posted July 27, 2017
The Limits of Central Banks’ Emerging Policy Shift’

The following article was published in the European Financial Review, July 20, 2017, summarizing and presenting major themes from my just published, latest book, ‘Central Bankers at the End of Their Ropes’, Clarity Press, July 2017.

THE LIMITS OF CENTRAL BANKS’ EMERGING POLICY SHIFT’, by Dr. Jack Rasmus, European Financial Review, July 20, 2017.

“The major central banks have a plan, but its consequences are questionable. In this article, Dr. Jack Rasmus analyses past and present factors of the global economy, from balance sheets to policy shifts, which have significant influence on the possible future of the financial industry and the global society as a whole.

As central bankers, finance ministers, and government policy makers head off to their annual gathering at Jackson Hole, Wyoming, this August, 24-26, 2017, the key topic is whether the leading central banks in North America and Europe will continue to raise interest rates this year; another topic high on the agenda is when the three major central banks – the Federal Reserve, European Central Bank and Bank of England – might begin to sell off their combined $9.8 trillion dollar balance sheets that they accumulated since the 2008-09 banking crisis.

But the more fundamental question – little discussed by central bankers and academics alike – is what are the likely effects of further immediate rate hikes and/or commencement of central banks’ balance sheet reductions? The assumption is further rate hikes and sell-offs will have little negative impact on the real economy or financial markets. But will they?

Central banks in the US and Europe were grossly in error predicting in 2008 that massive liquidity injections and zero interest rates would re-stimulate their economies and return them to pre-crisis real GDP growth rates. They are now about to repeat a similar error, as they presume that raising those rates, and retracting excess liquidity by selling off balance sheets, will not have a significant negative impact on the real economy or financial markets.

The Central Banks Monetary Policy Shift

Central banks’ balance sheets have been growing for almost nine years, driven by programmes of zero-bound (ZIRP) interest rates and the introduction of firehose liquidity injections enabled by quantitative easing, QE, bond and other securities purchases.

After eight years, the official consensus among central bankers and government policy makers is that the 2008 shift to unlimited central bank liquidity and zero (or below) interest rates is now over. The front page business press and media lead story is that central banks are now about to embark collectively in a new direction – raising their benchmark rates and selling off their massive, bloated balance sheets. But don’t bet on it. They may find sooner, rather than later, that rates cannot be raised much higher and that balance sheets may not be reduced much, if at all, without provoking a further slowdown of their still chronically weak real economic recoveries, or without precipitating a serious contraction in equity, bond and other financial asset markets.

In 2008-09 the Federal Reserve quickly dropped its benchmark federal funds rate from 5.25% to a mere 0.15% by January 2009. It followed with its initial bond buying QE1 programme in early 2009. By 2013 the Fed’s net balance sheet rose to $4.5 trillion.

The front page business press and media lead story is that central banks are now about to embark collectively in a new direction – raising their benchmark rates and selling off their massive, bloated balance sheets. But don’t bet on it.
The Bank of England promptly followed the Fed. It reduced its rates from 5% in September 2008 to 0.5% by early 2009, followed by a launch of several QE-like bond and equity buying programmes and then its formal QE “Asset Purchase Plan” in early 2009. Its net balance sheet level rose to approximately $600 billion.

Lacking full central bank authority at the time of the 2008 crash, the European Central Bank lowered rates initially more slowly while injecting more than $2 trillion in liquidity by various pre-QE programmes from 2010 to 2014, eventually introducing its highly aggressive QE programme beginning early 2015. Its rate and liquidity programmes drove Eurozone sovereign nominal bond rates to negative levels, as its aggressive $2.5 trillion QE programme raised its balance sheet to more than $4.7 trillion.

That’s a combined balance sheet total of roughly $9.8 trillion as of mid-2017 for the three major central banks alone.

Globally, however, balance sheet totals are actually far greater than the $9.8 trillion. When other major central banks, like Switzerland’s, Sweden’s, Canada’s and others are added, it’s well more than $10 trillion. And then there’s the nearly $5 trillion balance sheet of the Bank of Japan and the more than $5 trillion of the People’s Bank of China. Worldwide, central banks’ balance sheets therefore exceed well over $20 trillion…with the total still growing.

Attempting to sell off such massive balance sheet holdings – even the $9.8 trillion of the three central banks in Europe and America – may prove far more daunting than those central banks now anticipate. And their coordinated raising of interest rates risks precipitating another recession – given their fundamentally weak economies with chronic low bank lending, slowing investment, stagnating productivity, contracting public investment, and lack of real wage income gains. For the global economy has undergone a major structural change in recent decades that has been rendering central bank interest rate policies increasingly ineffective with regard to stimulating real investment and growth, while simultaneously contributing to further financial fragility as well.1

The New Normal: Unstable Interest Rate Elasticity Effects

In 2008-09 all three central banks quickly reduced their benchmark rates and began to add trillions of dollars, pounds and euros to their balance sheets. But real investment and GDP growth lagged, and periodically stagnated in the US and UK, and even contracted again in the Eurozone. In economists’ jargon, the elasticity of real investment to interest rate cuts was highly “inelastic” – i.e. the collapse of rates and accelerated central bank liquidity produced insufficient real investment, employment, and wage incomes necessary to restore pre-crisis GDP growth.

Now that central banks are reversing those policies – with the Fed in the lead and the BOE and ECB expected to follow – a “mirror image” of the error of the past eight years may emerge: it will take very little in terms of rate hikes or balance sheet reductions (which will also raise rates) to generate a further contraction in real investment and growth, and may even precipitate a major correction in financial market prices.

In other words, the negative impact of pending rate hikes on investment may prove highly elastic, just as it proved in the past that rate cuts’ positive effects on real investment were highly inelastic.

This may seem anomalous – i.e. rate reductions post-2008 had little positive effect on real investment and growth, but rate hikes now will have a quick and major negative impact on investment and growth. But it is not. The same global forces and restructuring in financial, capital, and labour markets that have taken place in recent decades causally underlie both effects. The global economy crossed a threshold in 2008-09 that is still not very well understood by central bankers and economists alike. The anomaly is only apparent.2 The causes are the same.

What then are the likely scenarios with regard to the three central banks – Fed, ECB and BOE – in the next six to twelve months as they attempt to shift their policies of the preceding eight years by raising rates and selling off balance sheets?

Three Scenarios: BOE, ECB & the Fed

The Bank of England’s (BOE) initial QE experiment was temporarily halted when the Fed suspended expanding its QE programmes in 2013, but QE was re-introduced in 2016 in the wake of Brexit. As of mid-2017, moreover, the BOE shows no indication that it will not continue its QE programme and thereby expand its balance sheet. Embroiled an in increasing difficult implementation of Brexit, and what appears to be several more years of growing economic uncertainty, the UK economy has begun to show signs of weakening in recent months. The BOE will therefore continue to add liquidity, both by QE and traditional means, in order to prop up UK financial markets in the interim. Balance sheet sell off is thus not imminent anytime soon.

On the other hand, more likely is the BOE will follow the Fed should the latter continue to raise rates, raising its benchmark marginal lending or discount rate to prevent a further decline of the UK currency to ensure much needed money capital inflows and to slow rising import inflation that comes with currency decline. So expect more rate hikes from the BOE, as well as more balance sheet accumulation.

Nor will the ECB’s balance sheet be appreciably reduced any time soon. European Central Bank chair, Mario Draghi, plans to attend the Jackson Hole gathering of central bankers and friends. It will be his first appearance since three years ago, where in 2014 he signalled the ECB was planning to introduce its version of quantitative easing, QE, which it did in early 2015. But this time it is highly unlikely Draghi will signal the ECB to follow the Fed in any reduction of its own $4.7 trillion balance sheet. More likely is some ECB intent to slow its QE bond accumulation programme in 2018 – i.e. after it sees what the US Fed will do in what remains in 2017 and after it replaces current chair, Janet Yellen, with former Goldman Sachs banker, Gary Cohn, next February 2018. Meanwhile, the ECB will allow rates to drift upward from their former negative and zero levels. Like the BOE’s, the ECB’s balance sheet will therefore continue to grow, as rates are allowed to rise in coordination with the Fed.

All eyes are therefore on the US central bank, the Fed, and what signals it gives, and its follow up, to the Jackson Hole August gathering, and the Fed’s policy committee in September. Will it continue to raise rates? Will it announce formally a schedule for balance sheet reduction in September? If the latter, will the announcement of sell-off be so minimal and token that it will generate a mere 0.25% hike in rates by year end 2018, as some pundits predict? Or will the psychological effects on investors – who have enjoyed eight years of record equity, bond, property, and derivatives asset price and thus extraordinary capital gains – consider the announcement as the signal to “cash in” and take their money and run, given the bubble levels already attained in equities, some bond markets, and real estate? And should the Fed continue to raise interest rates at a pace of 3 to 4 a year, what will be the impact on the US real economy?

Economic potholes are beginning to appear in a number of places. Bank lending to US business has declined sharply, now growing at only 2%; consumer loans for auto, mortgages and credit cards have halved over the past year; real investment and productivity have nearly collapsed; the so-called “Trump Bump” has dissipated; government investment has contracted below 2007 levels and infrastructure spending is still but a discussion envisioned for 2019 at the earliest, if at all; and job growth has been consistently low quality, resulting in wage stagnation or worse for the vast majority of the labour force.

In this unstable environment the Fed has nonetheless has announced plans to continue to raise interest rates and to begin selling off its balance sheet. The question is just how much and when? Consensus thinking at the Fed is that rates can continue rising 3 to 4 times a year at .25 basis points a crack through 2019 without serious negative effects. And that the Fed’s balance sheet can start selling off immediately in 2017, initially at a modest rate of $10 billion a month, accelerating further at a later date.

But these were the same central bankers who believed their QE and zero bound rate programmes would return the US real economy to robust growth by 2010 but didn’t; who maintained the Fed’s massive liquidity injections would attain a 2% goods and services inflation rate, which it still hasn’t; who argued that once unemployment fell to 4.5% (in the US), wage growth and consumption would return to past trends and stimulate the economy, which has yet to occur; and who argued in 2008, also incorrectly, that Fed QE programmes providing bankers virtually free money would stimulate bank lending and in turn real investment and growth. The Fed’s latest predictions could prove no more correct about the consequences of further rate hikes and balance sheet reductions than they were about QE, ZIRP, and all the rest for the past eight years.

It’s Not Your Grandpa’s Global Economy

To assume that selling off that magnitude of securities – even if slowly and over extended time – will not have an appreciable impact on nominal interest rates is the kind of assumption that resulted in previous predictive errors circa 2008 since the possible effects on investors’ psychological expectations of more rate hikes and balance sheet selling are completely unknown.

After eight years of treating symptoms and not the disease, the global financial system has become addicted to super-low rates and to continued central bank excess liquidity provisioning. What started in 2008 as a massive, somewhat coordinated central bank lender of last resort experiment – i.e. global bank bailout – has over the past eight years evolved into a more or less permanent subsidisation of the private banking and financial systems by central banks. The system has become addicted to free money. And like all addictions, the habit won’t be broken easily. That means central bankers’ plans to raise interest rates in the immediate months ahead will likely “hit a wall” well before the announced rate levels they are projecting. Plans to sell off balance sheets will almost certainly be limited to the US Fed for some time. The ECB and BOE – as well as Bank of Japan and others – will wait and see what the Fed does. The Fed will proceed at a snails pace that will represent little more than mere tokenism, and in the event of further slowing of real GDP growth, or US financial markets correcting in a major way, it will halt selling altogether. In short, there will be little Fed balance sheet reduction before the next recession, and a continued escalation of balance sheets by central banks globally. Central banks will enter the next recession with further bloated balance sheets.

After eight years of treating symptoms and not the disease, the global financial system has become addicted to super-low rates and to continued central bank excess liquidity provisioning.

The Fed is thus on the verge of another major disastrous monetary policy shift and experiment. It will be unable to raise interest rates as it has announced, by 3 to 4 times a year for the next two years. Nor will it be able to sell off much of its current balance sheet, since anything but token adjustments will accelerate rates even higher. In this writer’s opinion, the federal funds rate cannot be raised above 2%, or the 10 year Treasury yield much above 3%, without precipitating either a serious financial market correction or an abrupt slowing of real economic growth, or both.

What the eight years since the 2008-09 financial crash and great recession reveals is that the major central banks, led by the Fed, have painted themselves in a corner. The massive liquidity provided to their banking systems – engineered by zero rates and QEs – failed even to adequately bail out their banks. Today more than $10 trillion in non-performing bank loans still overhang the major economies, despite the more than $20 trillion added to their central bank balance sheets in just the past eight years.

The fundamental changes in the global economy and radical restructuring of financial, capital and labour markets have severely blunted central banks’ main monetary tool of interest rate management.

The fundamental changes in the global economy and radical restructuring of financial, capital and labour markets have severely blunted central banks’ main monetary tool of interest rate management. Just as reduction of rates have little positive effect on stimulating real investment and economic growth, rising rates will have a greater negative impact than anticipated on investment and growth. The Fed and other central banks may soon discover this should they raise rates much faster and further or engage in more than token balance sheet reduction.
Central bankers at the Fed, the BOE and ECB will of course argue the contrary.

They will promise the economy can sustain further significant rate hikes and can commence selling its balance sheet without severe negative consequences. But these are the same people who in 2008 promised rapid and robust recovery from QE and ZIRP programmes that didn’t happen. What happened was an unprecedented acceleration in financial asset markets as equity and bond prices surged for eight years, high end real estate prices rose to prior levels, derivatives boomed, gold and crypto-currencies escalated in value, and income inequality soared to record levels – all fueled by the massive $10 trillion central bank liquidity injections that drove interest rates to zero or below. And now they tell us they plan to raise those rates without serious negative effects. Anyone want to buy the Brooklyn bridge? I think they’re also trying to sell that as well.

About the Author

Dr. Jack Rasmus is author of the just published book, “Central Bankers at the End of Their Ropes? Monetary Policy and the Next Depression”, Clarity Press, July 2017, and the previously published “Systemic Fragility in the Global Economy”, also by Clarity Press, January 2016. For more information: http://ClarityPress.com/RasmusIII.html. He teaches economics at St. Marys College in Moraga, California, and hosts the radio show, Alternative Visions, on the Progressive Radio Network. He blogs at jackrasmus.com and his twitter handle is @drjackrasmus.

References
1. For the author’s 2016 analysis of global financial restructuring, Systemic Fragility in the Global Economy, Clarity Press, January 2016.
2. The theme of how central banks’ interest rate policies are failing is addressed in more detail in the just published book, Central Bankers at the End of Their Ropes: Monetary Policy and the Next Depression, by Jack Rasmus, Clarity Press, July 2017.

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