Saturday, July 26, 2014
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A Tale of Two Tapers

CAMBRIDGE – The United States Federal Reserve and the People’s Bank of China are not typically seen as two peas in a pod. But they have had similar experiences in recent weeks – and neither has been a pleasant one.

The Fed’s bout of indigestion started with Chairman Ben Bernanke’s June 19 press conference, where he warned that the Fed’s purchases of long-term securities might start to taper off if the economy continued to perform well – specifically, if unemployment fell to 7%. Stock prices swooned. Yields on US Treasuries spiked. Emerging-market currencies weakened on fears that capital flows from the US would reverse direction.

Indeed, the reaction was so extreme and alarming that a parade of Fed officials felt compelled to clarify. To say that the Fed’s policy of “quantitative easing” might taper off, they explained, was different from saying that it would be halted. When and how purchases of long-term securities were reduced would depend on incoming data. In particular, there was no guarantee that 7% unemployment would be reached before the end of the year.

By coincidence, June 19 was the same day that the People’s Bank of China decided not to provide additional liquidity to the country’s strained credit markets. The interest rate that Chinese banks charge one another for short-term loans had begun rising two weeks earlier on rumors that two medium-size banks had defaulted on their debts. The interbank rate went from 5% to nearly 7%. Investors expected that the PBOC would step in, as always, to prevent rates from rising further and slowing the economy’s growth.

Instead, the PBOC stood pat. Officials worried that banks had been lending too freely to property developers and large state-owned enterprises (which in many cases are one and the same). They were concerned that the banks, through their wealth-management arms, were borrowing excessively on the overnight market to finance high-risk investments.

In China, too, market reaction was violent. The Shanghai Composite, the country’s main stock index, tanked. Interbank rates shot up to 25%, raising deep concern about the stability of the financial system.

This was not what Chinese officials expected. Like their Fed colleagues, they found it necessary to clarify and backtrack. They reassured investors that they would “guide market interest rates into a reasonable range,” and backed their statements with credit injections.

Neither experience enhanced the reputation of the central bank in question. Though June 19 may not “be a date which will live in infamy,” few central bankers will remember it fondly.

But central bankers, like the rest of us, should learn from their mistakes. What are the lessons of this one?

First, the June 19 episode reminds us that central banks’ communications strategies remain works in progress. The Fed has repeatedly sought to explain its policies better. But, if a few relatively anodyne words can spark such a powerful reaction, then investors evidently remain uncertain, if not confused, about the Fed’s intentions.

The PBOC performed even worse, having done nothing to prepare the markets for its new anti-speculation strategy. The Chinese authorities are seeking to develop the renminbi into a first-class international currency. But China’s June 19 episode is a reminder that the PBOC in particular and Chinese policy-making institutions in general have a long way to go before they succeed in instilling the necessary confidence in both the renminbi and themselves.

A second lesson is that central banks are wise not to overreact to the latest bit of news. The Fed’s statements suggesting an end to quantitative easing appear to have been grounded in very recent evidence that the economy was improving. Now that the markets have reacted adversely, some investors have begun to worry that, as a result, the economy is doing worse. The Fed should wait for more – much more – data to come in before adjusting either its policy or its rhetoric.

The PBOC, similarly, seems to have overreacted to data indicating a bank credit boom. In fact, some of this supposed evidence was misleading, because it reflected nothing more than a change in regulatory standards that had brought hidden loans to the surface. The PBOC would have been wise to wait for more data, so that it could distinguish the trend from the accounting glitch.

A final lesson is that monetary policy is a blunt instrument for addressing asset-market problems. In the absence of inflation, it was mainly warnings about new asset bubbles that pressured the Fed to curtail its purchases of long-term securities. Similarly, worries about property prices drove the PBOC’s abrupt change of course.

Bubbles should be a concern, but the June 19 episode in the US and China reminds us that addressing them is first and foremost the responsibility of regulators. Central bankers cannot afford to ignore them, but they should be wary of reacting too soon. In the meantime, they have bigger fish to fry.

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  1. CommentedFrank O'Callaghan

    Professor Eichengreen calls attention to interest rates and central bank funding. These are not as fundamental as productivity, consumption, sustainability, employment and equality/distribution to an economy.

    Our modes of consumption and distribution have not kept pace with our modes of distribution and productivity over time. Unless we adjust soon, our new world of higher interest rates soon may plunge the developed world into the crisis of democracy happening in the population boom world as seen in the Arab stirrings now.

  2. CommentedProcyon Mukherjee

    The problem with the zero lower bound is that Fed can only make 'guidance' statements as it has no other instrument on hand. The question is any which way we see the Fed has to either say the economy is doing better or doing worse. In this case it settled for the former and the markets reacted the other way. Are we suggesting that Fed now should take a U turn? On the other hand making no statements is also not taken kindly by the market.

    The fact of the matter is that playing to the whims and fancies of the market cannot be the role of the Fed; by the gyrations that ensue each FOMC meeting we are repudiating the role of Fed to be the trustee of what happens well with the money it eases.

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