CENTRAL banks are in a dilemma. Economies are at last expanding and inflation is beginning to accelerate, following years of slack growth. The question is, how do central banks counter inflation under present circumstances? How do they withdraw excessive monetary liquidity and raise interest rates without causing a slide in global bond, equity and property markets?
In its latest annual report, the Bank of International Settlements (BIS), the central banks’ central bank, discusses the difficulties in ending quantitative easing (QE) and normalising monetary policy. QE, ie, the purchase of trillions of bonds from banks and flooding the financial system with money, has caused a massive bond and equity bull market and sky-high valuations. Other assets, such as property and art, have also surged in the past few years.
Major central banks are now overloaded with bonds. At the end of April this year, the Bank of Japan owned a whopping 38.9 per cent of government debt, UK, 21.4 per cent, euro area, 16.8 per cent, and US 13.4 per cent, estimates the BIS.
“On average, 24 per cent of total central bank holdings of government securities are set to mature in the next two years,” reckons the BIS. “This puts a premium on avoiding cliff effects.”
In other words, to prevent a slide in global bond and equity prices, central banks “would tend to prefer a more gradual unwinding” of their positions. Central banks will also have to keep the market informed about changes in strategies to reduce liquidity, says the BIS.
The question is whether the gradual unwinding of positions will avoid financial disruption. The BIS advises that the reduction of excessive central bank liquidity and higher interest rates, should be delicately handled. If the market perceives that central banks are ending quantitative easing (QE) and intend to reduce their purchases of bonds, global investors could begin to take profits. The danger is that the selling could gain momentum, causing a sharp slide of both bonds and equities.
“The normalisation of monetary policy in the major economies has implications well beyond their borders,” states the BIS. US dollar-denominated credit to non-bank borrowers outside the United States amounted to US$10.5 trillion at the end of 2016. Moreover “emerging market economies (EMEs) are likely to be the most exposed (from) the backdrop of the exceptionally accommodative US monetary policy … US dollar credit to non-bank EME borrowers roughly doubled between 2008 and 2016, reaching $3.6 trillion at the end of that period.” Rising global interest and an appreciating US dollar raise foreign currency debt burdens, placing pressure on emerging markets, the BIS opines.
Despite these concerns, the BIS contends that the “bright picture” is projected global economic expansion of 3.5 per cent in 2017, in line with the long-term historical average. Unemployment rates have fallen back to levels consistent with full employment. The danger, however, is that the excess liquidity in the financial system, devaluation of currencies and decline in unemployment are beginning to cause inflation to exceed former expectations.
The BIS evaluates four risks – geopolitical ones aside – that could undermine the sustainability of the upswing. First, a significant rise in inflation could choke the expansion by forcing central banks to tighten policy more than expected.
Second, serious financial stress could materialise as financial cycles mature, if a market correction were to turn into a more serious bust. This is what happened most spectacularly with the 2008 to 2009 financial crisis.
Third, consumption might weaken under the weight of debt, and investment might fail to take over as the main growth engine. Indeed, an overarching issue is the global economy’s sensitivity to higher interest rates given the continued accumulation of debt (see table).
Finally, a rise in protectionism could challenge the open global economic order. History shows that trade tensions can sap the global economy’s strength.
These risks may appear independent, but they are not, says the BIS.
© Copyright Neil Behrmann
This article was first published in The Business Times, Singapore
Jack of Diamonds, the sequel to Trader Jack- The Story of Jack Miner will be published in early this year. Neil is also author of anti-war children’s novel Butterfly Battle- The Story of the Great Insect War. The updated 2015 Waterloo commemoration version of Butterfly Battle is on Kindle and e-books. Reviews are on neilbehrmann.net and Amazon and more reviews are welcome. If the books are purchased direct on this site, a proportion of the proceeds will go to low cost charities