The unprecedented response of central banks to the global financial crises has fundamentally changed the framework and nature of central banking by blurring the lines between fiscal and monetary policy, according to Stephen Cecchetti, outgoing chief economic adviser to the Bank for International Settlements (BIS).
Now that the U.S. Federal Reserve is preparing to exit from quantitative easing, the issue for Cecchetti is what central banks are exiting to and what the future operating framework will be.
One thing is clear to Cechetti: “We are not going to go back,” he told Central Bank News in an interview.
Later today the board of the BIS is expected to pick a successor to Cecchetti, who is leaving as planned after a five-year term as adviser.
As part of their response to the crises, major central banks slashed their policy rates to essentially zero and stuffed their balance sheets with assets that traditionally were never held by central banks, be it the Fed’s purchases of mortgage-backed securities of the Bank of Japan’s purchases of corporate debt.
In the years to come, the balance sheets of major central banks will slowly shrink as they exit quantitative easing, but they are likely to remain much larger than before the crises, Cecchetti said.
This will have consequence for central banks’ operational framework.
One of the lessons from the massive expansion of central banks' balance sheets is that the composition, or maturity structure of their assets, matters much more than previously thought and affects the yield curve more than most people accept.
Just as the mandates of many central banks have been widened to include responsibility for financial stability, the tools used by central banks to guide economic activity have multiplied and are now much more targeted and refined compared with the relatively blunt tool of a single benchmark interest rate.
Central banks are now targeting specific economic sectors rather than just providing credit to the banking sector, whether this targets small businesses, the housing sector or the dairy industry.
A few examples of the tools that target an economy’s specific sectors include the Federal Reserve’s purchases of housing-related debt, the countercyclical buffers being introduced by the central banks of Norway and Switzerland to cool property prices and Sri Lanka central bank’s loan scheme for its dairy industry.
Another consequence of the change in U.S. financial markets since the crises is that the Federal Reserve may pick a new operational target for implementing monetary policy.
“I am not sure the Fed in the future will target the overnight unsecured interbank lending rate,” Cecchetti said, referring to the fed funds rate.
Since the early 1980s the Federal Reserve has used open market operations – typically the sale and purchase of treasury securities – to affect the fed funds rate, which is used by banks when they lend excess reserve balances at the Fed to each other overnight.
“The reason is that there may not be a very big market because banks will be more hesitant to lend unsecured to each other,” he added.
At this point, the fed funds rate is largely symbolic as it was cut to between 0 and 0.25 percent in December 2008 in response to the crises and probably won’t be raised until 2015 when the U.S. jobless rate is forecast to fall the 6.5 percent, one of the Fed’s two thresholds for raising rates.
“Maybe they are going to pitch some other operational target,” Cechetti said, suggesting repurchase rates.
And there are indeed growing signs that the Fed is preparing to use new tools in the world post-QE.
Since 2009 the Fed has carried out several reverse repurchase agreements with its primary dealers to test the operational readiness of such a tool.
Most recently, the New York Fed said on Aug. 5 that it would be conducting another series of small-value reverse repurchase transactions using Treasury and mortgage backed security collateral “to ensure that this tool will be ready to support any reserve draining operations that the Federal Open Market Committee might direct.”
During the April meeting of the FOMC, the Fed’s policy-making body, several members raised the possibility that “the federal funds rate might not, in the future, be the best indicators of the general level of short-term rates,” according to the minutes from the meeting.
Then at the July meeting, Fed staffers briefed the FOMC on how an overnight reverse repo facility could be designed as a possible complement to the payment of interest on banks excess reserves to improve the Fed’s “ability to keep short-term market rates at levels that it deems appropriate,” according to the minutes.
While Cecchetti admits that has no insight into the Fed’s decision-making process, he is familiar with its inner workings.
Among the positions Cecchetti held before joining the BIS in 2008 was executive vice president and director of research from 1997-1999 at the Federal Reserve Bank of New York, the arm of the Fed that implements monetary policy through market operations.
Though the Fed says that “no inference should be drawn about the timing of any change in the stance of monetary policy” from the tests of repo rates, it adds that they are “a matter of prudent advance planning by the Federal Reserve.”
The main issue that Cecchetti and the BIS has with the larger role of central banks in economic policy is that it has blurred the lines between fiscal and monetary policy, thus threatening their independence.
“What you now see is that central banks can essentially subsidize certain kinds of activities in the real economy through their balance sheet manipulation and that is a concern to me because we had always drawn a line between fiscal and monetary policy,” he said.
Cecchetti doesn’t fault central banks for taking the decisions they took during the height of the global financial crises, but questions how you can describe the Federal Reserve’s purchase of substantial amounts new mortgages since 2009 and 2010 as solely a monetary policy operation.
“We are going to have a hard time pulling back from this quasi-fiscal nature with their balance sheets. That is my biggest concern,” Cecchetti said.
Cecchetti first warned in May that the process of exiting quantitative easing by the Federal Reserve would trigger financial market volatility and he expects foreign exchange rates to continue to move a lot, presaging further volatility in the months ahead.
"You will see policy adjustments that can be pretty big as some central banks will be tightening while others are continuing to ease at the same time," he said.
"There will be interest rate volatility, there will be exchange rate volatility, there will be a need for different policy paths as some economies are going to be recovering and others not."
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