Where to next for central banks?

Saving the global economy might have been the easy bit – now central banks have to find a way to get out of the limelight.

The outlook for the world economy is far from sunny but talk of impending doom regarding the fiscal cliff in the US or the collapse of the Eurozone seems to have passed.  Central banks have been called on like never before to save us from economic catastrophe and have developed new strategies to deal with the unique problems thrown up by the global financial crisis.  But the deeper the central banks get involved, the more difficult it will be for them to extract themselves from their new dominant roles in propping up the global economy.  Signs of economic recovery mean that this tricky task is at hand but the way out will not be easy.

The first to have to come up with an exit strategy is the Federal Reserve in the US due to a relatively robust economy with the US economy expected to expand by 1.9% in 2013 and growth of 3.0% forecast for 2014.  The third round of quantitative easing means that the Federal Reserve is currently purchasing bonds worth US$85 billion each month with a promise to continue this until there is substantial improvement in the labour market.  With the unemployment rate having edged downward from 8.1% in August to 7.6% in June, the chairman of the Federal Reserve, Ben Bernanke has begun to talk of tapering off its bond buying which will be the beginning of the a long process of winding up the aggressive loosening of monetary policy.

The loose monetary policy has not only involved central banks becoming considerable buyers in the bond market but also interest rates being set at record lows.  It is fair to assume that these policies have helped ease the pain stemming from the global financial crisis, if not having staved off economic meltdown.  Yet, the flipside of the dominant role taken by the central banks is that the reversing of these policies brings its own problems.  Central banks have typically been supported for their actions in the face of possible disaster especially considering the squabbling of politicians.  While policies that boost the economy during slowdowns will always be welcomed, measures that add headwinds to an economic recovery (tightening of monetary policy) are unlikely to make central banks popular.  Yet, the bond buying and record low interest rates distort the economy and may create problems in the future. 

So a return to normality in terms of monetary policy is inevitable but it will be a protracted process with purchases of bonds by central banks being pared back followed by interest rates being nudged upwards all depending on the state of the economic recovery.  This chain of events may start this year in the US, maybe in the summer but probably later in the year or in early 2014, and will take at least a few years.  The decision making of the Federal Reserve will face even more intense scrutiny in the media considering the influence that its actions have over the markets for bonds and stocks (see Caution - windy road ahead for explanation).  The glare of the media will make it difficult to keep the majority onside as even the much-revered former chairman of the Federal Reserve, Alan Greenspan, discovered after falling from grace due to having been seen in hindsight to have left interest rates too low for too long.

The other major central banks will have the luxury of following behind the Federal Reserve.  The European Central Bank cut interest rates in May 2013 in a mainly symbolic sign of its continued intentions to bolster the Eurozone where the economy is expected to weaken by 0.3% in 2013 according to the IMF.  The real possibility of a breakup of the Eurozone was almost single-handily put to rest by the European Central Bank’s willingness to do “whatever it takes” to save the euro (for more, refer to "Whatever it takes"). Yet, the lack of a recovery has left the European Central Bank on red alert – everything is on hold in case another crisis breaks out.  The central bank in Japan is heading in the opposite direction to its US counterpart and is ramping up its monetary policy in the hope of kick-starting an economy which has been stagnating for the past two decades (for the details, see All bets are ON).

So trying times lay ahead for central banks and the rest of us left trailing in the wake of their actions.  Not only will the direction of prices for stocks and bonds depend on developments in monetary policy but gauging the suitable tempo of change by central banks will be crucial in encouraging the nascent recovery in the global economy.  It may be the beginning of the end in terms of central banks saving the world but there is still a long way to go to get to safety.