The Taper and Its Shadow

BERKELEY – The central banks of the North Atlantic region have vowed not to raise their short-term nominal interest rates until the economies under their stewardship show substantial recovery. So far, that has not happened. On the contrary, these economies continue to be battered by the fiscal headwinds of austerity; by uncertainty over whether America’s Republican Party will, in fact, undermine the “full faith and credit” of the United States by allowing the federal government to default; by a broken housing-finance system; and by uncertainty about how the burdens of structural adjustment are to be allocated.
With all of these issues unresolved, it does seem premature for North Atlantic central bankers even to start talking about an end to monetary stimulus. Yet they are doing just that. They are not saying that they will break their promises not to raise interest rates prematurely. But they are saying that their tolerance for continuing to enlarge their balance sheets by purchasing long-term bonds for cash is very limited. The so-called “taper” of such purchases – though postponed by the US Federal Reserve last week – may be at hand.

The problem is that financial markets simply do not believe central bankers’ claim that their current desire to taper quantitative easing (QE) is not connected to any future desire to raise short-term interest rates. Investors believe, not unreasonably, that the same central bankers who grasp for excuses to cut off QE will also grasp for excuses in the future to annul their forward guidance concerning borrowing costs. And investors will believe this unless and until North Atlantic central bankers offer compelling reasons for believing that further enlargement of North Atlantic central banks’ balance sheets does, in fact, run substantial risks.

In what sense did risks increase when the Fed purchased another $85 billion of long-term securities for cash in September?

Some say that QE increases risk because financiers then take that extra cash and invest it abroad, causing destination countries’ currencies to appreciate. These countries’ central bankers then expand the domestic money supply and lower their interest rates, overheating their economies. But how is this risk the Fed’s problem?

Others say that risk is increased because when the Fed buys Treasuries, the financial system responds by extending credit and holding riskier positions in aggregate. When the cost of risk-bearing drops, a larger amount of risk-bearing capacity is put to work.

But this overlooks the fact that risk-bearing capacity has a demand side as well as a supply side. QE neutralizes Treasury duration risk – the sensitivity of bond prices to changes in interest rates – within central banks that will hold the securities to maturity. So less risk in aggregate means more risk in aggregate?

That does not make sense. Who has issued all the risky bonds and taken out all the risky loans to increase the aggregate amount of risk? They simply are nowhere to be found – though it would be wonderful if they existed, because they would have taken the money and set people to work building assets that they hoped would allow them to repay their loans with a healthy profit.

Still others say that risk is increased not for the private sector as a whole but for systemically important institutions that are accustomed to short-term low-interest liabilities and long-term high-interest assets. These institutions rely on the law of large numbers to allow them always to hold their long-term bonds to maturity, earning riskless profits from the interest-rate spread (at least in the absence of a financial crisis, in which case they would be bailed out anyway).

But which institutions are creating this systemic risk? If they are US commercial banks, the appropriate policy is to send in bank examiners to ensure that they are not taking undue risks with government-insured deposits and to prepare to put them in receivership if necessary. If they are US universal banks and Fed policymakers do not trust the 2010 Dodd-Frank financial-reform legislation to enable proper resolution and receivership, the appropriate policy is to highlight Dodd-Frank’s shortcomings, not send “taper” signals, which raise interest rates and undermine the Fed’s mandate to aim for maximum employment.

Fed policymakers and other North Atlantic central bankers who believe that further extension of QE poses substantial risks need to explain exactly what those risks are and why we need to guard against them now. If not – if the risks compelling the end of QE are left vague – they will be unable to counter investors’ belief that a taper today will mean a new path for interest rates tomorrow.

J. Bradford DeLong, a former deputy assistant secretary of the US Treasury, is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research.

Copyright: Project Syndicate, 2013.
www.project-syndicate.org

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