Mervyn King. Image by Getty.
A few weeks ago, the big central banks were calmly embarking on their “exit” strategies from unconventional monetary accommodation. Then the global economy slowed but for a while inflation remained too high for the Fed or the ECB to consider further easing. Their hands were tied until inflation peaked. Recognising this, markets collapsed. But now that there are some tentative signs of inflation subsiding, the central banks are rediscovering their ammunition stores.
There are basically three types of action that they are considering. In order of orthodoxy, and stealing some of Mervyn King’s terminology, here is a taxonomy of possible measures:
1. Conventional liquidity injections
This is safe territory for the central banks, and they are willing to act swiftly and decisively if necessary. Yesterday’s injections of dollar liquidity into the European financial system are a case in point. Some European banks, especially those in France, were finding it very difficult to raise dollar financing, which they needed in order to pay down earlier dollar borrowings, and to make loans to customers in dollars. The resulting strains in the money markets were undermining confidence in the ability of these banks to remain liquid, and markets were increasingly unwilling to accept their credit. This presented a classic case for the ECB to inject liquidity, using conventional currency swap arrangements to raise dollars from the Fed. Although the ECB will incur a minimal amount of currency risk in the process, and will also incur some credit risk (which will be collateralised), this is very much business as usual for any central bank, as it was in 2008.
The recent actions of the Swiss National Bank are in the same category. The setting of a floor for the Swiss franc is not exactly an everyday occurrence, but it involves nothing more unorthodox than a burst of unsterilised foreign exchange intervention. This will add liquidity to the Swiss market, and certainly counts as monetisation, but it has been done on countless previous occasions. If needed, there could be a lot more of this type of action. Not many people would object on ideological grounds.
2. Conventional unconventional easing
These policies amount to purchasing government debt and some other assets, as well as offering more explicit guidance about the central bank’s future intentions on interest rates than ever before. The Fed’s likely policy actions at the FOMC meeting on September 20/21 will probably come into this category. “Operation Twist” would extend the average duration of the Fed’s bond portfolio, and would reduce the long term bond yield, encouraging investors to buy riskier assets such as equities and credit. Its effects would be similar to QE2, but would not involve a direct increase in the monetary base, so might be less unacceptable to some observers.
Its effects would also be moderate, and are probably already priced into bond yields. In consequence, the Fed might consider taking a further step to convince markets that it really, really intends to hold short rates at close to zero for a long while. Charles Evans, Chicago Fed president, says it should promise to hold interest rates at zero until unemployment has dropped below 7.5 per cent, provided that inflation remains below 3 per cent. This seems too radical – any mention of 3 per cent inflation could unhinge inflation expectations – but we might get something along these lines.
At the ECB, the current sovereign debt purchases probably fall into this category. Although they are larger than anything the ECB has carried out previously, and are focused only on troubled sovereigns, they can (just about) be defended as being necessary to allow the ECB to implement its intended monetary policy stance in the face of market stresses which would otherwise tighten that stance.
Measures in this category are broadly appropriate, as long as inflation remains within tolerable bounds. There is a growing shortage of aggregate demand in the global economy, fiscal policy is tightening and inflation pressures have peaked. Normally, interest rates would be cut and no-one would object. Many studies have shown that the effects of QE have been broadly similar to rate cuts.
By far the main problem with the case for these policies is that they may have directly triggered higher commodity prices. Most central bankers deny this, but then again they would, wouldn’t they?
3. Unconventional unconventional easing
This is where things become very unorthodox, and therefore very uncomfortable for many central banks. Rightly so. Into this category fall measures which blur the lines between fiscal and monetary policy, such as direct money financing of government spending, with no government bonds being involved. So far, such measures are on the outer limits of the debate, and do not have any overt support among the leaders of the big central banks.
One exception is the recent speech by UK MPC member Adam Posen, who calls for a public lending bank to be established in Britain, and suggests that this might be directly financed by the Bank of England. I would also place in this category calls for the balance sheet of the ECB to be used directly to solve the sovereign debt crisis in the eurozone. Purchases of troubled sovereign debt, well in excess of the amounts needed to achieve the ECB’s desired monetary stance, would be a quasi fiscal strategy operated via the balance sheet of the central bank.
Where does the median central banker stand in this taxonomy? At the Fed and the BoE, I guess it would be all the way into category 2, but not into 3. At the ECB, it would be about halfway into 2, with a firm rejection of 3. So far, only a few outriders have ventured into category 3. If the recession returns, that could be where the debate is headed.
