As global economic growth continues to improve major central are looking at the pathways they might take to return monetary policy settings from abnormally accommodative to normal. They face many challenges in the next few years taking monetary policy from abnormal setting to normal setting one of which is determining what a normal policy setting looks like. For some the issue is not just one of what constitutes a normal setting of their policy interest rate but is also an issue of what a normal-sized balance sheet looks like. Whatever normal looks like, there is a sense developing that abnormally accommodative policy settings are at best inconsistent with a now quite robust recovery in the global economy and at worst are distorting spending and investment decisions that may prove a threat to longer-term economic growth prospects.
Looking back there is little doubt that the extraordinary monetary policy easing moves in the wake of the 2008 global financial crisis and subsequent sharp fall in global economic activity helped the world to avoid an economic catastrophe. The prolonged phase of very easy monetary conditions also helped to slowly foster a pick-up in economic growth. For a time, growth was compromised by slow lift in credit as banking systems struggled to recover, much weakened and in some cases broken in the series of crises starting in 2008 but continuing through the European sovereign debt problems in subsequent years.
There was a strong case for many countries to leave very easy monetary conditions in place until the health of banks and stronger economic growth were more assured. The case was strengthened further by persistently low inflation. The fact that inflation has stayed relatively low implies that excess productive capacity still exists in many economies, even those that have been growing well for some time and are now growing at a pace consistent with growing inflationary pressure according to past experience.
In the US, the case for leaving very easy monetary conditions in place became untenable during 2015 as the economic recovery already three years old was fostering better bank credit growth, strongly rising employment and falling unemployment. The move away from very easy monetary conditions has been an ultra-cautious affair, initially a tapering down of monthly bond purchases accompanied by a very slow lift in the Federal funds interest rate from near-zero to currently 1.25%. The Federal Reserve’s balance sheet is still at its maximum size reached during the various quantitative easing phases post global financial crisis, $US4.2 trillion. The funds rate still sits around half a percentage point below the US annual inflation measure. In short, US monetary policy is still growth accommodating.
The next two-day US monetary policy meeting occurs on Tuesday and Wednesday this week. The Fed seems unlikely to change interest rates at this meeting although in earlier statements it has indicated another interest rate rise is likely later this year (probably in December) taking the funds rate to 1.50% and ahead of another three rate hikes next year which would take the funds rate to 2.25% by the end of 2018. What the Fed may do at the meeting this week is announce the start of selling down assets from its balance sheet. This is the opposite of quantitative easing causing a reduction in liquidity in the financial system as the Fed starts monthly sales of bonds and mortgage-backed securities to the market. The Fed has indicated previously that it will initially sell $10 billion of bonds to the market each month over the first three months, escalating the sales every three months until it reaches $30 billion a month of sales late in 2018.
The Fed has indicated that it will be sensitive to market reaction to its sales and can readjust accordingly. The problem is judging what order of market reaction the Fed will tolerate. Interest rate, including US interest, are currently still so low that they are helping to prime too much borrowing by some and arguably are adding to over-valuation in the US share market. The Fed probably wants to see US interest rates rise, but not too much or too quickly. The next phase of normalising US monetary policy has all the hallmarks of becoming a prolonged stop start process.
Even if US monetary policy normalisation goes roughly to the Fed’s current plan another six 25bps interest hikes come between now and the end of 2019 – a funds rate of 3.00% by end 2019. More likely the interest rate hikes will be more spread out in practice.
The Fed’s apparent plan for its balance sheet would see around a $US500 billion reduction by end 2019 to $US3.7 trillion and another eight years ahead selling down at $US360 billion per year to get down to below$US1 trillion. Again, this may drag out much longer in practice.
Just normalising monetary policy means that the US may face a decade and more of interest rates climbing erratically. The time frame may be even longer for countries and regions that have not started normalising yet such as Europe and Japan.
In Australia, monetary policy was never as abnormally accommodative as elsewhere, but it has been abnormal enough to leave a cash rate sitting more than half a percentage point below the annual inflation rate and persistent incentive for households to borrow too much and chase house prices too high.
The normal cash rate for the Australian economy growing around potential and with inflation around 2.5% (not that far from where the economy is now) would seem to be around 3.00%, perhaps higher. At some point, the RBA will start delivering several interest rate hikes. Perhaps the worst part of living with abnormally low interest rates for so long is that abnormal becomes normal. The Australian financial market, households and businesses are unprepared for the turn towards higher interest rates developing globally over the next few years.