A strategy on how to withdraw when you go to a war has been missing in the unconventional monetary policy
The party was in full swing on May 22, 2013, when Ben Bernanke presented a Congressional Testimony rather rhetorically that Fed would continue to buy $85 billion of bonds every month until unemployment rate fell to 6.5% from the current rate of 7.5%. The global financial markets scaled new heights. And then as if there was a power cut and the music stopped. The investors became more cautious after the minutes from the Fed?s last meeting showed that some members were prepared to start cutting the size of purchase as early as June 2013?just a few weeks away.
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First, the Testimony, where Bernanke mentioned that the housing market had strengthened, economic growth was improving and so was employment. But as nearly 8 million people were working part time even though they preferred full-time work, under-employment and unemployment were damaging the productive potential of the economy. The fiscal policy was an important drag on economic growth, which could slow the pace of real GDP growth by about a one and half percentage points during 2013, relative to what it would have been otherwise. Bernanke acknowledged that the current state of monetary policy in the US did not have the capacity to fully offset an economic headwind of this magnitude and advised the Congress to revisit the fiscal stance to ease the burden in short run while raising it in the long run.
There was a worry at the Testimony amongst the Congressman about the exit strategy. Just a week earlier, IMF Survey of May 16, 2013, had a discussion on exit strategy from unconventional monetary policies (UMP) of the advanced countries. The advanced countries were pursuing two broad objectives through UMP?to stabilise the financial markets and to provide further monetary policy accommodation at the zero lower bound. These objectives, obviously related, were successful, though only domestically, at restoring market functioning, and stabilising growth and prices. Globally, though initially, trade and asset prices were buoyed, but capital flows increased to emerging markets which were not easy to manage.
The bigger worry for the global economy, according to the IMF, was going forward. If the unconventional policies continue, how long could emerging markets, especially in Asia and Latin America, take the brunt. And, if the UMP was to reverse, what are the risks to the balance sheets of advanced central banks. These and related measures were discussed in detail in recent papers released by the IMF, especially one titled Unconventional Monetary Policies?Recent Experience and Prospects. As there is evidence that there is diminishing effectiveness of existing monetary measures, advanced countries could deploy other types of measures. Some of these could include pushing nominal rates into negative territory; and purchase of private assets such as corporate or bank debt, equities, real-estate and other physical assets. These measures would not be easy to implement, some even legally, and could impair existing markets.
In addition, costs and risks associated with prolonged use of loose monetary policy would also need to be managed. The major concerns are that banks and intermediaries may increase their liquidity risk; spurred by accommodative monetary policies, greater risk taking behaviour by economic agents could undermine financial stability; and delayed fiscal and financial sector reforms may hinder effectiveness of future monetary policy. Of paramount importance is the risk from exit policy. Rising interest rates would imply lower bond prices which would adversely reflect on balance sheets of central banks. If the central banks choose to reduce the size of their balance sheet they may incur substantial losses on sale of their assets. These losses could rise to nearly 4% of GDP in case of the US. There is also a possibility that transfer of profits from Fed to Treasury could suffer, which may lead to political interference in the affairs of the Fed. Increased uncertainty in the advanced countries does not augur well for global financial stability.
Indeed, UMP, analysed according to conventional wisdom, is in a mess. Probably the advanced nations are at a cusp of a new economic cauldron as the exit would not be easy. Well, for sure, emerging markets should brace themselves for higher capital flows.
In India, which has been facing the brunt of loose monetary policy of the advanced countries for more than a decade, there has been a discussion on exit policy of the US. YV Reddy, former Governor, RBI, has been talking about the need for a sound exit strategy since 2008. A strategy on how to get out when you go to a war has been missing in UMP. I am reminded of a young Abhimanyu caught in the Chakravyuha, a few thousand years ago, and it was not a happy situation.
The author is RBI Chair Professor, IIM Bangalore. Views are personal
