The world’s major central banks are declaring last orders at the punchbowl.
The Federal Reserve — which has been raising interest rates since 2015 — takes the next step toward normalizing monetary policy this month when it starts to reduce its $4.5 trillion balance sheet. The European Central Bank is expected to soon lay out its own plans for cutting asset purchases, possibly followed by a rate increase by the Bank of England in November. The Bank of Canada has already raised borrowing costs.
The trick for policy makers gathering this week in Washington for the semi-annual meeting of the International Monetary Fund is to scale back their support without hurting the global economy by upsetting financial markets that have been juiced by monetary largesse for years.
It’s “the end of an era,” Ray Dalio, who leads the world’s largest hedge fund at Bridgewater Associates, said in a Sept. 21 report for clients. The world economy and the markets are “entering a more dangerous time,” he co-wrote in the report, according to a money manager who’s seen it.
Compounding the difficulty: uncertainty over who’ll lead the world’s most powerful central bank, with Vice Chairman Stanley Fischer about to step down and Chair Janet Yellen’s term expiring in February.
“There is at least a risk that we see some unraveling in the markets” as central banks exit from quantitative easing, said Joachim Fels, a global economic adviser of Pacific Investment Management Co.
For now at least, all looks well on the economic front. The global expansion is coming off its best quarter since 2010 and the underlying momentum looks strong, Bruce Kasman and his fellow economists at JPMorgan Chase & Co. said in a Sept. 29 report.
“It feels like the global economy is in something close to a synchronous upturn” for the first time in years, said David Stockton, a former Fed official who is now a senior fellow at the Peterson Institute for International Economics in Washington.
Central bankers are moving to take advantage — even with inflation below their targets. Bloomberg Intelligence Chief Economist Michael McDonough sees net asset purchases by the central banks falling to a monthly $33 billion at the end of 2018, from $131 billion in September.
Interest rates also are going up in some countries. Both the Fed and the Bank of Canada have boosted rates twice in 2017 and U.S. policy makers have penciled in one more increase before year-end.
Not every central bank is turning to tightening, of course.
The People’s Bank of China, whose benchmark interest rate remains at a record low, is balancing a push to slow overall credit growth without hurting the economy. Japan is nowhere close to curbing its monetary support and Australian and South Korean rates also remain at lows.
“We don’t have to raise interest rates just because they’re going up elsewhere overseas,” Bank of Japan Governor Haruhiko Kuroda told reporters last month.
Those policy makers who are moving are doing so gingerly. The Fed’s plan to pare its balance sheet has been months in the making and starts off with asset reductions of just $10 billion per month. ECB President Mario Draghi has stressed that any change in policy will be gradual and ensure significant monetary support remains.
The Fed’s “well-advertised, well-anticipated, very gradual wind down in the balance sheet isn’t going to have much effect,” said former Fed Vice Chairman Donald Kohn, now a senior fellow at the Brookings Institution in Washington.
What’s more, no matter how much they cut back on stimulus, central banks are unlikely to return to the pre-crisis economic environment any time soon, if ever. The Fed, for example, ran a balance sheet of less than $1 trillion prior to 2008 and its benchmark rate was as high as 5.5 percent in 2006, compared with its current 1 percent to 1.25 percent target range.
So far, the measures haven’t fazed frothy financial markets. Global stock markets are trading at or near record highs while corporate bond spreads are around post-financial crisis lows. The fallout in currency markets also has been limited by the fact that a number of central banks are moving in tandem.
But joint action carries risks as well, potentially amplifying the impact of individual central bank moves.
“One wouldn’t want to be too assured that once everybody is kind of moving in the same direction, that there may be some discontinuities in markets,” former Fed Governor Daniel Tarullo said. After all, “we’ve never done this before,” he added, referring to the rollback in quantitative easing.
Ebrahim Rahbari and his fellow Citigroup economists see a “material risk” that the tapering of bond purchases by central banks could puncture asset prices and drag down global economic growth.
In some ways, policy makers have no one to blame but themselves for the delicate situation they now find themselves in. The danger is they’ve let the party go on too long, and it’s already too late.
“Asset prices of all sorts have gotten way out of line with historic experience,” Harvard University professor Martin Feldstein said in an Oct. 6 interview with Bloomberg Television. “The real danger is that, as that unwinds, it could bring down consumer spending, it could bring down economic activity.”