In the northern hemisphere, March sees the first signs of spring. Temperatures rise, life and energy start to return and the pace of activity quickens. But this year, it is not only Nature that is coming out of the long dark days of winter. For across much of the developed world, there are unmistakeable signs that economies are coming back to life and vigour too. Growth in all of the major economies is at last becoming more firmly established, and in the US, Eurozone and the UK, inflation is also beginning to creep up.
And this means that, after seven long years of unorthodox monetary policy, the major central banks are beginning to consider not just if, but when and how to return to more normal operations. Last Thursday, Mario Draghi, the president of the European Central Bank, said that while the ECB’s interest rates would stay unchanged, there was “no longer a sense of urgency for taking further actions” on monetary stimulus, and later this week the US Federal Reserve is almost universally expected to raise its official interest rates.
Nor, unlike in 2015 and 2016, is the Fed likely this year to be “one and done” – in both the last two years, the first increase in Fed Funds rate was also the last of the year, but this year most market commentators are pencilling in at least one and possibly two further rises after Wednesday’s expected hike.
But if interest rate rises are well and truly back on the agenda in much of the G7, another consequence of the unorthodox policies of recent years is still very much with us. Central bank balance sheets remain very large indeed – well over 20% of GDP for the Fed, the ECB and the Bank of England and very much more than that for the Bank of Japan. And there are few signs that this is about to change any time soon.
The lack of action does not mean that the subject has not been hotly debated within central banking circles. Central bankers have been discussing what constitutes the optimal longer-term size and composition of central bank balance sheets almost since the moment the policies of zero interest rates (ZIRP), quantitative easing (QE), and large‑scale asset purchases (LSAPs) that created today’s bloated balance sheets were initiated. And for every central banker who argued that there was no alternative to QE, there was a colleague who asked “where will this lead, and how do we end it?”
This caution about what one central banker called at the time “a lobster pot of a policy, easy to get into but impossible to get out of and ultimately likely to prove fatal to sound money” was overruled in the dark days around the start of the current decade – the counter argument of “we must do something, this is something, so we must do it” won the day in central bank policy circles. And, despite concerns that these policies had only dubious grounding in standard monetary theory, the result has, in many ways, been successful – the developed economies avoided a repeat of the 1930s Great Depression, and as we have seen, growth has finally returned to most of them.
But the question the doubters posed seven years ago has not gone away. Where indeed does QE lead, and is there a way to end it? And behind this question there are others, more fundamental and more difficult to answer, such as what the role of the central bank is in an economy and what its optimal involvement in a free market should be.
No central bank can afford to be totally indifferent to the markets or totally divorced from them, but there is a thin dividing line between involvement in a market to improve its operation, and interference with a market which is so great that it impairs its independent existence and functioning.
This last has haunted central bankers throughout the period of QE: at various times in the last seven years, such has been their direct involvement in markets that markets have been in danger of ceasing to act as a window through which central banks can see how the economy is working, instead becoming a mirror, showing the central bankers only how their own policies are working.
So, the desire to end the experiment of QE is felt keenly, partly because of the natural wish to be able to declare “mission accomplished, crisis over”, but partly also to return markets to an independent existence from which central banks can once again derive useful information.
But in order to take the debate from within their own councils, and bring it out into the public domain, central banks will need to address three specific issues, and create a coherent narrative for all three.
First, they will need to be able to answer the line that “In the good old days (i.e. pre-2007, pre-2000, pre-1986, pre-1970 – pick the period and rose-tinted spectacles of your choice) life was good, economies worked and central banks had small balance sheets. If we can only get back to small central bank balance sheets then the good life and prosperous economies will return”.
This is simplistic, and it should be easy to rebut – it confuses coincidence and causality, and ignores all the other changes since QE was brought in, not least the effect that very low interest rates have had on the interaction between bank reserves and interest rate policy. But it is so seductive an argument that central bankers cannot assume that it will not need their careful attention.
Second, they will need to have a coherent theory for whether the impact of the central bank balance sheet on an economy is predominantly a stock matter or a flow matter. Is it the fact of having a large balance sheet that matters, or is it the act of growing it? And at the end of QE, is the return to normality when the central bank balance sheet stops growing, or when it shrinks back to some predetermined and smaller size? (And if so, what size?)
In short, what does the end of QE look like, even in theory? Central bankers have been asked for a definitive answer to this for over five years, and have never once produced a convincing one. The implication is that central bankers themselves have not yet agreed among themselves on the answer, either to this or to the related question of how the size of their balance sheet impacts other market participants. But they cannot hope to win any support from the politicians or the public for any proposed course of action until they can publicly display a consistent and coherent analysis of the issues.
And third, if central bankers decide that their balance sheets should shrink, they will need to both have and then articulate to the public a very clear idea of how to do it, how fast to do it, how far they intend to pursue it and what the responses of the economy and markets are likely to be as they do so. Until they do, it would be reckless to start the process – they could cause real damage to all three of the economy, the markets and not least their own reputation if the process goes wrong.
These, especially the latter two, are not easy questions for central bankers to address. The unorthodox nature of much of recent monetary policy – ZIRP, QE and LSAPs – means that, just as there was no rulebook for how to conduct them, there is no rulebook, no vade mecum, for how to end them. But whereas the scale and urgency of the crisis seven years ago meant that central bankers had then to be brave and unorthodox, or face an economic crash of 1930s proportions, there is no such urgency now, no such need to gamble the economy’s future on an untried policy change.
Recently, though, some central bankers have started to try to open the dialogue on balance sheet size. A thoughtful speech by Lael Brainard, a member of the Fed’s Board of Governors, at the start of the month accepted that the issue needs discussion and suggested that interest rate levels and balance sheet size were independent of each other – in other words, either could be used independently of the other when the economy needed stimulus to be added or withdrawn.
Implicit in Ms Brainard’s analysis is that the Fed’s balance sheet does not need to be shrunk as policy returns to normal; indeed she posits that it should not be, to allow more room for the interest rate lever to take precedence in the coming months, although this remains the minority view for the moment among central bankers, most of whom do still expect central bank balance sheets to shrink as a percentage of GDP as policy is normalised.
But at least Ms Brainard has fired the starting gun for the necessary and wider task of analysing exactly what QE has done and is doing, determining exactly what size balance sheet is optimal, and announcing exactly how to achieve it. The long haul back to more orthodox monetary policy, and eventually more normal interest rate levels, is gathering pace.
A version of this article was published earlier as a Guest Comment by Llewellyn Consulting