The marathon of monetary policy normalization begins

The marathon of monetary policy normalization begins

Major central banks are about to start unwinding unconventional support measures launched during the COVID pandemic. The monetary policy normalization process will be slow. What kind of risks does the process pose to investors?

The Fed chairman Jerome Powell made the most expected speech of the year last Friday in the Jackson Hole central banking conference. Jackson Hole is a prestigious annual get together of world’s most prominent central bankers, other policy makers and academics.

Former Fed chairs have occasionally used this setting to clarify the Fed thinking on the possibilities and limits of monetary policy, or to hint at major policy changes. After the dot-com bubble Alan Greenspan explained in detail in his year 2002 speech that monetary policy cannot be used to deflate a stock market bubbles. Ben Bernanke used the occasion both in 2010 and 2012 to suggest a new round of large-scale bond purchases by the Fed in the aftermath of the global financial crises.

This year, chairman Powell didn’t use this platform to reveal anything that interesting to investors. Perhaps expectations on this highlight of the central banking year are geared up too high. Market participants expecting major announcements are usually disappointed. When something interesting has been revealed, the timing has been just right. Like with Bernanke’s two speeches, which were preceded by worsening economic and financial conditions over the summer.

What did Powell say? Well, he basically just reiterated the consensus view of the Federal Open Market Committee (FOMC) from the July meeting. Progress is made toward maximum employment, and inflation is expected to return to levels consistent with the Fed’s goal of inflation averaging 2 percent over time. This implies that if the economy evolved broadly as anticipated, it could be appropriate for the Fed to start reducing the pace of asset purchases in the autumn.

Powell could have provided a more detailed timeline for ‘tapering’, that is, scaling down the asset purchase programs. And perhaps a more specific plan how fast the tapering of treasuries and of MBS (Mortgage-Backed Securities) purchases will proceed. The housing market is running hot in the US, S&P/Case-Shiller home price index is almost 20% up year-on-year. The continued support by the Fed for the housing sector is questionable.

The Fed sees the recent spike in inflation still to be transitory. Inflation has hovered around 5% for the last three months. The newly established monetary policy strategy focuses on average inflation over time, and thus allows inflation to exceed the 2% level when inflation has been muted for a long time. Inflation running at 5% is, however, certainly a case for concern for the Fed policymakers. It is wise to look through the COVID related transitory price shocks. But a wise central banker monitors price developments closely and is ready to act if price pressures stay elevated for an extended period.  

Markets cheered Powell’s cautious approach to tapering, in the US equity prices rose and treasury yields edged lower. Why was the bond market reaction so calm? One thing is that Powell just repeated the earlier message of the FOMC. The other thing is that he underlined that tapering the purchase program does not give any guidance on the first rate hikes in the future. This was the most important message to the markets. The Fed policymakers wanted to make sure that the so called ‘Taper tantrum’ of 2013 would not happen again. Back then Bernanke’s communication on the tapering of the asset purchase programs was interpreted to imply a start to a series of rate increases. Failed communication caused unintended financial turbulence globally, especially in the Emerging Markets.

That’s all for the Fed’s approach to tapering. Much ado about nothing, a reader might think. Well, prominent central bankers are listened carefully by the markets, even though they quite seldom say anything super interesting.

Much of the monetary policy normalization debate focuses on the US. This is quite understandable, as the economic rebound from the deep downturn caused by the coronavirus has been strong and the repercussions of Fed’s policy actions are felt all around the world. In eurozone the discussion on tapering will surely intensify during this autumn. Eurozone inflation hit 3% in August, up from 2.2% in July. Is it time to exit from the crisis mode in eurozone as well?

Higher than expected inflation figures will surely be discussed in the ECB’s Governing Council meeting next week. Sure, the newly revised monetary policy strategy with a symmetric inflation target of 2% will give more room to tolerate inflation running higher than the old ‘close, but below 2%’ target. But there will concerns about high inflation and continued asset purchases among the ECB policymakers.

Quite interestingly, the ECB might start unwinding the crisis measures in sync with the Fed during the autumn. In principle, the ECB could decide on the tapering already next week, when also new macroeconomic projections are released. The more likely moment for the decision is in December, when the projections are released next time. This schedule would allow ECB policymakers to observe whether inflation continues to surprise on the upside. It would also give the first mover position to the Fed. Fed’s FOMC will convene in late September and will release new macroeconomic projections. This would be the optimal time to announce the tapering, provided that the COVID situation isn’t getting worse.

Should investors be worried about the upcoming tapering decisions? I don’t think so. When the central bank rates are at zero and large asset purchase programs are in place, the effective policy rates are negative. When the purchase programs are gradually scaled down, the effective rates will approach zero from below. Financing conditions will continue to very supportive for a long time.

This autumn we may well see the first steps toward normal times in monetary policy. The path will be long and slow. Tapering is only the first step, which will be followed by interest hikes, positive real rates and eventually scaling back the balance sheets.

It seems quite obvious that both the Fed and the ECB will be extremely cautious in winding down crisis-era stimulus measures. The real risk is not that the central banks withdraw support measures too quickly. On the contrary, the greater-than-before tolerance to inflation both in the US and in the eurozone leads to more moderate pace in tapering and in rate hikes and creates risks to policy errors, which might cause macroeconomic and financial instability down the road.

Monetary policy normalization is a marathon. And it seems that central bankers on both sides of the Atlantic have decided to start the race very slowly.

September 3, 2021
Anssi Rantala
Senior Advisor / Chief Economist