QE3? Don’t even think about it, says BIS

Because of the dismal economic situation in the United States, there is growing speculation that the Federal Reserve Bank might sooner or later embark on another round of “quantitative easing“, nicknamed QE3. The current version of this policy (QE2) is going to be terminated this month.

In its 81st new annual report, which has been published on Sunday afternoon in Basel, Switzerland, the Bank for International Settlement issues a dire warning against such a move. “Don’t even think about QE3!” is the big message the BIS sends to Ben Bernanke in Washington.

According to the BIS,  monetary policy is no longer part of the solution but part of the problem with regards to economic stability and prosperity. The central bank of the central banks even sees the fundamental credibility of  monetary policy at risk.

In general, the next twelve months will be tough ones for central bankers, the BIS is convinced:

“Monetary policy challenges, already difficult, are intensifying.”

Interest rates should be higher, and unconventional monetary policy should be reversed, the Basel based institution stresses. The current stance of monetary policy does more harm than good, they assert:

 ”The persistence of very low interest rates in major advanced economies delays the necessary balance sheet adjustments of households and financial institutions. And it is magnifying the risk that the distortions that arose ahead of the crisis will return. If we are to build a stable future, our attempts to cushion the blow from the last crisis must not sow the seeds of the next one.”

The BIS  is convinced that consumer prices are about to rise quickly and that central banks should swiftly react to contain inflationary pressures:

“Highly accommodative monetary policies are fast becoming a threat to price stability. “

The BIS is quite outspoken with regards to inflationary dangers in the industrial world and suggest that swift and bold rises of interest rates might become necessary to fight inflation and safeguard the reputation of central banks:

They claim:

“The spread of inflation dangers from major emerging market economies to the advanced economies bolsters the conclusion that policy rates should rise globally. At the same time, some countries must weigh the need to tighten with vulnerabilities linked to still-distorted balance sheets and lingering financial sector fragility. But once central banks start lifting rates, they may need to do so more quickly than in past tightening episodes.”

Quantitative easing should end, the BIS states:

“With the end of unconventional policy actions in sight, central banks face the risks associated with the resulting large size and complexity of their own balance sheets. Failure to manage those risks could weaken their hard-won credibility in delivering low inflation, as could a late move to tighten policy through conventional channels.”

Additionally, the monetary policy decisions of  central banks must not be influenced by their own exposure to government and private debt, the BIS stresses. During the financial crisis,  central banks massively bought governments bonds (and, at least in the United States, securitized mortgages bonds). Hence,  they are now facing interest rate risks, exchange rate risk and credit risks. Therefore, monetary policy decisions could mean they lose money themselves. For example, higher  long-term interest rates may lead to losses if central banks sell bonds. However, the BIS stresses:

“Given their large-scale government bond purchases, central banks are running the risk of being seen as either working to ease sovereign debt strains or having their policies rendered ineffective by the actions of debt managers. Central banks must guard against even the hint that they are using monetary easing as an excuse to monetise public debt. Markets and the public must remain confident that central bank balance sheet policies are a means of maintaining price stability and that, with inflation threats growing, policy will be normalised very soon.”

According to the annual report, the current era of very low interest rates in the United States, Great Britain and Japan endanger global economic stability. One potential source of trouble are carry trades, where investors borrow money in developed countries with very low interest rates and invest in emerging countries where they can earn higher returns. Those carry trade positions have been increased, the BIS notes:

“Funded at very low interest rates in currencies such as the US dollar and Swiss franc, these positions are bets that the high interest rate differential will more than compensate for possible countervailing moves in exchange rates.

The shift of funding has two potentially damaging effects. First, by exerting upward pressure on exchange rates in the emerging market economies receiving the capital flows, it makes their exports less competitive and puts a brake on their growth. For economies that are overheating, this currency appreciation is part of the natural equilibrating process. Second, large gross cross-border financial flows can fuel unsustainable credit expansions and asset price booms. What begins as a response to strong fundamentals can become a serious threat to financial stability.”

The BIS warns that we should not take too much comfort from the fact that inflation expectation still seem to be well anchored . They are convinced that this could change overnight and refer to the 70s as an example:

“As the experience of the 1970s and 1980s shows, once inflation expectations take off, a costly, protracted effort is required to rein them in.”

What do I make of this?

In recent months and years, I had a clear bias towards easy monetary policy and have  been criticising the ECB for being too tight. The big lesson from Japan as well as from the Great Depression is that policy makers are at risk to change their course too early rather than to late.

(Update: In 2009, Christina Romer, an economics professor with Berkeley and formerly an economic  advisor of Barack Obama, gave a speech  on that issue ["Lessons from the Great Depression"] that I found very convincing.)

Hence, I’m still not fully convinced that the Federal Reserve Bank and the Bank of England should change track now.

However, the BIS is making some good points. At least, they made me think twice.