How do you reverse the monetary easing cycle ? And when ? And how do you avoid the fallout ?

Monday 18th May 2015

 How do you reverse the monetary easing cycle ? And when ? And how do you avoid the fallout ?

GLOBAL INSIGHT : "All eyes on the Fed as sun starts to set on era of monetary loosening" , The Financial Times, p.6

We thought it might never end ...... in the years since the financial crisis, central banks have implemented an aggressive policy of slashing interest rates and of asset purchases (QE) in the hope that such measures would kick-start a global recovery. We are now at the stage where the early, somewhat tentative signs of growth are signalling a gentle reversal in policy in some areas, while others remain in full, monetary easing mode.

On the one hand, the ECB has confirmed its intention to carry out its QE programme through to completion in September 2016 (although as we discussed the other day it has given itself some wiggle-room should circumstances change). The Bank of Japan is fully wedded to its own QE agenda, and even China's central bank has been cutting rates in the face of slowing conditions. On the other, the Bank of England has consistently been talking rates higher (notwithstanding the likelihood of CPI data out tomorrow showing a slip into deflation, something that the B. of E. will hope is temporary). Much more importantly from a global perspective, we know we can expect an upward move in rates in the US, we just don't know when. Are the recent weak numbers merely a seasonal blip, or indicative a more fundamental slowdown ? 

Whenever it happens, what will be the effect of a US rate rise ? For the markets in the immediate term ...... chaos, probably. The mere mention of tapering down the QE programme by then Fed Chairman Bernanke in 2013 prompted the so-called "taper tantrum" in bond markets. It's hard to see how much more the Fed can do to avert such chaos ..... a rate rise has been regular signalled when conditions merit and it'll be up to market participants to analyse the data just like everybody else. The problem of market turmoil lies in its fundamental illiquidity, a topic much discussed in this blog but one we'll leave for today. But assuming the markets calm down after a short period of ludicrous volatility, what of the wider ramifications for exchange rates and capital flows, particularly for emerging markets ? Not good.......

From this viewpoint, the idea that central banks might collaborate to manage exchange rates is a non-starter. The logistical and political problems would surely be insurmountable, and as Ferdinando Giugliano points out it may even be illegal  --  central banks only have a mandate for domestic issues. Besides, history is littered with failed and expensive attempts to manage currency levels in the face of market forces.

One suggestion is that IMF might offer increased lending facilities to emerging nations to ease their problems, a role that would of course entail increased funding from contributing nations. Greater funding was agreed in principle back in 2010, but was blocked by the US Congress. Given the current make-up of Congress, that would seem to be a pretty major hurdle to overcome, even if the IMF should retain its appetite to do so.