At some point this year the European and US central banks will attempt to unwind the extraordinary measures they took to keep their financial systems afloat during the financial crisis. As the minutes of the Federal Reserve Board’s December meeting illustrate, however, they are quite nervous about that prospect.
As Adam Carr notes, there is both division and confusion within the Fed about the scaling back and withdrawal of some of the quantitative measures it took during the crisis, measures that doubled the size of its balance sheet to $US2.2 trillion.
In the end they decided to do nothing to wind back the programs at the meeting, opting instead to maintain its plans to buy $US1.25 trillion of agency mortgage-backed securities and $US175 billion of agency debt in the first quarter of this year before gradually slowing the pace of its purchases “to promote a smooth transition in markets”.
Some members, however, believed it might be desirable in future to provide more stimulus by expanding the planned scale of the Fed’s already large-scale asset purchases and continuing them beyond the end of March, particularly if economic growth weakened or the functioning of the mortgage market weakened.
Another Fed member, however, felt conditions in the economy and markets had improved sufficiently to scale back the planned asset purchases and begin reducing the Fed’s massive holdings of securities. As it stands, most of the crisis measures are supposed to be withdrawn by mid-year.
The indecisiveness of the Fed is understandable. Its interventions during the crisis to flood the financial system with liquidity were unprecedented. Their premature withdrawal from a still-fragile and risk-averse banking system – and a stabilising but still barely functioning mortgage market – could by itself create adverse unintended consequences.
The contrary view is that leaving those facilities in place for too long and providing open-ended access to very cheap liquidity will inevitably have unpleasant consequences, whether through an eventual re-ignition of inflation or, in the near term, the encouragement of unproductive and potential destructive speculative activity.
The European Central Bank has already announced a measured program for progressively withdrawing its emergency stimulus measures, shortening the maturities of the funding it has been offering and narrowing the range of securities it will accept as collateral. Most of its programs will end in March.
The US faces a delicate task in winding down its programs because its banks have been relying on the ability to pursue near riskless arbitrages between the near costless funding from the Fed and the rates available on government guaranteed securities to rebuild their liquidity and profitability.
The US banks are said holding something of the order to $US1 trillion of excess reserves that in more conventional circumstances would either have been lent or used to buy back securities from the Fed. Demand for credit in the US, however, remains very weak and the banks themselves are still in recovery mode.
Pimco’s Bill Gross referred to the impact of the withdrawal of the emergency stimulus on carry trades today. As noted by previously the availability of very cheap funding hasn’t just led to banks deploying those funds in government guaranteed securities to create positive trades, but appears to have created a proliferation of higher-risk, higher-reward trades and asset bubbles in commodities, equity and high-yield debt securities and emerging markets.
The central banks know that they have to wean their systems off their dependency on the emergency stimulus and they know that process has to start this year and probably sooner rather than later if there aren’t to be unpleasant consequences.
They also know that withdrawing the measures will be an extraordinary delicate task, given the still-fragile and vulnerable state of their economies and institutions and the fear that a misjudgment could trigger an abrupt and destabilising rush to unwind the carry trades the massive infusions of cheap liquidity have spawned.
Hence the uncertainty and hesitancy that can be detected in the Fed’s minutes.
This article first appeared on Business Spectator.
James was the editor and publisher of SmartCompany and LeadingCompany for five years. He is now the Australian Financial Review‘s companies & markets editor, and a former BRW editor.
