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The central banks of the North Atlantic have promised that they will not raise the short-term safe nominal interest rates they control until the economies under their stewardship show substantial economic recovery.
So far the economies have not done so: they continue to be battered by the destructive fiscal headwinds of austerity, by uncertainty over whether the Republican Party will in fact attempts to crash the credit of the United States, by broken systems of residential finance, and by uncertainty about how the burdens of necessary structural adjustment are to be allocated. With all that, it would seem premature for central banks to even begin to talk about adopting a less stimulative monetary posture.
Yet the central banks of the North Atlantic are doing so.
They are not saying that they will break their promises not to prematurely raise interest rates. But they are saying that their tolerance for continuing to enlarge their balance sheets by purchasing long-term bonds for cash is very limited indeed -- the so-called "taper".The problem is that financial markets simply do not believe the central bankers when they say that a present desire to "taper" is completely unconnected with any future desire to raise short-term interest rates. Financial markets think, not unreasonably, the same central bankers who grasp now for excuses to cut off quantitative easing now will also grasp for excuses in the future to say that things have changed and that forward guidance promises should not be kept. And financial markets will continue to think this, unless and until central bankers come up with reasons for believing that further extensions of quantitative easing do in fact run substantial risks.
So let us try to help central bankers explain why the taper now is unconnected with future forward-guidance promise breaking. Let us listen for the reasons that further enlargement of North Atlantic central bank balance sheets carries substantial risks:
OK. Let us set out the reasons: The Federal Reserve spend an extra month buying an extra $85 billion of long-term U.S. Treasury securities for cash, and risks are increased because?
Some say risks are increased because financiers will then take that extra cash and invest it abroad, in order to keep such a capital flow from raising the value of their currency foreign central bankers expand their own money supplies and lower their own interest rates, overheating their own economies.
But is this risk the business of the Federal Reserve?
Others say risk is increased because when the Federal Reserve buys Treasuries the financial system responds by extending credit leverage and holding riskier positions in aggregate: a lower price of risk-bearing means, when financiers seek to report positive profits and reach for yield, a larger amount of risk-bearing capacity put to work. But this misses the fact that there is not just a supply of this risk-bearing capacity but a demand for people to accept risks as well. Quantitative easing takes Treasury duration risk off the table, and neutralizes it inside central banks that will hold the securities to maturity. So there is less risk in aggregate for the private sector to hold. Less risk in aggregate means more risk in aggregate? That does not make sense: Who is it that has issued all the risky bonds and taken out all the risky loans to increase the aggregate amount of risk? We simply do not see them. Would that we did, for they would've taken the money and set people to work building assets that they hope would allow them to repay their loans with a healthy profit!
Still others say that risk is increased not for the private sector as a whole, but for systemically-important institutions that are used to having short-term low-interest liabilities and long-term high-interest assets and relying on the law of large numbers to allow them to always hold their long-term bonds to maturity and thus to risklessly profit off the spread -- at least in the absence of a financial crisis, in which they would be bailed out anyway. But which are the particular institutions that are creating this systemic risk? If they are commercial banks, then the appropriate policy is to send in the bank examiners to make sure they are not taking undue risks with government-insured deposits, and to ready the FDIC to put them in receivership if necessary. If they are universal banks and the Federal Reserve policymakers do not trust Dodd-Frank to enable proper resolution and receivership, then should not the Federal Reserve be yelling loudly about Dodd-Frank's shortcomings, rather than sending "taper" signals, which raise interest rates and thus break its mandated commitment to aim for high employment?
Federal Reserve, and other central-bank policymakers, who believe that further extension of quantitative-easing policies poses risks need to explain exactly what those risks are and why we need to guard against them now. If not -- if the risks impelling the end of quantitative easing are left vague--then central banks will continue to fail to successfully build a firewall between their policies with respect to the size of their balance sheet and their policies with respect to the future path of interest rates.