The recent pronouncements of a succession of central bankers have veered into hawkish territory. In combination, their rhetoric has triggered markets to reappraise the speed at which monetary policy will be tightened. This has led some market commentators to suggest there has been a behind-the-scenes agreement to tighten policy.
This suggestion seems wide of the mark. The comments – by Mario Draghi of the European Central Bank, Mark Carney and Andy Haldane of the Bank of England, Stephen Poloz of the Bank of Canada, a raft of U.S. Federal Open Market Committee members, and the Swedish Riksbank – surprised markets for their uniformly hawkish tone. They are unlikely to have been coordinated. But they are correlated in the sense that central bankers are responding to the same global economic conditions. In many economies, growth in activity has picked up and unemployment rates have fallen. And while inflationary pressures remain stubbornly subdued for the time being, the improvement in economic activity should eventually cause inflation to rise. In some cases, the latest shift in central-bank rhetoric also appears to be motivated by concerns about financial stability.
Activity growth has picked up and unemployment rates have fallen. This should eventually cause inflation to rise.
Reading the runes
Central-bank “speak” is always closely followed for hints about the future course of monetary policy. In response to the aforementioned comments, 10-year bond yields rose by between 20 and 40 basis points across much of the developed world; in some cases, bond yields are now above levels reached around the turn of the year, when the “Trump reflation trade” was in full swing.
The coordination mirage
Financial markets have a record of seeing policymaker coordination where none exists. One only has to go back to April 2016, when speculation was rife that an additional “Plaza Accord” style agreement had been put in place among the G20 economies to weaken the dollar; yet, by late 2016 the broad trade-weighted dollar had actually appreciated to highs last reached in 2002.
Central banks have certainly coordinated policy in the past. For example, in 2008 they cut interest rates together in response to the deepening global downturn, and in 2011 they helped prevent runaway appreciation of the Japanese yen following a devastating earthquake. And the G20 economies agreed to a coordinated fiscal stimulus in 2009, as global aggregate demand was weakening. But these were special measures appropriate to special circumstances. Today’s economic backdrop hardly calls for those levels of global policy coordination.
Nevertheless, the latest bout of central-bank speak is no doubt correlated, in the sense that policymakers are responding to similar global economic developments. In particular, activity growth has picked up and unemployment rates have continued to fall. In the U.S., unemployment is below the U.S. Federal Reserve’s (Fed’s) estimate of the “natural” rate that is consistent with stable wage growth, while unemployment rates in many other developed economies are rapidly approaching a similar point. Broader “output gap” measures suggest dwindling or even zero spare capacity in most developed-market economies. While wage pressures remain modest, core inflation is below target and inflation expectations are contained almost everywhere, the implication is that they should all rise over time. This appears to justify a gradual reining in of the degree to which monetary policy is stimulating the economy.
The latest change in tone may also reflect an additional concern – that low interest rates are fostering financial instability by promoting bubbles in asset prices and stimulating excessive credit creation. The minutes of the Fed’s June meeting noted that “some participants suggested that increased risk tolerance among investors might be contributing to elevated asset prices more broadly; a few participants expressed concern that subdued market volatility, coupled with a low equity premium, could lead to a build-up of risks to financial stability.”
The Bank of International Settlements, known as the “central bankers’ central bank,” seems to share this concern. In its latest Annual Report, it argued that “even if inflation does not rise, keeping interest rates too low for long could raise financial stability and macroeconomic risks further down the road, as debt continues to pile up and risk-taking in financial markets gathers steam.”
Comparing the costs
Central banks are right to take risks to financial stability seriously. The relevant question is how to deal with these concerns. Loose monetary policy may come at the cost of fostering financial instability. But the costs of tighter monetary policy may be lost output, higher unemployment and a failure to meet the inflation target. A sensible assessment of the appropriate stance of monetary policy must take these trade-offs into account. Indeed, recent academic work suggests that large increases in short-term interest rates – based on financial stability considerations alone – involves costs that well exceed the benefits. In short, interest rates are too blunt an instrument to deal with financial-stability concerns.
Central banks are right to take risks to financial stability seriously.
The best tools for the job of warding off threats to financial stability appear to be regulation, supervision and macro-prudential policy. None of these are perfect; they certainly do not guarantee that financial-stability risks have been banished. But stress-testing banks, raising capital requirements and ensuring mortgage borrowers are capable of continuing repayments, even if interest rates should move significantly higher, don’t carry the same risks to output and employment that conventional monetary-policy tightening does. In the years ahead, financial markets may do well to expect more macro-prudential measures and a little less monetary-policy action.