But it probably can’t do so alone.
But it probably can’t do so alone.
A year and a half ago, in a piece I wrote for Capital Matters, I warned that unwinding the Federal Reserve’s swollen balance sheet and thus removing the “lid” on suppressed interest rates would cause . . . turbulence:
Even a mild downturn in the wake of bursting the stock market bubble would have grave consequences following so closely after the pandemic. Creation of another housing bubble would be catastrophic.
So here we are.
The stock market has gotten socked, and new home sales are plunging, with home prices now looking to follow suit. The unfortunate and ironic consequence of the Fed’s well-intentioned effort to spread prosperity as widely as possible with maximum stimulus — unresponsive to incoming data because of a backward-looking framework — is that the disadvantaged population it aimed to help will suffer the most from “last-hired, first-fired” syndrome in the downturn to come.
The original target of the Fed’s earlier quantitative-easing (QE) policies — the bond market — has now ceased to track the Fed’s swollen balance sheet. As described by Ben Bernanke:
QE does indeed appear to work in practice, affecting financial markets—and, through them, the economy. . . . Central-bank purchases of longer-term securities reduce the supply of those securities held by the public, driving their prices up and their yields down.
The chart below illustrates the close relationship between the size of the Fed’s balance sheet and ten-year Treasury-note yields, which are considered the basis for determining home-mortgage rates.
The Fed’s own research indicated that the post-financial-crisis QE programs reduced bond yield by about a full 1 percent. In the chart, ten-year yields fall in this period from 3–4 percent to 2–3 percent. Post-pandemic QE doubled the Fed’s balance sheet and seemed to have doubled the balance-sheet effect, bringing yields down further to 1–2 percent.
As the Fed began raising short-term interest rates in March, the relationship between the ten-year bond yield and the size of the balance sheet started to fray. With ten-year yields still south of 3 percent in August, below core inflation of 5–6 percent, Fed chairman Jerome Powell began jawboning rates still higher with his aggressive Jackson Hole speech, further severing yields from the balance-sheet effect.
One financial market that is still influenced by central-bank balance sheets is foreign exchange. The charts below compare exchange rates between the euro and Japanese yen with the difference in growth rates for the portfolios held by the European Central Bank and the Bank of Japan, which have been accumulated executing QE.
For each currency pair, as the Fed boosted asset growth responding to the pandemic, the dollar declined, and, as the Fed throttled back its growth while the ECB and BOJ maintained theirs, the dollar jumped. There are multiple factors affecting the exchange rate, but each pair appears significantly related to the relative differences in central-bank activity.
As the dollar constitutes over 50 percent of global foreign-exchange holdings and transactions, and many commodities are accordingly priced in dollars, foreign-economy inflation is sensitive to dollar exchange rates. For Europe, high inflation rates have been spurred by even higher import inflation and by the depreciation of the euro against the dollar, as shown in the chart below.
For the euro area, a major part of the Continent’s 10 percent inflation has been the near 40 percent increase in import prices, which has been swollen by the dollar’s 20 percent gain on the euro.
In the following chart, Japan’s numbers are different, but the analysis is similar.
Japan’s recent consumer inflation was 3 percent, which doesn’t sound like much compared with the U.S. and Europe, but Japan hasn’t seen that level since 1982. Import inflation’s now running near 50 percent and the yen’s fall against the dollar of over 30 percent figure prominently as causes of Japan’s new higher inflation.
So foreign-exchange markets are also beset by instability as central banks unwind their balance sheets in an effort to combat the inflation caused, in part, by building up those balance sheets in the first place.
Currently, these large central-bank balance sheets are serving no policy purpose. In fact, they counter the effort of raising interest rates to fight inflation: The Fed and ECB are trying to raise interest rates, while the swollen balance sheets suppress them. The best path out of this awkward position is, as I proposed in National Review at the beginning of this year, for central banks and treasuries to cooperate to exchange new Treasury debt for current reserves at central banks, while canceling the treasury issues in central-bank portfolios. This avoids going through the financial markets (and all the dislocation that would entail), and rapidly brings down central-bank balance sheets while leaving government and private-sector financial positions unchanged.
Given the relationship between central-bank balance sheets, foreign-exchange rates, and inflation, it is important that central banks coordinate any such stabilization operations. If rapid balance-sheet reduction through swaps of reserves for debt requires too much agility, which cumbersome balance sheets don’t allow, the central banks can at least coordinate the pacing. For example, Europe can step up reduction while the U.S. slows down. An example of such coordination is the 1985 Plaza Accord, in which the major advanced economies agreed to coordinate exchange rates for macroeconomic stability.
Given the different situations in which major economies find themselves today, and demonstrations of financial-market power such as that which the U.K. has experienced, fixing exchange rates is too tall a task. Coordinated central-bank balance-sheet reductions, though, can stabilize FX markets, nudge currencies in desired directions to dampen global inflation, and leave each central bank free to pursue domestic objectives with interest-rate policies.