Fixing the roof while the sun shines
Is it all blue skies on the path to normalising monetary policy, or are there clouds on the horizon?
On 19th and 20th April, the G20 Finance Ministers met for the second time this year.
As is usual for these meetings, ministers exchanged views on a number of topics. These included recent economic and global developments, the global outlook, risks facing the economy – and what measures are in place or actions being taken to minimise and mitigate these risks.
The global economy is starting to grow
One topic that ministers agree on is that we’re starting to see the green shoots of global recovery following the 2008 recession. Because of these shoots, ministers have reinforced their intention to continue to focus on the normalisation of monetary policy globally.
Since 2008, monetary policy has been in a state of inertia in pretty much every country. Interest rates have been held at the lowest rates for the longest time in current history.
It was needed at the time to prevent an all-out global depression, but it was a state we all knew couldn’t last forever. The question now is, how do we get back to normalisation without running the risk of destabilising and possibly disintegrating the fragile global growth seen in recent years?
And, is getting back to pre-2008 monetary conditions, in fact, the best idea?
Why should we normalise?
Let’s look into the reasons given for ‘normalising’ policy.
The first (and second) reason relates to inflation – more precisely the avoidance of too high or too low a spike. Next, you have the argument that we need to rebuild the policies before the next crisis. For example, if a crisis on the level of 2008 were to happen again now – just what could be done in terms of policy reform to try and counter it? And the last reason is that normalisation aims to prevent global financial instability.
But if not done correctly, normalisation itself could be the catalyst for instability.
What are the risks?
Central banks are now starting to take away some of the monetary accommodations we’ve seen over the last decade by raising short-term interest rates and reducing their balance sheet.
This causes premiums that need to be paid to investors to increase, meaning banks have less money for themselves, which is referred to as a tightening in financial conditions. If this happens it could lead to less borrowing as a whole, causing volatility within financial markets.
Another potential area of disruption for the markets is the risk of an inflation surprise if it rises too quickly or falls too fast. This could have a negative impact because in some countries, policy rates have risen quicker than expected but markets are continuing to price on the basis of a slower, more gradual pace of change.
This means that, at the moment, markets aren’t really factoring in the changes to inflation a large policy rate change (for example) may bring, and therefore companies may not have the capital they expected, due to less revenue being created by an up or downward spike in inflation.
The risk of a rise in defaults
Emerging markets are particularly vulnerable to a change in current financial conditions. This is because, thanks to the current economic climate, more investors than ever are involved with emerging markets. These lower level ‘weaker’ investors would be the first to default if there was a change.
Similarly, the current leverage loan market that is made up of commercial loans that’ve been given to borrowers who aren’t investors or already have large amounts of debt, is also at risk of being crippled by a ‘too fast, too soon’ approach to normalising policy.
In the past few years, this market has grown massively. Whilst regulators have attempted to rein in risk-taking, there’s no denying that the quality of creditors within this pool are more vulnerable against movements in the global economic market than regulators would like them to be. A sharp rise in defaults of these loans following a tightening of financial conditions or a complete shutdown of the market would have large and wide negative implications for the real economy.
We are seeing attempts to curb this lending behaviour, especially in the UK and the US. However, this is also causing a trend towards borrowers looking at alternative finance solutions outside of the banks themselves.
Banks still aren’t up to full strength
Another element which needs careful monitoring is the fact that there are a number of financial institutions who still need to strengthen their balance sheets and increase the level of capital they are carrying before any large-scale changes. As it stands, the shock of financial tightening could cripple the sector once more.
An interlinked global economy may not be good for growth
Whatever changes are made nationally, it’s clear they will have worldwide repercussions. Economies are so interlinked that there isn’t a way to diverge them to protect against the risks of making change and creating volatility in specific markets or countries.
What is apparent from the risks above is that they all share a similar if not identical mitigation and minimisation strategy. Change needs to happen smoothly, with no ‘too fast, too soon’ element that will increase the vulnerability we are seeing within markets.
We also can’t deny the power of communication in the success of normalising policy. Those policymakers and investors involved within this global change need to understand exactly what is coming from each nation – and how they need to prepare for it. In this delicate game, there is no such thing as a good surprise.