Since the 2008 financial crisis, central banks have been rewriting the global economics textbook.
They have grown more powerful than ever, taking on responsibility for boosting the economy as governments cut spending and for making sure the financial sector is secure and stable.
US Federal Reserve chief Janet Yellen wrote a new chapter in this growing textbook on Wednesday, when she called an end to the seven-year run of ultra-loose monetary policy aimed at re-inflating house prices, stocks and government bonds.
The chapter is called: “How to start raising interest rates without the markets collapsing.”
And Mark Carney, governor of the Bank of England, might want to read it.
When Yellen raised rates from 0.25% to 0.5% on Wednesday, stock markets around the world boomed on Thursday. Carney would want a similar reaction.
The danger of raising rates is that it could cause markets to dip. Cheap money has been inflating stock markets over the last 7 years and low interest rates have driven people to invest in assets like stocks and houses that are still rising. Once this policy of low rates and easy money is reversed.
Once this policy of low rates and easy money is reversed, you’d expect a lot of people to bank their gains and get out.
Unemployment in the UK is falling and retail sales and house prices booming, so the Bank of England will likely need to pull off a similar rates rise within the next few years.
Here’s what Carney could learn from Janet Yellen’s playbook:
Step 1: Give every a very long lead up.
The US Federal Reserve has been signalling that it’s ready to raise rates since around Spring 2015. That’s a long time, long enough for the market to get itself ready for the inevitable.
“In our view, and at the time of writing, the Fed communication machine gets a ‘thumbs up’. Its forward guidance has set the market up well for this hike,” David Absolon, Investment Director at Heartwood Investment Management said in an e-mailed statement.
It wasn’t all smooth and easy. The Fed learned a difficult lesson in September, when Chinese markets crashed in June and August ahead of the potential rise. The market volatility was too much, and the Fed ducked out, signalling a rise in December instead, by which time everyone was ready.
Step 2: Don’t raise rates by much.
Although raising rates from 0.25% to 0.5% is technically a doubling of the interest rate, it was well in line with the market expectations.
It’s a symbolic raise more than anything, and not really not enough to start people rushing into savings, tearing their money from the stock market and causing panic.
Here’s Bloomberg’s Simon Kennedy (emphasis ours):
The era of easy money in the world’s major economies isn’t close to being over.
Even after Federal Reserve Chair Janet Yellen and colleagues raised the target range for the federal funds rate to 0.25 per cent to 0.5 per cent, that’s still way below its 2 per cent average since 2000 and the 3.2 per cent of 2000 to 2007.
Step 3: Balance out the prospect of future rate rises with an emphasis on watching for dips in inflation.
Oil and commodities prices are very low. So, inflation — one of the goals of central banks — is hard to come by at the moment.
For investors and business owners, low inflation makes debt repayments more expensive over time. If you’ve borrowed money at an interest rate of, say 3%, but can’t put your prices up, then you have to sell more stuff to make repayments. That’s tough.
But Yellen calmed the markets by showing that she understands the risks of raising rates while inflation is so low. She said that the Federal Open Market Committee (FOMC) is committed to not let inflation persist below a 2% goal and that “we really need to monitor actual inflation performance” before the rate-rises continue. If weakness in inflation is looking like it is not transitory, “that would give us pause,” she said.
Step 4: Don’t sell all your government bonds at the same time.
Perhaps the hardest thing for the Fed to do as it rolls back its crisis-era policy is return its balance sheet to normal and sell-off all the assets and government bonds it had accumulated.
If they announced a rate-hike and an asset sale at the same time, the bond markets would have reacted badly. But the Fed trod a cautious path.
Here’s how that Fed balance sheet has exploded over the years:
Here’s UBS analyst Drew T. Matus on the subject (emphasis ours):
They did not offer up a schedule for returning the balance sheet to normal via roll-offs or (less likely/more problematic) asset sales. We had anticipated that the Fed would begin to allow roll-offs by mid-year as they continued to normalize policy. However, the statement notes that balance sheet adjustment is unlikely until “normalization of the level of the federal funds rate is well under way.” As such, it now seems likely that a sustained balance sheet roll off should not be expected until 2017.
Step 5: If possible, make it a unanimous call across the committee.
Monetary policy at both the Bank of England and the Federal Reserve is set by committees, which vote on when and how to raise or lower interest rates.
If you’re going to start unwinding a seven-year policy, it helps if everyone is on board. It’s a signal to the market that the change is a permanent one and they can count on it going forward.
While the Fed decision was unanimous to raise rates by 0.25%, the Bank of England’s last Monetary Policy Committee was 8-1 against a raise.
When the time comes, Carney will want to get as much support as possible from his other committee members avoid a 5-4 or 6-3 split decision to show everyone is on board and in agreement.