CENTRAL BANK POLICY is already being tightened. The problem is that in the world after quantitative policy, central bank policy can no longer be represented by a simple interest rate line on a chart. Policy has become more complex, and that complexity is something that markets seem to overlook. Central bank policy now rests on three pillars, and tightening in any of these three policy areas will restrict economic activity.
The first pillar of policy tightening is quantitative policy. Both the US Federal Reserve and the Bank of England are now tightening quantitative policy. Although the Fed only intends to stop its bond purchases at the October Federal Open Market Committee meeting, it has already been tightening. This is because the Fed’s balance sheet has begun to shrink as a proportion of US gross domestic product.
In normal circumstances, the Fed’s balance sheet should grow in line with the nominal growth of the US economy, in order to keep a steady relationship between the liquidity in the economy and the size of the economy. With the Fed growing its balance sheet at a slower rate than nominal GDP growth, the ratio has declined.
The Bank of England’s position is even more advanced. The Bank of England’s balance sheet peaked as a share of the economy at the end of the first quarter of 2013, and has been slowly but steadily declining ever since.
The second pillar of policy tightening is financial regulation. Financial regulation used to be a significant weapon in the armoury of any central bank. Regulation fell into disuse during the 1980s, but it is unquestionably back today. Policy regulation can work in two ways.
First, regulation of the banking sector can force banks to hold more liquidity, and that has been a policy across the world’s major economies ever since 2009. The more liquidity that banks are forced to hold as idle balances, the less stimulatory any central bank injection of liquidity will be. Not only are the US and the UK tightening policy in this manner; the European Central Bank seems to be creating a regulatory climate that replicates a policy tightening.
Second, central banks can directly intervene to limit credit creation in an economy. The Bank of England is the leading proponent of this policy. Restrictions on UK mortgage credit creation, put in place over the summer, have started to have a visible impact on both mortgage lending and housing market activity.
The third pillar of policy tightening is the conventional form of monetary policy tightening. Raising interest rates will be contemplated in the coming months, at least in the Anglo-Saxon world. It is worth remembering that real, or inflation-adjusted, interest rates are resolutely negative. As inflation starts to rise, the real interest rate will become even more negative. If left unchanged, therefore, monetary policy will actually ease rather than tighten (as it is real interest rates that matter to economic stimulus).
From a policymaker perspective, different combinations of policy tightening can be put in place to achieve the desired outcome (which is presumably the control of inflation). Each policy will have different implications for different parts of the economy, however.
Tightening monetary policy, for instance, will impact both existing and new borrowers of floating rate debt. Financial regulation is only likely to impact new borrowers of debt, and existing borrowers will be less affected. Thus, the Bank of England’s current policy leaves the household cash flow of existing mortgage payers unaffected, but is working to restrict the creation of new credit in the economy.
From an investor perspective, these differences may matter. Not only will policy tightening have different direct consequences for financial markets — quantitative policy and bond markets being the most obvious — but it will also have indirect impacts through the reactions of consumers and companies.
Central banks may simultaneously tighten and ease policy — as arguably the European Central Bank is doing with a policy that effectively eases credit conditions for larger companies — without creating many immediate benefits for smaller companies. There are further complications for those countries that seek to tie their foreign exchange rates to developed economies, for interest rate changes may cease to be the dominant policy tool. (If, for instance, US rates are kept low because tightening takes place through one of the other two pillars of policy, countries with dollar pegs may end up having too accommodative a domestic monetary policy).
The global financial crisis has made things more complex in many areas. Investors need to become more sophisticated in their analysis of central bank policy. A chart of the policy interest rate is no longer a guide to how the central bank is seeking to influence economic activity.
Paul Donovan is senior global economist at UBS Investment Bank
This article first appeared in Forum, The Edge Malaysia Weekly, on October 27 - November 2, 2014.