CENTRAL-BANK policy is already being tightened. The problem is, 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 will restrict economic activity.
The first pillar of policy tightening is quantitative policy. Both the United States Federal Reserve (the Fed) and the Bank of England (BOE) are now tightening it. Although the Fed only intended to stop its bond purchases at the Federal Open Market Committee meeting last week, it has already been tightening. This is because the balance sheet of the Fed has begun to shrink as a proportion of US gross domestic product (GDP). In normal circumstances, that 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 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 BOE’s position is even more advanced: Its 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 is financial regulation. Financial regulation used to be a significant weapon in the armory 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 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 United Kingdom tightening policy in this manner, the European Central Bank (ECB) 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 BOE 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 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 increase, 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 BOE’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. Policy tightening will not only have different and direct consequences for financial markets—quantitative policy and bond markets being the most obvious—but also have indirect impacts through the reactions of consumers and companies. Central banks may tighten and ease policy at the same time, as the ECB is arguably 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 counties that seek to tie their foreign-exchange rates to developed economies, for interest-rate changes may cease to be the dominant policy tool (and if, for instance, US rates are kept lower 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 the managing director and deputy head of global economics of Zurich-headquartered UBS. He is responsible for formulating and presenting the UBS Investment Research global economic view, drawing on the bank’s worldwide resources.
Donovan took up philosophy, politics and economics at Oxford University. He holds an MSc in financial economics from the University of London.
In the Philippines his column appears exclusively in the BusinessMirror once a month.