inflation potential and possibly other institutional distortions) no longer warrants such degree of support.
The first inclination has been to cut back bond buying and other balance sheet-expanding actions (generally not considered a tightening of policy but more in the nature of reducing the degree of largesse) in preparation for the eventual real tightening action (raising interest rates).
The problem with this approach is that it leaves a major unguided missile to decide in its own right its preferred point of re-entry and the way to proceed, which by its very nature can tend to be chaotically disorderly, offering maximum cost to the economy.
Not clever, in other words.
Along this route of march, mayhem can be unleashed before the Fed has even had the opportunity to buy one bond less than it was doing before.
For any hint of tapering is automatically escalated by bond market traders to finessing the Fed timing of the first interest rate hike, which for them is central in their pricing decision.
Revisit May 22 2013 and Fed chairman Ben Bernanke suggesting that the time to start slow tapering of bond buying was approaching.
Bond investors were told the Fed intended to start raising interest rates only very late in the decade and it would then only proceed very slowly to tighten policy, taking years to normalise interest rates.
But the main point of this message was that it left the bond market without guidance as to how to price bonds today that were promised to be losing value in years to come along an uncertain trajectory as eventually the yield curve would rise.
Indeed, tapering bond purchases implied immediately one important source of bond demand less, and progressively so, followed in subsequent years by as yet uncertain timing of increases in short term interest rates, whose cumulative future effect is to raise bond yields and lower prices.
By starting the clock by talking about imminent tapering and ultimately distant interest rate raising decisions, the Fed invited the market to start deciding how to price these suggestions.
The market opted to start pricing in these implications upfront, if only partially, but aggressively enough, and thereby did far more than what Fed policy envisaged as desirous for the US economy.
It turns out that it is difficult to control a very large pool of bond money when confronted with deep uncertainty regarding the future value of principal even if half is owned by holding-to-maturity foreign central banks and governments and another fifth by the Fed itself.
In the words of Professor Peet Strydom (May 2012): “Forward guidance is unlikely to work because in an uncertain world with diverging expectations the central bank is unlikely to be successful in acting like a Walrasian auctioneer.”
In the four days following May 22 2013, bond prices fell heavily and spreads of more risky (EM) assets opened up dramatically, as unknown future developments were discounted to the present on an accelerated basis on account of timing uncertainty (and preferring being safe rather than sorry of being left holding a depreciating asset – the ultimate hospital pass).
At issue here is whether markets buy the Fed worldview or diverge sharply enough to derail Fed intentions by not acting on its guidance regarding the shape of future events including policy tightening.
So, how about reversing the order of business?
Do not start with tapering (or even talk of tapering) but decide at what point the economy can handle a very mild and gradual increase in interest rates.
The European economy is clearly not there yet, with its growth in low decimals and inflation well below its two percent target, giving rise to a November interest rate cut, and possibly still more policy easing to come.
But in the case of the US matters may be different.
Instead of promising to keep rates very low for very long and then only slowly raising them thereafter, surrendering to markets the bond pricing decision in a climate of severe uncertainty, take back such pricing leadership.
Wait until the economy is judged ready for a very slow step-like increase in interest rates and then start this process while communicating the modesty of growth and the weakness of inflation, anchoring the slowly changing future interest rate trajectory, in turn shaping the yield curve.
Once launched, this process can be accompanied by very slow (lagged) bond tapering.
Short and long-term interest rates should only rise slowly if so signalled by the central bank and underwritten by self-evident proof of a modestly performing economy and very low inflation.
As the credibility of the policy stance is borne out by the unfolding data, market pricing should come to reflect this.
The biggest challenge may come early, as we saw during May-September 2013, as the market view about future growth and inflation may diverge from that of the Fed.
Here the data and policy stance need to anchor market expectations, preferably sooner rather than later.
Instead of offering no policy action and a great vacuum of uncertainty as to how to price, the market should encounter a firm pair of policy hands that say “given this data we price accordingly”.
By taking back the pricing decision, the Fed can then incorporate the tapering decision and ultimately the balance sheet shrinking decision.
Instead of telling markets what you hope to be doing in the distant future and asking them to believe you, holding the fort in good faith in the meantime, no such thing is attempted.
Instead, policy accommodation is maintained guided by weak growth and inflation UNTIL the (expected) data warrants action after which a very gradual withdrawal may be attempted, inviting markets to also reprice.
That may sound remarkably like it used to be.
The path out of an unconventional overhang requiring very slow repricing may well be best served by this approach rather than by an attempt to tell all about the distant future and allowing markets to take pricing leadership in hand.
As 2013 has already shown, that may be too wild a bronco. Instead, those reins should be held firmly PRECISELY because asset pricing needs to change so slowly while markets in their uncertainty are tempted to walk away and accelerate the whole thing, the very opposite of what is required.
As Strydom puts it: “The central bank will have zero success in conducting monetary policy by accepting real sector benchmarks that lie beyond its control (something BOE governor Mark Carney has already discovered in the UK in 2013).
“The central bank has monopoly power in determining interest rates so please return to old fashioned monetary policy with interest rates at the centre.
“Do not upset market participants with tapering QE.
“Get the interest rate pattern in place, the economy moving and QE reversal will be like having cake in the end.”
- Cees Bruggemans is an independent consulting economist. You can follow him on Twitter @ceesbruggemans or e-mail him at email@example.com