Ben Bernanke spoke, and the world shuddered. Testifying before Congress, the chairman of the Federal Reserve indicated that the FOMC could start to scale back the pace of its asset purchases “in the next few meetings.” In suggesting that the Fed might start buying less than the current $85 billion of bonds per month as early as September, he pulled the trigger on what Warren Buffet called the shot heard around the world.
Markets around the world went into a tailspin. All of the main G10 equity markets suffered declines on Bernanke’s words. Most notably, the Nikkei 225 tumbled 7%, its largest single day drop since the Tokohu earthquake and tsunami in 2011.
This is remarkable. Bernanke was clear that change to QE would involve buying fewer securities, not ending the programme entirely. In his prepared statement, Bernanke struck a dovish tone, praising extraordinary monetary operations for their role in supporting the real economy and making it clear that the Fed did not want to pull back on stimulus measures prematurely. Continuing Buffet’s analogy, Bernanke might have fired the shot, but the gun was full of blanks.
We did, however, get a preview of how the market might react when monetary conditions do begin to normalise. Three insights are apparent after seeing how financial markets could react if the Fed were to begin to change the direction of monetary policy.
1. There’s no such thing as strictly domestic monetary policy. Formally, the Fed will keep with accommodative monetary policy until the FOMC is sufficiently confident that the unemployment rate will fall below 6.5 per cent. All central banks are bound by their domestic mandates, such as price stability or promoting full employment within their respective borders. Recently the Fed has been focusing on the employment side of its mandate.
The sell-off that met Bernanke’s suggestion of slowing QE underscores the truly global nature of domestic monetary policy decisions. Discussions of monetary policy coming out of central banks around the world often begin with the domestic picture of, say, the labour market and price levels and then turn to international headwinds later. To the extent that international reverberations of domestic monetary policy can have an impact on a central bank’s domestic policy goals, it is indeed within a central bank’s mandate to consider the global implications of monetary policy. In other contexts, such as recent fears over currency wars, the international community can exert significant influence on domestic policy.
So in spite of the Fed’s domestic mandate, the international picture is important as well. If Bernanke just hinting at winding down QE can have such a strong impact on asset prices globally, it’s likely that the Fed doesn’t just look at domestic labour market and price level indicators when deciding on US monetary policy.
2. Asset prices are highly sensitive to stimulus withdrawal. This seems obvious on the face of it, but no one really knew (or knows) how tightening monetary policy will impact asset prices. We have no modern precedent. The last time the Fed raised its benchmark interest rate was in June of 2006, when the target rate was increased from 5 per cent to 5.25 per cent. Interest rates at that level aren’t even conceivable in the current policy environment. We’re in uncharted territory, both with regard to the level and duration of interest rates and the size of the Fed’s balance sheet.
The frenzied downside reaction to Bernanke’s testimony highlights how sensitive global asset prices are to central bank largesse. This is especially true considering the Fed didn’t actually do anything. He hinted at the possibility that the Fed might consider scaling back the pace of QE. Even so, scaling back asset purchases probably wouldn’t alter the path of the Fed’s balance sheet materially. Also, interest rates would still remain pressed up against the zero bound.
The fall in pro-cyclical asset prices probably wasn’t entirely due to Bernanke. China is slowing, and many investors were likely taking some profits off of the recent bull run, particularly in equities. Nonetheless, it’s clear that Bernanke’s comments pushed prices down to some degree. If asset prices were indeed justified by fundamentals, then Bernanke’s comments would have had a more muted effect. The sharp fall in risk assets suggests that central banks are blowing bubbles in the financial markets. The extent to which asset prices are due to bubbles versus fundamentals might be proxied by how steep the drop in prices were in response to Bernanke’s comments. However measured, last week offered some clues about just how dependent on stimulus some assets really are.
3. When monetary normalisation does occur, it will be slow and announced far in advance. Eventually, monetary policy conditions will have to return to normal. Some might argue that future monetary policy will be radically different to pre-2008 trends due to the “new normal” situation in the real economy. I think monetary policy indicators will eventually revert to the long-run averages. Regardless of which camp you might be in, virtually no-one agrees that monetary policy can remain as it has been for the last five years.
This raises the question of how central banks will unwind highly accommodative monetary operations. Like all central bank operations, monetary normalisation will be as much about communication strategy as it will be about the technical details of the policy change.
John Williams of the San Francisco Fed opined that policy movements could be up or down, but that would be out of step with the Fed’s policy since the crisis. The Fed, along with its peers around the world, have tried to blunt the uncertainty associated with being off the monetary map by communicating its policy decisions in advance and even tying policy to some concrete dates or indicator values.
Last week, the Fed saw the effects of announcing the potential of tapering QE months in advance, and they were nasty. Barring a substantial spike in inflation, the Fed might eschew the Volcker approach to monetary tightening and instead slowly communicate to the market that QE will be slowly winding down and, eventually, interest rates will slowly rise. That is, not only will policy be announced far in advance, but policy changes will be gradual. This could allow asset bubbles to deflate prior to the tightening itself, which would hopefully minimise volatility in the markets. It may also allow firms and individuals that hold deflating assets to realise losses more gradually and remain solvent.
This blog has focused on the Fed, but the same arguments apply to the Bank of England or the European Central Bank. In short, the episode surrounding Bernanke’s testimony before Congress gives us a glimpse into what to expect when central banks globally start cooling down the printing presses.