Theme: Monetary exit policy – this time is different
Global monetary policy is historically expansionary. Real key interest rates are sharply negative and the world's central banks have been “printing money” – boosting their assets by over USD 10 trillion − since the outbreak of the pandemic. But now their stimulus policies must be reversed without risking the recovery or triggering a fall in asset prices that may jeopardise global financial stability. The US Federal Reserve's rapid policy shift and its thoughts on balance sheet policy, as well as the Bank of England's exit strategy, are expected to provide guidance for other central banks as they move towards less expansionary policies. Aside from rate hikes, our scenario estimates that US quantitative tightening (QT) steps will have an effect on long-term bond yields equivalent to +15 basis points per year. According to our forecasts, overall global monetary policy will continue to stimulate growth and asset prices in 2022 and 2023.
During 2022-2023 the shaping and direction of global monetary policy will be greatly complicated by troublingly high inflation and the potential negative impact of COVID-19 outbreaks on production and labour markets, as well as by high asset values and growing economic inequality. Ever since the 2008-2009 global financial crisis − and most recently during the pandemic − central banks have used their key interest rates and balance sheets (for example, asset purchases) to stimulate economic recovery and reach inflation targets.
As GDP normalisation has progressed and inflation has climbed, central banks have been weighing various strategies for a policy mix that will lead to less expansionary monetary policies. In recent months, several major central banks led by the Federal Reserve have launched − or will soon launch − exit policies based on a) ending continued asset purchases, b) hiking key interest rates, c) trimming their balance sheets or d) combinations of these tools. Their exit policy experience is limited, while structural factors such as demographics and weak productivity have changed the playing field and manoeuvring room of central banks.
Complicated policy considerations
Early in 2022 central banks like the Fed, Bank of Japan (BoJ) and European Central Bank (ECB), are continuing to pursue expansionary policies by means of new asset purchases, while real key interest rates have become increasingly negative due to rising inflation. Their policies are now at a crossroads. The optimal design of a monetary exit policy the timing and speed of rate hikes and their interaction with quantitative tightening (QT) programmes raises important questions:
- How loose is their policy, and at what interest rate and balance sheet levels does it become contractionary?
- How can/should a monetary exit policy be coordinated with fiscal policy over the next few years? • How rate-sensitive are the often record debt portfolios of households, businesses and countries? Any buffers?
- How will financial conditions change for example yield curves, credit spreads, equities and currencies and what impact will this have on financial stability?
- What is the optimal level of a central bank’s balance sheet and monetary policy securities portfolio?
- How are a central bank’s finances affected when the funding cost of a domestic asset portfolio rises? Can this jeopardise its [financial] independence?
The aim of central bank policymakers is to design a monetary policy that is in harmony with fiscal policy and does not lead to an inflation-driving recovery, while contributing to further improvements in the labour market. Another task of monetary policy is to enable reallocation of resources and structural changes directly related to the post-pandemic environment and necessary solutions to the acute climate change crisis.
The need for faster monetary normalisation has increased in recent months, despite continued uncertainty about new COVID-19 outbreaks. Short-term stagflation tendencies are another policy challenge. But there is growing pressure for faster monetary policy adjustment halting asset purchases, then hiking rates and reducing asset holdings for two reasons: 1. economies are stronger with higher inflation and tighter labour markets and 2) monetary policy portfolios are record-sized in absolute terms and as a share of GDP.
To achieve less expansionary monetary policies, rate hikes are probably preferable to balance sheet reduction (QT), for several reasons. Central banks have far more experience with rate hikes, while transmission from interest rates and their impact on the economy and financial conditions are perceived as clearer. Today there is also a lot of uncertainty about how shrinking a monetary policy securities portfolio will affect the real economy. From a communications standpoint, rate hikes are also preferable because they provide the public with a clearer picture of the central bank's intentions.
How expansionary are today’s monetary policies?
To determine how stimulative these policies are, reference points are needed. It is not entirely clear how these reference points currently look. They are affected both by the impact of the pandemic on the functioning of economies and by long-term structural changes that are hard to ascertain, even under normal circumstances. Yet these reference points provide valuable information on when key rates will reach levels where monetary policies shift from easing to tightening the economy.
One such reference point is the neutral interest rate, that is, an interest rate that is compatible with normal resource utilisation. Calculations by the Fed show that neutral nominal rates in Europe and the US may be in the 2-2.5 per cent range, higher than current levels but far lower than in a historical perspective. Our analyses of the impact of the pandemic on the neutral interest rate, taking into account what central banks have communicated, conclude that normal key rates today may even be somewhat lower than 2.0-2.5 per cent.
Economic models usually view real interest rates (i.e. inflation-adjusted) over time as determined by the GDP growth trend, but various studies indicate that this relationship is relatively weak. In recent years, we at Nordic Outlook and other observers have noted that neutral interest rates are driven by structural changes that affect savings behaviour, the propensity to invest and since 2007 by rapidly growing public debt and central bank QE policies. The globalisation of capital markets also suggests that normal interest rates are at about the same level in most developed economies.
1 per cent of GDP = minus 5-7 basis points
There is also empirical evidence that the QE programmes we have seen in Japan since late 2001 and elsewhere since the global financial crisis have also helped push neutral interest rates lower. Our calculations indicate that global central bank assets have grown by more than USD 20 trillion since Lehman Brothers collapsed in 2008 equivalent to 23 per cent of global nominal GDP (2019). International studies show that expanding a central bank balance sheet by 1 per cent of GDP can put downward pressure on (long-term) yields of roughly 5-7 basis points. At the global level, this corresponds to 120-160 bps.
There are many indications that QE was most effective, directly and indirectly, when the programmes were introduced and the first purchases were made. QE sent a valuable signal that it would be some time before key rates began to be hiked again. Today’s concern is likely to be more about whether markets can absorb an increased supply of government securities. Market conditions also play a part; QE policy was introduced or expanded in an environment of economic and financial stress. How large the impact of QT will now be is hard to quantify.
The Fed’s latest exit process was very lengthy (see graph). In autumn 2019, market concerns about liquidity supply, and a sharp repo rate upturn, forced the Fed to launch another tool in 2021 (the Standing Repo Facility SRF) with a lending capacity of a full USD 500 billion. SRF is expected to be an important tool for ensuring US Treasury and repo market stability in coming years.
The Fed’s System Open Market Account (SOMA), its monetary policy portfolio, totals more than USD 8.2 trillion equivalent to 36 per cent of GDP and consists of 70 per cent government securities and 30 per cent mortgage-backed securities. The weighted average maturity of government securities is about 7.5 years (see chart for 2022-2027 maturities). Mortgage bond maturities will be moderate in the next five years.
The Fed’s QT and rate hiking strategy
The Fed’s message is that soon after its QE policy ends (in January and February it will buy another USD 90 billion in securities), it will hike its key interest rate and start shrinking its balance sheet. We expect a 25 bp hike in March and three more hikes in 2022. Starting in the second half, the SOMA portfolio will be allowed to start maturing. Given its maturity structure and the need for predictability and clarity, the Fed is setting a ceiling on the monthly amount it will allow to mature: USD 50 billion. This means about USD 600 billion 7 per cent of the total SOMA portfolio may fall due yearly in 2023- 2024. From 2025 onward, the Fed will need to actively sell government securities to meet the SEK 50 billion per month target (maturities will not be enough). All else being equal, our exit scenario will put upward pressure of up to 15 bps on long-term Treasury yields.
The Bank of England states that over GPB 70 billion of its government bond holdings will mature in 2022- 2023, or about 8 per cent of the original QE programme totalling GBP 875 billion. The BoE has said that the portfolio will be allowed to mature when its key interest rate reaches 0.50 per cent. We think this will happen as soon as February, making the BoE the first central bank to implement a QT policy. In 2024 and 2025, another GBP 130 billion worth of bonds will mature. As a next step, the BoE has announced that it may also be prepared to actively sell bonds, but only when the key rate has reached 1 per cent. This is expected to occur by next autumn. The experience of the BoE will provide valuable information for other central banks that are in the process of designing their own exit strategies.
From a central bank perspective, the advantage of implementing a QT policy is that the reduction in capital supply that occurs when central banks scale back their market presence may also push neutral interest rates higher. Such a process would make it easier for central banks to hike key rates and thus create future manoeuvring room by moving away from zero interest. But this will have consequences not only for servicing record-high public debt. It may also increase the cost of financing the digital and green transition. Based on the experience of Japan, QE policy has not created serious enough problems to make QT preferable to rate hikes.