How do you stop a flood once the dam has burst? That's the challenge facing central banks as vaccine rollouts promise an end to the COVID-19 crisis.
Having hauled out a bazooka and even much greater firepower to keep investors in line during the pandemic, how will central bank policymakers be able to manage the trick of stowing these big guns away?
Central banks flooded the financial system with liquidity, backstopped markets as lender and buyer of last resort, and reassured investors they could create an infinite amount of money to cope with the crisis.
Easing Was Simple; Managing Market Expectations Could Be Harder
That was, in retrospect, the easy part. Managing expectations during the recovery will make communication the key to keeping nervous investors calm.
That has not really been the forte of central bankers. Let’s not forget the infamous taper tantrum of 2013 when Federal Reserve policymakers misjudged the impact of telling investors they planned to gradually reduce the quantitative easing implemented to counter the financial crisis.
Stocks and bonds tanked when then-Fed chair Ben Bernanke told a congressional committee that the Fed would probably begin tapering its purchases of bonds as the economy improved.
The Fed has grown more cautious in its remarks, but that doesn’t solve the fundamental problem of communicating central bank intentions and, even more important, convincing investors that the eventual tightening of monetary policy is in their best interest.
Against this background, the consensus forged by crisis could start to fray as divergent hawkish and dovish tendencies reassert themselves.
At the Fed, the interest-rate hawks – led by Esther George and Loretta Mester, presidents of the Kansas City and Cleveland regional banks respectively – will start lobbying for forward guidance that the expected economic recovery will require a less accommodative stance from the central bank. Doves like Neel Kashkari of Minneapolis and James Bullard of St. Louis will seek to dampen that kind of talk.
Similarly, the 25-member governing council at the European Central Bank will begin to diverge as hawkish German and Dutch central bankers push for tightening and dovish policymakers put the brakes on any action. Ironically, this may play to the strength of ECB president Christine Lagarde, whose political background makes her adept at finding compromise.
The Bank of England has been toying with the idea of negative interest rates, but clearly is reluctant to go that route. The question mark for policymakers there is how the economy will fare after Brexit, and opinions are all over the map on that issue.
Ultimately, the question for the Fed and other central banks is whether inflation will start to accelerate. The follow-up question is how they will react if it does.
Fed policymakers don’t anticipate raising rates through the end of 2023—at least, right now they don’t. But, as always, they will react to incoming data and revise their projections accordingly.
Will the Fed tolerate an inflation pace above 2% for longer than a nanosecond? Easier said than done, though they have said they will let it run for a while over 2% to counterbalance the long period with inflation below that target.
Other central banks will be constrained to follow the Fed’s lead. China may work at internationalizing the renminbi and liberalizing access to its financial markets, but a reactionary regime means that will be slow going, so the Chinese currency poses no threat to dollar dominance.
The EU will have to get serious about promoting a banking union if the euro is to become a rival to the U.S. dollar, and there’s no sign that will happen next year, or maybe even in our lifetimes. For now, that means the dollar and the Fed are in the pole position.
Perhaps everyone is right and inflation will not top 2% next year, or the year after that, or the year after that. That leaves the Fed with the dilemma of how to stop buying bonds, how to stop reinvesting in maturing bonds, how to bring its balance sheet under control, and, eventually, how to let the world know interest rates are going up.
That means investors should listen carefully.