Honey, I need to shrink the debt
The US Federal Reserve, otherwise preoccupied with inflation, seems to be recognizing the importance of one more variable: financial stability. The minutes of its latest policy meet show that some committee members including chair Janet Yellen are getting worried about financial stability.
Traditionally central banks across geographies and more so in advanced economies are either ostensibly targeting inflation or are at least focused on prices. Financial stability is not one of the priority mandates unless instability is knocking on the door.
This is why global debt levels, whether sovereign, private or even household, have been rising because of ultra-low real interest rates. The accompanying chart from the Bank for International Settlements’ (BIS’s) annual report shows global debt levels have been increasing. Global debt was $151 trillion in 2016, up from $128 trillion in 2010 and $105 trillion a decade ago. While reduction in interest rates was needed to stoke growth in the post-financial crisis period, it hasn’t triggered deleveraging.
The Reserve Bank of India in its financial stability report said, “There is a view that the increase in indebtedness is partially attributable to central banks’ ‘obsession with near-term price stability’, which means that so long as the increase in near-term inflation is limited (partly held back by both the tail winds of globalization and credibility of central banks), they have little incentive to restrain the build-up of financial imbalances.”
A look at the arguments of Fed members who endorse postponing the unwinding of its balance sheet reflects this obsession with near-term price stability. Fed members noted sluggishness in inflation and even said that balance sheet reduction is as good as policy rate increases.
But the ebbs and highs of central bank balance sheets have a direct impact on financial stability as they influence asset prices. Here Yellen’s comment that US equities are rich by some indicators shows that the Fed chair is indeed worried that it could precipitate another episode of financial imbalances by being in accommodative mode longer.
The fact that Fed officials are becoming uncomfortable on financial stability suggests that there is recognition of central bankers’ role in fuelling debt binges and that it is time to throttle back the accommodation.
With the Fed expected to start trimming its balance sheet as well as hiking rates, central banks are expected to slowly tread the path of tightening. What will then happen to the debt stockpile?
BIS notes that for tackling a financial cycle, monetary policy needs to be synchronized and symmetric. “Otherwise, over long horizons, failing to constrain financial booms but easing aggressively and persistently during busts could lead to successive episodes of serious financial stress, a progressive loss of policy ammunition and a debt trap,” states the BIS annual report.
Central banks need to pull the plug on liquidity through balance sheet reduction. And the Fed should lead. Needless to say, what that will do to asset prices will be interesting.