Since the start of the crisis, the major central banks have increased their balance sheets to stratospheric levels, multiplying their sizes by three, four, and more. Although the approach differed from one central bank to another,
they have created a lot of money to buy various assets such as government bonds, private debts and distressed assets held by failing commercial banks. This has led to a new euphemism, nonstandard monetary policy. When the crisis comes to an end, the next euphemism, exit, will reach the front page of all popular media.
It may be early to raise this question as the crisis is far from over. Optimism is back in the Eurozone but not growth. In the US, the fiscal cliff has been sidestepped but not the deficit issue and arbitrary sequestration, now expected to happen next month, is the worth possible solution with potentially disastrous economic implications. Great Britain has started to lose one of its stars as credit rating agencies rightly worry about continuing recession. Strikingly, Japan has become a source of hope since the newly elected government asked the Bank of Japan to… carry out nonstandard policies.
Still, even the most hopeless pessimists accept that the crisis will stop one day. What will oversized central banks do then? Meanwhile, is all this money floating around creating an inflation threat? The second question is easiest to answer. There is a well-known relationship between “money” and inflation, which has led many to predict that this massive expansion of central bank balance sheets will eventually result in massive inflation. This is not necessarily true. Confusion reigns because we mix up various forms of “money”. Inflation is eventually directly proportional to “money in circulation”, which includes cash (very small) and bank deposits used to carry out economic transactions. The “money” created by central banks, aptly called “central bank money”, includes cash (very small) and money held by commercial banks and other financial institutions like insurance companies. Since 2007, we have seen an explosion of central bank money but money in circulation has been very stable. The reason is well known. As the financial markets are in disarray, banks have largely lost access to liquidity and have stockpiled “money” lent by central banks, that is central bank money. At the same times, fragilized banks have limited lending, a process called deleveraging. The key point is that the sort of money that is associated with subsequent inflation has not increased. This is why inflation has not increased.
Mounting inflationary pressure?
Yet, flushed with liquidity, commercial banks have the ability to rapidly expand credit, which would increase inflationary money. They will surely do so when they have restored financial solidity and when growth prospects are good. This means that, to prevent a massive inflation boost, central banks will have to reabsorb much of the liquidity that they created and which is not currently circulating outside commercial banks and other financial institutions. Of course, the central banks know that full well. The next questions are: Will they? Can they?
Some people believe that central banks will in fact accept some inflation because this will help reduce government debts. This can work if the public debts are not indexed to inflation and of sufficiently long maturity. During the crisis, maturities have shortened and there has been some indexation before the crisis. This has reduced the effectiveness of the inflation tax. Inflation, therefore, is an option to deal with large public debts, but it is not as attractive as it was when it was last used in the 1970s. In addition, one lesson from this period is that inflation is easy to start, but hard to keep in check and extremely costly – in terms of growth and employment – to bring back down. This is a lesson that today’s central bankers have digested. They are most unlikely to ignore it. The other difference with the 1970s, is that central banks are now quite independent, so they can resist political pressure to inflate. The recent grumbling at the Bank of Japan, which most was “respectfully asked” to aim at a 2% inflation rate, the normal target in most developed countries, illustrates the difficulties that governments would face if they ever tried to coerce central banks into inflationary policies.
The most likely scenario, therefore, is that central banks will want to exit, i.e. to cut down the size of their balance sheets and reduce central bank money, when the time has come. This is where things become complicated. To start with, it is unlikely that the switch from crisis to healthy recovery will be clear-cut. Good signals will emerge, mixed up with sustained concerns so it will take time until we know fir sure that the crisis is over. If central banks move too fast, they might stunt the recovery, if they wait for too long they may miss the departure of the inflation train. After several years of crisis, they are likely to choose to take the inflation risk over the risk of a third recession and renewed stress in the banking system. Fortunately, the signal to act will come primarily from the speed of growth of bank credit, which is closely monitored and known in real time.
Interest rates – to raise or not to raise
Then comes the question of whether to raise interest rates before or after withdrawing liquidity. The two actions are linked. Withdrawing liquidity will lead to a tightening of monetary conditions, much as interest rates cannot be raised without withdrawing some liquidity. The real issue is whether the excess liquidity can be withdrawn without pushing up interest rate to very high levels. This is turn requires to understand whether all the extra liquidity will have to be withdrawn so that we go back to pre-crisis balance sheet sizes. Probably not. New bank regulation requires bank hold more cash. In addition, banks and other financial institutions may choose to be safer than before the crisis and hold more liquidity to depend less on market financing. Of course, we do not know whether this will be the case and, if so, to which extent. In addition, with a changed banking system, the level of the interest rate that is needed to achieve a particular monetary stance may be different from what it used to be. In addition, the effect of exit on exchange rates is not known and central banks will not all exit at the same time. Large movements among exchange rates may unnerve central bankers and politicians alike. All this means is that central banks will be in uncharted territory and will need to experiment. This is not particularly reassuring.
Finally, how exactly will central banks exit? In principle, they will sell back the assets that they have acquired, mopping up the liquidity that they created. But if they proceed fast, to prevent inflation, they will depress the prices of these assets. Not only will that disturb financial markets, and the financing of governments as these assets largely include public debts, but it could also impose capital losses on central banks. Even more of a concern is that some of the assets acquired during the crisis are of dubious value. There are solutions, though. Central banks can always issue their own debt instruments, which are probably the safest instruments that one can imagine. In addition, capital losses are not, and should not be a concern for central banks. They are not commercial operations and they can operate with zero or even negative capital, as some (Chile, Israel) actually do. This may mean seigniorage shortfalls for governments but seigniorage revenues are small anyway. Still, any income is good to take and hard to miss.
Until the crisis, we never saw nonstandard policies so exit strategies will be experimental. There are many questions, and some answers, but are we asking all the right questions and are the answers all correct? Experiments typically bring surprises, some good, some bad. The only way of reducing the uncertainty is by studying carefully before acting. Central banks are apparently thinking hard about exit, but they do so secretly. This is the most worrisome aspect of the question. The crisis is largely the consequence of groupthink among central banks, which agreed then that bubbles are not something that they need to worry about and, more generally, that financial stability is not a serious concern. Groupthink about exit could very well lead to mistaken strategies. It is high time to open the debate on a complex operation that will have to be performed, hopefully in the not distant future.