Monetary boomerang
William De Vijlder
![William De Vijlder]()
William De Vijlder
Economic adviser to the general management of BNP Paribas, Professor in economics at Ghent University
In most countries, central bank independence from government is taken for granted. Yet, the autonomy, i.e. the ability to do whatever a central bank considers necessary within its mandate, is sometimes surprisingly limited, albeit for other reasons.
The first reason is the greater role played by domestic financial markets. Over the decades, the ratio between stock market capitalization and GDP has grown significantly and, more recently, quantitative easing has led to a massive rise in investment in corporate bonds. The stock market has also benefited, albeit more lastingly in the United States than in the Eurozone. As the riskier asset classes (equities, corporate bonds, etc.) are more sensitive to monetary policy, it makes sense for a central bank to consider how the markets might react before tightening its policy, just as it did when policy was eased (remember that when a central bank eases, the financial market reaction is considered as a key transmission channel by means of a wealth effect, i.e. people feeling richer and hence spending more when the stock market rallies, and confidence effects). The aim is to avoid major corrections and the resulting detrimental effects on the real economy. In practice, taking into account how the markets will react can lead to a less restrictive policy: the fear of e.g. an equity market correction introduces a dovish bias in the conduct of monetary policy. As always, the challenge is to find the right balance between ignoring the markets and being hostage to them.
Capital flows are the second factor limiting central bank autonomy. Work done by the BIS in particular has shown the importance of the repercussions of U.S. monetary policy on bond yields in other countries, particularly the emerging ones. When the U.S. eases its monetary policy, capital pours into the emerging countries forcing the central banks to cut their interest rates more than they would have done based on local economic factors alone. And those capital inflows also push the emerging currencies up against the dollar.
When a U.S. monetary tightening is on the cards, the pendulum swings the other way; the emerging currencies fall, the dollar strengthens and investors begin to pull out of the more volatile emerging markets. This causes the financial and monetary conditions index (FMCI) in the United States to tighten. The FMCI is a synthetic index that reflects the impulse or contraction caused by the behaviour of variables that influence GDP: the dollar, stock market, bond market, credit market, etc. The tightening of the index is caused by a boomerang effect; it is the previous aggressive monetary easing that "brings a cold wind" to the United States when the Federal Reserve is thinking about tightening its policy. This phenomenon has also been a contributory factor in its decision not to increase rates since the December 2015 rate hike on the grounds that the international environment was too unstable. This reading has now evolved in a positive way as of late.
It is also a kind of "self-stabilizing" mechanism: the mere mention of monetary tightening is enough to set off reactions that reduce the need to increase rates, reactions that are followed by a softer tone, a fall in the dollar and an easing of monetary conditions. And the pendulum swings back again...
Some observers believe that these forces of action and reaction keep the economy on track, like an experienced driver who can negotiate a winding road at speed through a subtle combination of braking and acceleration. In the world of economics and business, that can work if there are no new shocks (obstacles on the road). In reality, shocks happen and prompt a (monetary) reaction. The downside of all this is that the Fed will struggle to build enough leeway to lower rates in the event of a sharp slowdown in growth. So it is not surprising that, at the moment, there is much debate in the U.S. academic world on what will happen when the next recession hits if the official rate is still close to zero. A debate that will no doubt also rear its head in the Eurozone before too long.