September 29, 2017


On September 20th, after a two days meeting, the Federal Open Market Committee (FOMC) decided to do what everyone was expecting. Indeed, the Fed Chair Janet Yellen, amid some evaluations of the good outlook of US, announced that the US central bank would keep the interest rates fixed at 1.00 – 1.25 % and, starting next month, will start to shrink its 4.5 trillion-dollar balance sheet. The stimulus provided by the aggressive asset-purchasing programs is no longer needed. The unwinding of the Quantitative Easing has eventually begun.


It was no bold move: through forward guidance, Yellen prepared the markets to this event. In fact, the dollar sharply appreciated against the euro and the yuan, but the phenomenon already started to fade on Thursday 21st. However, that was due probably to the signaling of a rate hike in December, which investors had not fully included in their expectations yet.


The FED knows it needs to be very careful to make the exit from QE as smooth as possible; the lesson from the ‘taper tantrum’ of 2013 has not been forgotten. At the time, the then Chair Ben Bernanke decided to reduce the amount of bonds purchased by the bank; investors panicked and the yields of bonds exploded. Treasuries lost $1.5 trillion in value overnight.


Central bankers clearly spent a lot of time to coordinate their movements towards monetary tightening.  The timing is right: the world is enjoying synchronized economic growth for the first time in many years; the recovery from the financial crisis is solid. Well, the FED was the first to raise rates – four times since 2015 – but that was obviously due to the better condition of US with respect to, say, the Eurozone, which suffered the sovereign debt crisis in 2012 as well.
The BoE Governor Carney announced an upcoming rate hike, and the ECB president Mario Draghi will most certainly start to lay down the plan for the European QE unwinding in October.
Some may question whether this is consistent with their mandate.


As a research paper by Goldman Sachs shows, out of the four major central banks of Western economies (BoE, FED, ECB, BoJ), only the Bank of England reaches unemployment below target and inflation above (but in this case the Brexit-originated political and economic environment plays a unique role, as recently outlined by the BoE Chair).
Instead, the US economy is still stagnating in lowflation, even if it enjoys a level of employment close to full potential.


The case of lowflation is a major issue that tantalizes central bankers and economists all over the world – especially in Europe, where the ECB mandate concerns only the level of prices and not employment.


The FED Governor Lael Brainard has recently addressed the problem. In her view, an unprecedent disconnect between economic models and inflation behavior has arisen.

She argues that resource utilization does not drive inflation as expected: the US are enjoying roughly the same level of employment of the pre-crisis years, when the PCEPI (personal consumption expenditure price index) was much closer to the target. Import prices do not play the role assigned by theory neither: their recent upward trend did not change the situation.

The proposal of Brainard is to focus on the balance sheet shrinking – without rushing with the unwinding – and raise interest rates only afterwards, when the pattern that inflation follows will be understood.


However, Yellen seems to have undertaken another course of action. According to her latest speech, we should not worry too much about an under-target inflation; the economist Gaplen at Barclays claims that the FOMC is confident that the phenomenon will be transitory and, over time, the PCEPI will pick up and follow the employment growth as it is expected to do.


Actually, this is a rather optimistic view. Economic growth and (expected) monetary tightening summon another controversial phenomenon: appreciation.
On September 7th, Mario Draghi recognized that volatility on the exchange rate increases uncertainty and threatens the price stability on the medium run. That is why the ECB will follow an extremely accommodating monetary policy for an extended period of time, especially as far as the interest rates are concerned – even if they are hitting their zero-lower bound.
However, this might be only a European concern: both the Euro and the Yuan (for very different reasons) are appreciating against weaker US Dollar and Pound (again, different drivers), and the Yellen intervention did nothing more than add a little volatility to the forex market.


Thus, this coordinated retreat from the aggressive assets purchase programs that Bernanke initiated during the Great Recession raises a big question concerning economic theory -  a question that has been lingering for a long time on the advanced-countries’ economies and now desperately needs an answer. Is the Phillips curve (the relationship between unemployment and inflation codified by the economists) still working? And if not, should central banks still target inflation?
This is not only an academic dispute; the different answers that will arise will shape the future monetary policy and, consequently, deeply influence the real economy. A real economy which is no more used to conventional conditions.


Let’s go back to the fundamentals. In the middle of the greatest financial crisis since the Great Depression, the FED Chair Bernanke realized that the conventional monetary tools were not enough and started a series of unprecedented (by dimensions) assets purchases. Many other central banks followed, filling their balance sheets with enormous amounts of corporate and long-term government bonds in order to decrease their yields and encourage credit.

Now that these special injections of money in the economies are coming to an end, we need to carefully analyze the side effects they brought about.


As the Bank of America strategist Barnaby Martin points out, this ultra-loose credit market allowed firms without positive returns on capital to survive many years. Those ‘so-called’ zombie companies haunt especially Europe, and they might cause a proper apocalypse once they will have to pay interests on their bonds.

Second, QE programs happened to damage middle-class savers. In order to maintain future consumptions, they now have to buy more expensive assets with lower yields.

Since the assets purchase programs ease the financial conditions of the governments, which can pay little or no interest on their national debt, this unintended consequence of QE has a serious political impact too: it might seem like a monetary tax that cut the middle-class spending to benefit the government finances.

Those who held large amount of assets at the beginning of the process and did not need to buy more of them during it, saw their prices skyrocket; unsurprisingly, the wealthy were better off.


Therefore, monetary policymakers need to take into account a vast array of business-related, social, political issues when they come to decrease their money injections. On top of that, there is the unresolved question of lowflation. Central bankers are cautious by nature, and the unwinding seems a gigantic challenge, maybe even more difficult to face than the Great Recession itself.


And still, we need it. Many investors and economists are worried about the birth of new speculative bubbles, encouraged by ultra-low interest rates. They fear that the macroprudential tools adopted during this period will not be enough. The bullish equity market will eventually collapse, as a research paper by Deutsche Bank analyzing possible crisis triggers argues. When it will happen, our economies will need central banks ready to react, which means with non-zero interest rates, in order to effectively reduce them, and a viable balance sheets, to be bloated if needed.


Mario Draghi and Janet Yellen, we must concede, are starting to build up appropriate defenses, but they risk not to finish them. Both their mandates are about to expire.
The first to (probably) leave will be the FED Chair, on February 2018. The US president has been ambiguous about her reappointment; despite having lately embraced the low rates policy and stopped the criticism against her, it still seems unlikely that Trump will choose Yellen for a second term. Currently, the top candidate is Gary Cohn, former president of Goldman Sachs. Realistically, he will not take any ruthless decision on monetary tightening; he may still represent a threat if he pushes for deregulation and dismantles the macroprudential tools, which are supposed to tame bullish markets and avoid violent bubbles’ bursts.


As far as Frankfurt is concerned, Mario Draghi is expected to leave his office on October 2019.
The Italian economist is praised by many as a true savior of the Eurozone; since the famous “whatever it takes” speech of 2012, he managed to defeat the German opposition and follow the FED unconventional monetary policies, together with interest rates at and below the zero-lower bound. This monetary bonanza largely benefited the Southern EU countries, partially releasing them from the burden of sovereign debts, and unlaced credit. The economic stimulus arguably saved the single currency.


Nevertheless, Draghi found fierce opposition in Berlin, especially by the finance minister Schaeuble, and in Frankfurt itself, by the Bundesbank President Wiedemann. Both repeatedly showed concerns about the unconventionality of the ECB course of action and the threat of consequent distortions in the financial markets. Many accused him of being biased towards the Mediterranean Member States; thus, the QE was considered as a policy aimed only to make their troubled finances more manageable.

Had this hawkish opposition been in charge, the unwinding would have started many months ago, and at a significantly and dangerously fast pace.


That is exactly what is coming next. The top candidate for the ECB presidency is Wiedemann itself, sponsored by the German Chancellor Angela Merkel. Even if he will not make it, given the likely opposition of Rome and Paris, the CDU will easily find an as much hawkish but less emblematic substitute. Even if not in the near future, the ECB will become less interested in overly indebted Southern fellows and keener on profitable yields and financial discipline. Most importantly, its new president will be eager to quickly make up for years of “ill-advised” monetary bonanza.


Interesting enough, the aforementioned paper by Deutsche Bank gloomily enlists a series of possible causes for the new future financial crisis. Amid global political risk, China sovereign debt, the enormous BoJ risky balance sheet, Brexit and its political consequences within EU, the upcoming Italian elections, we can find the unwinding itself, if imprudently managed.


Yellen and her colleagues must proceed with caution but decision. They must leave a strong legacy and lay down a solid and coherent path to monetary normalization, which needs to be followed by their successors. Mario Draghi promised that its “whatever it takes” would be “enough”. Let’s hope so, because we might all be dead in the long run, but for the medium one we still need central banks.














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