On normalisation in abnormal times
19 March 2017
One of the few issues on which Janet Yellen and Donald Trump are likely to agree is that the Fed should not act as the world’s central bank, but should focus on the US. And yet the Fed has an outsized effect on the global economy. During the week, the Fed delivered a widely expected 25bp rate rise to 1%, and signalled that another two rate rises were likely in 2017. Global markets responded positively to this moderate pace of normalisation.
It is good to see interest rate normalisation commence in earnest – it signals that a recovery is taking hold – but this process is unlikely to be smooth sailing. Central banks have moved into uncharted waters in the post-crisis period, and unwinding these policies will likely create turbulence in the global economy – particularly given the current abnormal political context. Small economies have been acutely exposed to large country macro policy over the past few years, and provide a useful perspective on the economic and political risks in the normalisation process.
Indeed, running a central bank in a small economy has been a particularly challenging job over the past few years. QE in the US and the Eurozone has further constrained the already limited ability of small economies to independently operate monetary policy. Small advanced economies outside the Eurozone have been required to cut interest rates sharply to relieve upward pressure on exchange rates and to try to deliver on their inflation target. And in countries like Switzerland and Denmark, negative interest rates have been required.
However, these low interest rates have not been able to fully offset the upward pressure on exchange rates from loose monetary policy in the core. There has been strong appreciation in effective exchange rates in small advanced economies relative to large advanced economies over the past several years: examples include New Zealand, Hong Kong, Singapore, Israel, and Switzerland. This appreciation has made it harder to achieve inflation targets – and has led to a loss of export competitiveness that has compounded the effects of weak global trade growth.
This low interest rate environment has also created substantial pressures on house prices in small economies, which have risen sharply over the past several years from Denmark and Sweden to New Zealand and Hong Kong (and by more than in large countries). Some small countries, notably Singapore, have implemented aggressive macro-prudential policies in response.
So small country central bankers face conflicting pressures to lower rates to hit inflation targets and constrain currency appreciation, but at the risk of worsening financial stability. This led some central banks to move cautiously on lowering rates, even at the cost of below-target inflation. Large country critics such as Paul Krugman – who accused the Swedish Riksbank of ‘sado-monetarism’ for not lowering rates further – do not appreciate the complexities facing small countries.
Monetary policy normalisation from the Fed (and the ECB over time) will help to alleviate these issues. But normalisation will also bring a series of new challenges. The sustained period of low interest rates has led to stretched real estate valuations and high levels of household debt. As interest rates rise, there is potential for significant corrections in real estate prices – with a consequent impact on the real economy. In countries like New Zealand and Hong Kong, for example, where real property prices are up by over 50% since 2012, rising interest rates may lead to meaningful economic and financial stress. Normalisation will likely be as challenging to navigate as the QE period.
Normalisation will also create pressures outside small economies. Low USD interest rates have contributed to significant debt accumulation in many emerging markets, including China; rising interest rates and a strengthening USD may lead to stresses. The fact that the normalisation rate has been well telegraphed helps of course – as does the stronger growth in many emerging markets. Indeed, the relaxed market response in the past week contrasts markedly with the ‘taper tantrum’ in 2014. But significant risks remain.
In addition, normalisation is also likely to generate strengthened political pressures on central bank independence – in the US and beyond. There is increased public frustration with central bank independence – an institutional innovation pioneered in small countries like New Zealand and Sweden – because of the unorthodox policy decisions taken over the past several years. Some of this frustration has been due to the impact of QE on savers (in Germany, for example), but it is as likely that rising rates will create political pressure.
In the US, there is a distinct possibility of a more hands-on White House approach to the extent that normalisation cuts across President Trump’s policy priorities. Indeed, over the next few years, several Fed Governors need to be replaced by President Trump – who has a weak commitment to independent institutions. This could lead to significant changes in Fed policy behaviour. Political pressure on the ECB and the Bank of England is also possible, particularly to the extent that normalisation commences in the context of an anaemic jobs recovery.
My assessment is that the current political climate in developed countries is driven by a desire to take back direct political control from independent institutions as much as being against globalisation. Normalisation may create additional pressure on this fault line. We should not over-estimate the permanence of independent central banks, an institution that has been around for less than 30 years. Such change would increase the likelihood of ongoing loose monetary policy – and higher trend inflation – in some large countries.
Overall, the start of monetary policy normalisation is welcome but it will bring economic and political challenges. The post-crisis policy experimentation may lead to long-lived changes in the global economy. Normalisation is unlikely to be a smooth process. It is likely to be more like the turbulent seas of the 1970s than the Great Moderation of the 1990s.