A strong stock market and higher-than-expected job growth have put the US Federal Reserve and its governor, Ben Bernanke, under pressure to outline a possible road map for an exit from this extraordinary policy accommodation, notes Akash Prakash
We are beginning to see active discussions about an exit from the extraordinarily low interest rates and quantitative easing policies in both the United States and the United Kingdom, even though both countries are still experiencing high unemployment rates.
These discussions have begun since both economies seem to have stabilised and there is concern that excess use of these policies will lead to unintended side effects that may outweigh the benefits.
A strong stock market and higher-than-expected job growth have put the US Federal Reserve and its governor, Ben Bernanke, under pressure to outline a possible road map for an exit from this extraordinary policy accommodation.
This is a topic of great significance to equity and bond markets.
Can they continue to keep going up in the absence of the Fed stimulus?
When will Mr Bernanke start to taper off the stimulus? What would be the implications if the Fed stopped buying securities?
How will the Fed reduce its current gargantuan holdings of these instruments? All these issues and more are the top priority for most investors.
Indeed, at the first sign of a hint from Mr Bernanke that these unconventional policies may be removed, markets have faltered.
The International Monetary Fund has come out with an interesting paper in this regard, titled 'Unconventional Monetary Policies -- Recent Experiences and Prospects'.
The paper argues that while quantitative easing may have been the right way to respond to the broad-based economic crisis, its impact on the macroeconomy was quite limited and was declining with time.
The paper highlighted that any exit from these policies was going to be difficult and would potentially create volatility in all asset markets.
The IMF economists have also tried to project the losses each major central bank will take on its stock of government bonds as economic conditions normalise and interest rates rise.
For example, they estimate that if we follow the pattern of 1993-94, when the Fed began to normalise interest rates from a starting level of three per cent, central bank losses would equal between two per cent and 4.3 per cent of gross domestic product for the US, UK and Japan.
These figures are the capital losses on the central banks’ government bond portfolios as rates rise and push bond prices lower.
These losses will also be a one-time fiscal burden on the governments concerned, as they will end up paying for them either through reduced central bank dividends or through recapitalisations.
Just to put things in context, in 1994 Alan Greenspan, Fed chairman at the time, raised the federal funds rate from three per cent to 4.5 per cent, which pushed 10-year US Treasury bond yields up by 200 basis points.
Just a 200-basis-point rise was seen as a 'bloodbath' by bond market participants, and a similar rise would again cause the type of losses highlighted above.
The scary thing, of course, is that in this cycle we are starting with the federal funds rate at effectively zero, and 10-year yields below two per cent.
To get anywhere near normality, the amount of adjustment required this time is far greater than in 1994.
The bigger the adjustment, the more the scope for volatility, losses and sharp moves in asset prices.
The IMF report also contains estimates of the damage if the central banks’