Trillions of new dollars, euros, yen and pounds are sloshing around the global financial system, a result of extraordinary efforts by the leading central banks over the last several years to try to yank their economies out of their long slump. And it has to go somewhere. Will that somewhere wind up being a new set of financial bubbles that pop and send us back where we started?
That’s the fear of a wide range of financial commentators and some of the central bankers themselves. It’s one of the most crucial questions facing the generation of central bankers taking charge now, and one with consequences for everyone on Earth. With a new report out Thursday, the International Monetary Fund is wading into the debate.
The IMF's “global financial stability report” includes a chapter (authored by S. Erik Oppers and five colleagues) on the risks of such central bank activism. It presents a thoughtful, measured take on what could go wrong after these many years of monetary action, even as it makes clear how much we don’t really understand about how the financial system is working, and not working, in this post-crisis era.
First, there's a new term to define. The IMF has coined its own name for the unconventional efforts undertaken by the world's major central banks in recent years to boost the economy -- including quantitative easing (or buying bonds with newly created money), policies to try to make more credit available in specific segments (credit easing, to use Fed chairman Ben Bernanke’s term), and public statements on policy to try to adjust investor expectations of the central bank's future actions (forward guidance).
The IMF groups all of these as “MP-plus,” or monetary policy plus. This could be useful: I’ve referred to these sorts of steps countless times as “unconventional” (including in the paragraph above), but now that the four most important global central banks have all been using them, and have for years, maybe they’re not so unconventional after all.
So, what are the potential risks? There are two broad classes: first, that these policies will tempt institutions to take on too much risk, blowing another bubble; second, that the central banks have insinuated themselves so deeply into various markets that when they withdraw, it will upset the economy.
In the first category, with ultra-low interest rates in place, pension funds and insurance companies might “reach for yield” by overpaying for risky investments, creating an asset bubble. Banks, trying to take on greater leverage, could get too complacent about the cheap money. MP-plus policies “could unintentionally lead to pockets of excessive search for yield by investors and to exuberant price developments in certain markets, with the potential for bubbles,” the IMF paper says.
In the second category, banks could become “addicted” to central bank financing, as the IMF puts it, delaying their reckoning with bad loans on their books and slowing an economic recovery. Credit easing policies, such as the Federal Reserve’s purchase of mortgage securities, could distort markets and make the central bank such a dominant player that a return to private investment is anything but smooth.
So, the IMF wants to ensure that everybody is thinking about these risks. But it also doesn't see much evidence that they've become so heightened that central banks should be backing away from their policies now. “MP-plus appears to have contributed to financial stability, as intended, but risks associated with it will likely strengthen the longer it is maintained,” the report said.
And being overcautious could lead central bankers to make a different sort of mistake --taking their foot off the accelerator when almost all the world's advanced nations still have lagging economies (including Western Europe, Japan, Britain and the United States, and excluding only Australia, Canada and the Nordic countries).
Here’s how the authors’ boss, IMF chief Christine Lagarde, framed that warning in a speech Wednesday. “Let me emphasize that, in present circumstances, it makes sense for monetary policy to do the heavy lifting in this recovery by remaining accommodative,” Lagarde said. “We know that inflation expectations are well anchored today, giving central banks greater leeway to support growth. But experience also tells us that this can have unintended consequences. Low interest rates push people to take on more risk — some of which justified, some of which not.”
Got that? Do everything you can to promote growth, Lagarde is telling her friends at the central banks. Just be sure not to do too much.