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?