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September 24, 2013

The Dilemma Central Banks Face in Deciding to End Economic Stimulus

How and when will historic and extraordinary central bank policies be reversed? Or will they be reversed at all? Better Markets Senior Fellow Robert Jenkins says that one could be forgiven for betting that “too little too late” is more likely than “too much too soon.”

“Rehearsal for Reversal”
 
Remarks Robert Jenkins, Better Markets Senior Fellow, at Hermes Investment Conference, September 24, 2013

How and when will central bank policies be reversed? Markets want to know the plan. Central bankers wish they had one. One thing is for sure, it is going to be a rocky road. Here is why.

Central banks worry about four things: 1) inflation; 2) the economy; 3) financial stability; and 4) political pressure. Between 2008 and 2012, all four factors favoured aggressive easing and creative largesse. Let’s start with inflation. Rising prices were not the concern – deflation was. What about the economy? At the time, depression loomed – growth was a distant dream.  Financial stability?  Panic was in the air to the point that any and all measures that might restore confidence and liquidity were justified.  Political pressure?  Elected officials welcomed every intervention that might calm markets and restore growth.  In short, “on the way in” and “on the way down” the key concerns pushed – and pushed strongly in the same direction.

By contrast we now face a period when these same four factors pull in different directions and to different degrees. Thus: 1) Inflation: concern over deflation has faded in favour of divergent views as to inflation expectations. 2) The economy: policy makers now debate the likelihood or speed of economic recovery. 3) Financial stability: market instability caused by fears of Central Bank inaction has been replaced by worry over what form the next actions will take. 4) Political pressure: unsurprisingly, most politicians continue to press for any and all measures to pump up the economy – particularly where elections loom.

So what should we expect? First, policy statements will be confused and confusing. Although central bankers understand the importance of clarity of communication, they will be unable to offer as clear a direction and pace of travel on the way “up and out” as they did on the way “down and in.” For example, a policy of forward guidance could be consistent and credible when the economic challenge was clear and compelling. How can it possibly be as effective a tool on the bumpy road back?  In the language of the trade the policy path will be “economy – dependent.” And the economy will throw off mixed signals. Different central bank officials will interpret these differently – and say so publically. This is already the case.  And even in the unlikely event that complete consensus is reached within a central bank, that view may not correspond to the policies of key CB counterparts abroad – much less with the preferences and pronouncements of elected officials at home.

Second, authorities will continue to underestimate the magnitude of the market’s reaction to what will appear to them to be a well intended, sensible and modest demarche. Resultant price swings will surprise regulators whilst worrying bankers and the body politic.

Third, central banks know that the financial system remains fragile. Many of these extraordinary central bank policies were designed to buy time so that the financial establishment could take the tough decisions, absorb the hits and build the necessary resilience into their balance sheets and the wider financial framework. Alas, the time has not been used to meaningful effect. Five years on from the onset of the crisis, levels of leverage in the banking system are dangerously high. And sadly, the twin challenges of “too big to fail and too big to bail” remain unresolved.  Thus each hint of policy change will trigger political pressures to slow down or back off.  Such exhortations may very well find a sympathetic ear within the regulatory establishment.

The result will be contradictory statements and signals. Testing the waters before taking the plunge is likely to result in a series of false starts and timid retreats. Statements will be made, interpreted, reinterpreted and even disavowed. Central bankers are cautious by nature. Hence probabilities will favour backing off to plunging ahead. In this as in many other aspects, recent events represent a rehearsal for reversal.

Finally, just as authorities have retreated from many needed financial reforms, governments and their central banks may well find reasons to postpone indefinitely the great unwind. So in addition to asking how and when these extraordinary central bank policies will be reversed, it may be useful to ask a third question: will they be reversed at all? Of course, no one can know for sure. But one could be forgiven for betting that “too little too late” is more likely than “too much too soon.”

Robert Jenkins is Adjunct Professor, Finance at London Business School and Senior Fellow at Better Markets. He recently served on the Financial Policy Committee of the Bank of England. 

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